Friday, August 29, 2014

Long Term Non-employment

The Financial Times has an interesting article on long term unemployment.  It is a review of this presentation at Jackson Hole by Jae Song and Till von Wachter.

They utilize longitudinal microdata to track the employment status of displaced workers over time.  Using "non-employment" in lieu of "unemployment", they find little difference between the re-employment behavior of workers in the recent recession and workers of previous recessions.  Here is a graph of very long term non-employment persistence from the paper.  While there has been some change in the trend over time, there is little difference between recessionary times and expansionary times.  Also, there is little difference between the outcomes since 2008 and previous periods.  This is a fairly shocking finding, considering the well-known existence in the BLS's Household Survey of a large quantity of very-long-term unemployed workers.

Here is a graph of unemployment duration by age.  Keep in mind that short term unemployment durations are pretty normal now, so all of this extra average duration is coming from 1/6 of the pool of unemployed workers.  So, estimating from BLS data, it looks like about 5.2% of the labor force is unemployed in a fairly normal labor market, with average unemployment durations of less than 20 weeks.  Then, there is another 1% of the labor force that is unemployed, with an average unemployment duration of more than 120 weeks.

At first glance, these data are telling two different stories.  Here are some more graphs from the article.  First, this graph shows the fraction of the labor force that has been non-employed for one year, two years, etc.  This shows that extended unemployment was slightly worse in the 2008 recession than it had been in 1980, but not excessively worse.

The next graph (Figure 12A from the paper) shows the re-employment behavior of displaced workers in four recessions.  The recovery to employment in the 2008 recession has followed a pattern similar to previous recessions.  It is worth noting that a displacement episode appears to lead to a permanent 10% reduction in employment among the affected workers.

Finally, in the Figure 6A from the paper, we can see the surprising finding that the level of long-term nonemployment has been unusually low in the 2009-2011 period.

This suggests that much of the very long term unemployment in the current count is mostly a categorization issue related to workers whose behavior hasn't been materially different from previous recessions, but who may have been more likely to refer to themselves as unemployed in surveys because of subtle framing effects related to public labor policies, such as emergency unemployment insurance (EUI).  If that is the case, it would suggest several implications:

1) Unemployment has been overstated, relative to previous recessions.  This would apply to the approximately 1% of the labor force that currently is categorized as unemployed with very long unemployment durations.  It would also apply to the U-6 unemployment rate that includes marginally attached and part time workers.  The paper outlines how there tends to be marginal employment activity over time with long term non-employed workers, after a displacement, but that over time permanently non-employed workers become a larger proportion of the remaining non-employed.  Following this pattern, we should continue to see a reduction in U-6 unemployment.  I suppose that we might end up with a permanently self-identified population of unemployed workers, but I think it is more likely that to the extent that this group reflects the displaced workers who permanently leave the labor force, they will slowly begin to self-identify as not-in-the-labor-force.

So, if this is the case, the current unemployment rate, stated comparably to previous periods, might be in the low 5%s.  This would explain how real wages have been higher than we should have expected, given the unemployment rate.  The authors also point out that the permanently non-employed displaced workers tend to be older, which also might explain why unemployment in this recession tended to be excessively high for older age groups.

Here is a graph of employment flows.  Note that the most unusual movement in the recent recession was the unusual increase in flows between unemployment and "Not in Labor Force".  Flows between Employment and "Not in Labor Force" and between Employment and Unemployment reached levels slightly worse than the 2000 recession and about the same as the labor market in 1995 when these data series begin.  And, these sets of flows are currently back at normal recovery levels.  This would lead one to expect a business cycle where unemployment topped out in the high single digits and is back around 5%.  The outlier here is the flows between unemployed and "Not in Labor Force", which moved much higher, relative to the other flow sets, and which remain elevated.  Could this unusual movement reflect a change in self-identification and categorization among marginally attached workers who, in previous downturns, simply identified as "Not in Labor Force"?

This also comports with the recent high level of job openings and the idea that, adjusted for demographics, JOLTS indicators point to a historically comparable unemployment rate around 5.7 (which, given our current demographics would come in at around 5.3%).

2) I have been too hard on EUI.  If this paper is on to something, then EUI didn't change labor behavior significantly, so it shouldn't be blamed for the long-term unemployment problem or for significant hysteresis in the labor market.  These are workers who are mostly just being labeled differently within a fairly typical labor market behavior.  I would still argue that it might not be the most efficient redistribution program, but this paper seems to support the argument that the apparent increase in unemployment durations from EUI comes mostly from movement between "Not in Labor Force" and Unemployment, not from delays in re-employment.

To the extent that this data is informative, it might suggest that in the next downturn, an extremely generous EUI program won't necessarily be that damaging to the labor market - it will just appear to be.

These implications would all generally point to a more optimistic picture of the current economic context.  It would mean that historically comparable Labor Force Participation took a deeper cyclical dive than the reported numbers suggest.  Although, the adjusted statistic would show a dip earlier in the recession, with stronger recovery since then.  But, it also means that we are currently basically recovered and that the labor recovery was stronger and sooner than we thought it was.  Much of the remaining reductions in unemployment would typically be recorded as re-entries into the labor force.

Finally, these findings show how beneficial functional NGDP targeting could be.  There is something to be said for the creative destruction that might come out of a difficult economic period.  But, I think it's incorrect to argue for unnecessary economic disruptions.  The aggregate costs surely outweigh the benefits.  This paper points to significant permanent disemployment coming from economic dislocations.  If some of these labor disruptions are a result of suboptimal monetary policy, and if more stable nominal demand could prevent some of these dislocations, it could lead to higher labor force participation and utilization over time.  I don't think higher labor force participation should be considered a goal, a priori.  But, the permanent disemployment from these dislocations are almost certainly inefficient and are not remotely optimal for the affected workers, so in this case, it would represent improvement.

Wednesday, August 27, 2014

Squaring the Circular Logic of the Interest Rate-Leverage Connection (Updated)

I have outlined theoretically and empirically how the equilibrium level of corporate leverage, counter-intuitively, could rise when interest rates rise.  Here is a graph of corporate debt and equity values over the past half century (adjusted for inflation), with interest rates and equity premiums.

The next graph compares corporate equity and debt levels as a proportion of operating profits to nominal 10 year interest rates.

Now, regardless of any problems with this theory, it is clear that there is very little connection between relative debt growth rates and interest rates, and there is no evidence of firms significantly leveraging up on debt when rates are low (either real or nominal rates, short or long rates).  Except for recent periods of cyclical disequilibrium, debt levels have remained at a relatively stable proportion of operating profits over a long period of time.

In fact, due to the relative stability of debt levels, I have pointed out that the changing leverage comes about mostly through changing equity values.  So, generally when stock market levels are high and PE ratios are high, this is not a product of frothy markets fed by debt-accumulating corporations.

I recently was looking at Robert Shiller's CAPE ratio, and noted that its fluctuations follow a very similar pattern to the inverse level of interest rates and the inverse level of leverage.  In other words, when CAPE is high, leverage (Debt to Enterprise Value) tends to be low and interest rates tend to be low.  But, you might notice some circular logic here.  Enterprise value is a product of price.  Since debt levels are fairly stable, the change in leverage comes mostly from a change in enterprise value, which is mostly going to come from a change in share price.

So, how do we know that this isn't just an accounting identity?  To start, as I mentioned above, debt doesn't have to be stable.  In fact, I think it probably bucks conventional intuition that debt levels don't rise relatively when interest rates decline.

There is a kind of a paradox here.  Because, when corporations manage their capital, which partly entails minimizing their weighted average cost of capital (WACC), they use the market value of their equity to estimate costs.  In other words, they are looking at the cost of debt and the cost of equity with the same Debt to Enterprise Value model that I am using here.  They should be targeting their debt levels based on relative market values and costs of their debt and equity.  And, empirically, the pattern of D/EV matches what we would expect to see from that model of capital management.  If so, how are all of the adjustments to aggregate capital structures being carried by changes in equity, which is mostly a product of changes in equity share price?

I think we have to think about corporate capital as having many competing constraints, and the level of debt as a multiple of NOPAT probably hints at a lot of those constraints.  Here is the standard cost of capital formula:

If we assume away some market frictions, the cost (K) of each form of capital should reflect the same set of risks, so that, theoretically, except for the tax consequence, a firm should be indifferent about the capital mix.  This is the Modigliani-Miller theorem.  But, I think what we see in the graph above is that, in actual capital markets, in the aggregate, the cost of debt starts to accelerate when debt gets above 5 or 6 times net operating profits after tax (NOPAT).  If these constraints are in play, then, even if a firm is managing capital with the WACC model in the current tax context, with dynamic capital costs, then the absolute level of debt compared to output will tend to settle in a tight range regardless of more general risk premiums.  These other constraints, which affect K(d) as leverage increases compared to NOPAT, will make EV/D ~ PE look like an accounting identity.

In fact, it appears that there was a slight shift upward in the mid-1980's, to a slightly higher debt/NOPAT ratio.  And, using the implied corporate interest rate from the Federal Reserve Z.1 nonfinancial corporation financial tables (interest paid / Credit Market Instruments), there appears to have been a corresponding increase in credit spreads (the black line).  This could reflect any number of changes, including what appears to be an increase in average debt maturities.  This also happens to coincide with the development of the high yield bond market.  So, there may have been a one-time shift from financial innovations that allowed firms, in the aggregate, to increase debt/NOPAT levels.  But, it appears to be associated with a steep rise in K(d).

When low rates lead to a tendency for deleveraging, firms may engage in some pure capital management - buying down bonds, issuing new shares, changing dividend or buyback policies, etc.  But, these moves have expenses that may not be justified over the long term.  When equity becomes such a large portion of enterprise value, incremental increases in operations can have a large effect on share value.  So, even though debt will tend to remain at the maximum optimum level relative to NOPAT, firms will have incentives to increase NOPAT through operations management - more efficient use of working capital, etc.  In this way, NOPAT and debt levels can grow, and the high relative equity value will mean that this operational growth will be especially multiplied in the total value of the firm.  The original NOPAT expansion will create value, and then the expansion of debt made possible by the NOPAT expansion will create additional value.

So, we should expect to see NOPAT growth during times of low interest rates and low corporate leverage.  This is what we find.  NOPAT grows when leverage is low.  (Keep in mind that leverage was especially low in the late 1990's because of excessive growth expectations, and the high points after that were times of disequilibrium during demand crises - notice that leverage peaks when NOPAT crashes.  Firms quickly deleveraged as demand recovered.  So, cyclical fluctuations have been especially high during this period, but cyclically adjusted leverage has been close to 30% throughout this time.)

I am sure there are other narratives that can be built around other hypotheses, so this information doesn't create any exclusivity for my hypothesis.  But, the data can support my hypothesis.

Interestingly, GDP hasn't followed the trend of NOPAT.  Before the 1970's, real GDP was growing quickly.  And, real GDP growth leveled off during the high rate period, though not as sharply as NOPAT, understandably.  But, instead of reaccelerating, GDP growth has continued at that lower real growth rate as interest rates have declined.  I suspect there is a combination of innumerable explanations for this, including corporate foreign profits, demographic consumption and saving patterns, and maybe even issues with the difficulty of measuring consumption value in the age of the internet.

It's a shame that this sort of subject tends to be reined in by us vs. them thinking regarding corporate profits versus other household income, because there are probably many interesting things going on here - many of them reasonable and helpful for general prosperity - that would only be visible to the curious and non-judgmental observer.

My Attempt at a Curious & Non-Judgmental Interpretation:

For the investor, the real NOPAT chart shows how there is plenty of room for more growth in corporate valuations, simply coming from recovery in NOPAT.  At this point in the cycle, equities probably still offer a decent expected return without depending on expansion of valuation multiples.  (If the expansion continues, allowing for a recovery in interest rates, equities will also benefit from corporate re-leveraging as rates increase and enterprise value expands.  This would allow more NOPAT expansion and equity growth even as some valuation multiples retract.)

Regarding GDP, I suggest that the housing "bubble" was a reasonable and predictable result of the baby boomer phenomenon.  Boomers are utilizing real estate as a chimera of consumption and savings.  Homes are storing value for future consumption.  From 1997 to the peak in 2006, $8.3 trillion was accumulated in real estate equity.  The rise of home values tends to be blamed for creating unsustainable spending.  I believe this has it backwards.  Mortgages rose less than equity did.  Homes, on net, were replacing spending, not funding it.

While this seems like a reasonable phenomenon to me, it isn't particularly efficient.  The homes are storing value for future consumption, but this is only partly through home production.  Much of the savings simply creates a temporary nominal increase, just as if a rush of savers bids up the price of bonds.  While the homes are a store of value, they don't serve as a basis for economic growth and productivity.  Saving through the foreign operations of US corporations seems like a more efficient means of consumption smoothing.  But, both are inevitable.

I don't think either of these savings vehicles are picked up particularly well as either consumption or savings, so since the mid-1990s, when the baby boomers started entering this phase, GDP has been understated.  And, there has been a real loss in potential GDP growth, due to the allocation of capital to real estate in lieu of more dynamic productive assets.  (On the other hand, there is no unironic way to complain about stagnation and low productivity on a blog.)  In effect, we have all been waiting for the productivity slowdown coming from the aging boomers.  But markets are forward looking, and to the extent that trades through time are available (as they are through real estate), economic trends will be traded and shared through time.  Markets are simply allowing for an exchange with the future, which is manifest as a seemingly premature slowdown in GDP.

(Some people argue that home prices should be factored into inflation measures.  They are dangerously wrong.  But, I will note that if we did count home appreciation as inflationary GDP growth, nominal GDP growth would have been much higher in the 2000's, with most of the increased nominal income going to middle class households.  But, such is the mania behind our current malaise, that broad nominal appreciation of the most widely held durable asset in the economy is vaguely accounted for only as a cost.  So, the colloquial story of the 2000's goes something like:  high home prices led to unsustainable consumption that created a false level of nominal GDP.  And real GDP was much lower than reported, because inflation would have been much higher if home prices were accounted for in inflation measures
.......this is mistakes on top of mistakes on top of mistakes, believed with religious fervor.  I am also frequently told, with the same conviction, that the falling labor force participation of 25-54 year olds is a sign of economic desperation.  I am also frequently told, with the same conviction, that the rising labor force participation of 55+ year olds is a sign of economic desperation.  Religious fervor is helpful to believe such things.  Likewise, as we all know, US corporations are unpatriotically moving out of the US to avoid taxes.  And, we all know, actual US corporate taxes aren't high at all.  They have so many tax breaks that their effective tax rates are much lower than the headline rate.  Both things, believed with fervor.)

Since 2006, the Fed has devastated the real estate savings that the baby boomers had accumulated.  With another 5-10% price accumulation, homes will probably be back near a healthy equity/mortgage balance, at which time, after an 8 year (wow) pause, boomers can accumulate marginal new real estate equity.

Of course, wide swaths of the American public, from all sides of the political spectrum, are explicitly calling for the disruption of both of these vehicles for deferred consumption - calling corporations with operations abroad unpatriotic and warning of the developing new housing "bubble".  Many of these outspoken critics of this phenomenon are boomers themselves, who, no doubt, in their personal financial dealings are holding large positions in real estate and multi-national corporations, specifically to prepare for their future retirements.

I've said it before.  H.L. Mencken was a Pollyanna.

PS.  It also happens that the one-time increase in female labor force participation coincided with the high leverage period.  Female LFP peaked and began to trend down along with male LFP coincidentally when leverage declined in the 1990's.  So, part of the dilemma may arise from this.  This may have caused the 1960s-1980s GDP to be unusually high, while this + the age-demographic decline in LFP caused the 1990s+ GDP to be unusually low.

Added:  I should have done this before I posted.  Here is the GDP graph, adjusted for the size of the labor force.  This has a shape much like the graph of NOPAT, except, instead of rising and falling inversely with leverage, GDP/LF rises and falls with Enterprise Value.  This is affected by the Equity Risk Premium (ERP), in addition to risk free interest rates, so GDP growth stalls and returns a little earlier in the 1960s-1980s period, because ERP declined before interest rates did.  (Note: the trend lines on the NOPAT graph were mathematically derived, but I just eyeballed these.)

Tuesday, August 26, 2014

More Non-Evidence of Part-Time Work Shift

I was thinking about labor supply and demand, and the anecdotal evidence from employers that they are shifting work to part time because of the ACA.  I haven't seen definitive evidence of a significant shift to part time work in the data for number of employees.  Here is the chart of part time employment from yesterday's post.

After an initial shock and a shift from "non-economic" to "economic" reasons, the total number of part time workers has been moving down to about 1% above the pre-recession level.  This is typical for a recession.  The size of the shift up in "economic" part time workers, and the slow subsequent decline are unusual, but these trends pre-date the ACA, so it seems inaccurate to pin much if any of the trend on the ACA.

I have posited that one underappreciated factor here is that the binding constraint here may be the supply of willing part time workers.  But, if that is the case, if employers are experiencing higher costs for full time workers, then we should see an increase in pay for part time workers, as labor supply and demand settle at a new equilibrium that accounts for the new cost structure.  If the quantity of available part time workers is relatively inelastic, maybe this adjustment would mainly play out in wages.  Employers would need to increase the wages on part time jobs to entice workers who preferred full time work to move to a suboptimal work scenario.

But, there doesn't appear to be anything here, either.  Relative weekly wages for full and part time workers have moved in lock step over the past 14 years.

So, it still seems like there is a disconnect between the survey data, anecdotal evidence, and labor data.

Monday, August 25, 2014

ACA Survey from the Philadelphia Fed

Here is a survey from the Philadelphia Fed with some interesting answers regarding the ACA (HT: Patrick Sullivan).  You can click on the links for details.  The gist of it is that the manufacturers reported that, as a result of the ACA, they have decreased the number of full time workers, increased the number of part time workers, raised prices on their products, raised contributions, premiums, and deductibles on their employee health plans, and reduced coverage.

First, a caveat.  It seems to me that the jury is still out regarding part time employment.  There is a lot of anecdotal and survey evidence of this effect, but I don't see strong evidence of it in the data.  Now, it could be that there are a number of supply and demand factors at work in the part time employment realm.  I think that as the economy recovers, the binding constraint on the total level of part time workers will be the supply of part time workers.  In the meantime, I don't see any obviously odd movements in part time employment.  I'm not sure how to square this with employers reporting that they are transitioning to part time work.  There is a lot going on there down in the weeds.

Here is the graph of part time workers, as a proportion of the labor force.  The sharp rise in part time workers for economic reasons clearly happened during the recession, pre-ACA.  Possibly the recovery could have been sharper.  But, I don't see any smoking gun here, regarding an ACA-related jump in part time employment.

The average weekly hours worked from the monthly establishment survey also doesn't seem out of line compared to long term trends.

from the BLS
This all is a reminder of the difficulty of accounting for the costs of these sorts of things.  There have been a few policies that I have harped on, such as minimum wage hikes and Extended Unemployment Insurance, with specific claims about how they harmed workers.  But, in those cases, the policies had a very pointed and direct effect on some specifically identifiable people, so we can identify some sharp empirical evidence about their effects.

But, with so many regulations, like the ACA, the effects are tough to suss out.  Any effects there might be probably just slightly bend the curve of growth of human quality of life, and the damage comes in the long term.

Most of the changes the employers point out probably are accounted for as increases in nominal GDP.  There is a lot of economic activity engaged in compliance activities.  And, for regulations like this, it comes down to how the hedonic changes in price levels are accounted for.  When you lose access to your family doctor, does the BLS account for this as a decrease in quality?  Frankly, in an industry so screwed up, I don't understand how they can begin to account for economic activity.  What is the market price for a medical procedure that is "billed" at $2,500, but settled with your insurance company for $200, with a $20 co-pay?

It seems to me that much of the added costs of the ACA, the results of this survey being good examples, will play out as inflationary.  But, on the other hand, something like secondary education isn't accounted for at all in inflation measures.  That kind of government expenditure is simply recorded as real economic activity.  (Please correct me in the comments if I'm wrong.)

So, while GDP is useful for much analysis, with government expenditures at nearly half of GDP and a growing number of mandates, it ceases to be a good measure of absolute quality of life.  Some measure of the quality of public services and mandates would be required.  I'm not aware of any measure that can remotely address that.  A problem with programs like ACA is that they muddy the usefulness of indicators like GDP.  I'm not sure they even effect growth rates coherently, except in the very long term.  Government programs certainly have a knack for growing, which will usually show up as real growth in the GDP.  The same goes for mandate-based rent-seeking.  The production of ethanol, which probably put millions of acres of US farmland to use with no net positive economic benefit, added $44 billion to GDP in 2013.  (And created nearly 400,000 jobs!)

In 2012, total US government expenditures (including transfers) amounted to $47,159 per household.  The median household US income in 2012 was $51,017.  The median US household is left with $3,000 to spend on government mandates and all private personal consumption (housing, food, transportation, etc.)  To the extent that the median household engages in any private consumption at all, it is because our progressive tax code has essentially transferred those resources from high income households to median income households.  What is the value of that $47,159 of expenditures?  Could it possibly be anywhere near the amount spent?  Does it really take essentially all of the labor of the median US household just to support public services?  How can essential public services (not including off-budget mandates) require more expense, per capita, in real dollars, than the entire pre-1960 US economy?  Some people argue that we should return to 1950's tax rates.  If it is the essential services and social support of the 1950's that they want, shouldn't they argue for a return to 1950's public budgets?

Saturday, August 23, 2014

Minimum Wages, Crime, and Unemployment

Results from longitudinal panel data regarding the effects of minimum wage hikes on people who were working at minimum wage level jobs.  Appears to lead to unemployment and crime, especially among teens.  (HT: CafeHayek):
Does crime respond to changes in the minimum wage? A growing body of empirical evidence indicates that increases in the minimum wage have a displacement effect on low-skilled workers.  Economic reasoning provides the possibility that dis-employment may cause youth to substitute from legal work to crime. However, there is also the countervailing effect of a higher wage raising the opportunity cost of crime for those who remain employed. We use the National Longitudinal Survey of Youth 1997 cohort to measure the effect of increases in the minimum wage on self-reported criminal activity and examine employment-crime substitution. Exploiting changes in state and federal minimum wage laws from 1997 to 2010, we find that workers who are affected by a change in the minimum wage are more likely to commit crime, become idle, and lose employment. Individuals experiencing a binding minimum wage change were more likely to commit crime and work only part time. Analyzing heterogeneity shows those with past criminal connections are especially likely to see decreased employment and increased crime following a policy change, suggesting that reduced employment effects dominate any wage effects. The findings have implications for policy regarding both the low-wage labor market and efforts to deter criminal activity.

Friday, August 22, 2014

Readings on Fed control and risk premiums

Eugene Fama, The Review of Asset Pricing Studies, from December 2013:
In sum, the evidence says that Fed actions with respect to its target rate have little effect on long-term interest rates, and there is substantial uncertainty about the extent of Fed control of short-term rates. I think this conclusion is also implied by earlier work, but the problem typically goes unstated in the relevant studies, which generally interpret the evidence with a strong bias toward a powerful Fed.

An interesting attempt at isolating compensated equity risk, using a measure called "Excess Conditional Value at Risk":
Research that has led to the low-volatility anomaly in cross-sectional stocks from a similar universe indicates that volatility is not compensated with a volatility premium. The authors find evidence of a risk premium, but it depends on the definition or measure of risk. Tail risk measures the probability of having significant losses, and should be what investors care about the most. This article investigates several risk measures, including volatility and tail risk, and finds that volatility is not compensated. Tail risk, however, is compensated with higher expected return in both U.S. and non-U.S. equity funds.

Thursday, August 21, 2014

Extremely Positive News on Economic Mobility

Richard Reeves from the Brookings Institution has released this video about income mobility (HT: EV).

I suspect that the statistics he cites will be a very positive surprise to most people.

For all people born in the bottom income quintile, only 1/3 will remain there.  For a statistically average poor family with three children, one child will grow up to remain in the bottom quintile.  One child will move out of the bottom, but will have income below the median, and one child will have an income in the top half.

For black Americans, in particular, the outcomes are not this good.  But, even for black children born in the lowest quintile, half will move into a higher quintile.

For white Americans born in the lowest quintile, amazingly, the distribution of incomes is roughly flat across quintiles, with the odds of ending up in any quintile falling between 16% and 23% - near to what Reeves calls an "opportunity utopia".  That almost seems unbelievable.  That utopia would be a worthy goal, but I would never have guessed a society could come this close.  With perpetually poor places like Appalachia, or with areas characterized by vastly different standards of living, from West Virginia to Connecticut, how could this be possible?  But, apparently, it is.

Then, he shows the results for children born to parents who are never married versus those born to married parents, with no adjustment for race.  Remarkably, the results are very similar.

For poor children of never-married parents, about half will move to a higher quintile.

For poor children of married parents, again, they are in an "opportunity utopia".  In fact, for a child born into the lowest quintile to married parents who stay married, the lowest quintile is the quintile they are least likely to end up in.  I repeat, for a child born into the lowest quintile to married parents who stay married, the lowest quintile is the quintile they are least likely to end up in.  For children of parents who are married, this is better than a utopia.  Do we even have a word for that?  Is America dreaming?  I wouldn't know how to dream of something better than utopia. But for people who are married when they have children and stay married, we are living in it.

A child born into the bottom quintile to married parents who stay married has an 83% likelihood of moving up to higher income quintiles!

The result is the same regarding education.  If you are born poor and you drop out of high school, you have about a 46% chance of moving up.  If you are born poor and you graduate from college, you are living in the uber-utopia.

Here are a couple of graphs from the report:

This is the distribution of adult incomes of children born into families with married parents.  That is amazing.  And, in the report, the charts are interactive, so you can click on "Never Married" and then click on "Continuously Married", and watch the probabilities change.  And, despite the tone of the accompanying narrative, it is amazingly clear that the marital status of the parents and the education level of the children are much more important than the quintile the children are born into.  College graduates who were born into the first quintile have much better outcomes than high school drop outs who were born into the fifth quintile, for instance.

I haven't seen the raw data, so I don't know how much of the difference in the racial outcomes is due to family structure and education.

Next is a graph showing the amount of time parents spend with their kids, based on the parents' education.  The report points out that a gap has developed between the more educated and the less educated parents.  But, I can't help but noticing that parents with a high school education or less spend nearly 3 times more time with their children than the average parents did 30 years ago, regardless of education!  That is incredible!  As a nation we should be very proud of this development!

On the other hand, some people look at this graph and bemoan that educated parents spend almost 40 minutes more with their children than than less educated people.  This can only be described as a pathological reaction.  It would be interesting if someone set up a study where they presented made up social economic statistics with a helpfully negative tone.  How positive would the reported outcomes have to be before the subjects reached a consensus that inequality wasn't a high priority problem.  The issue has such value because there may be no threshold high enough for it to cease to be a purported issue.  In the report, this graph is shown in order to visualize the "gap".  Nothing positive is said about the trend.  It's as if the reader is expected not to see anything positive going on.  The extreme rise in parental attention among both groups is like the ape on the basketball court.

Is there any way to square the image of poor families ever more desperate to hang on to their disintegrating share of hope with this finding that the most vulnerable parents spend nearly 3 times more time with their kids than educated parents from 30 years ago did?  If spending time with kids is important, then why are outcomes for poor children worsening even while their family time skyrockets?  Are poor kids worse off because children of educated parents have more parent time?  Is there a fixed-pie of parental attention, such that, when educated parents spend time with their children, children of less-educated parents are harmed?  Can someone pencil that out for me?  How did I even end up with a functional life when my own parents barely even noticed me, by today's standards?

The video ends with, "We have a big problem, and we need big solutions."

Wednesday, August 20, 2014

July Inflation Update

Here are updates on a couple of charts I introduced in this post. 

I have been looking at core inflation without shelter.  To the extent that very low long term interest rates are driving home prices, shelter inflation may be a countercyclical indicator.  (To be clear, I think rent equivalent is the appropriate inflation measurement to use.  The notion that a context of moderate rent inflation, very low interest rates, and rising home values is inflationary is dangerously wrong.)  In this context, a crippled credit market is artificially curbing demand for homes, reducing the supply of new homes.  The effect is that an undersupply of homes is leading to rent inflation.  As credit markets loosen, home supply will respond.  Oddly, in this way, demand recovery will be a supply recovery.  Recovery of real estate credit markets may actually suppress nominal GDP relative to real GDP, as it is (correctly) measured.

In the first graph, we can see that core-less-shelter inflation swung down.  All the net core inflation in the month came from shelter.  This is the second month of moderating inflation after several months of increasing inflation, which clouds the picture of where inflation my be leading as QE3 ends.

The continued strength in shelter inflation suggests that we are still early in the credit market recovery.  The real estate recovery should create a bit of a virtuous circle, as the continued re-inflation of property values feeds back into credit creation and reduces mobility frictions.  As long as this is allowed to continue, home prices should continue to rise, home supply should increase, and rent inflation should moderate.

The strong level of rent inflation is a sign of a recovery in household formation, which is a signal of the strengthening underlying economy.  Bank credit continues to show strength as the QE3 taper winds down.  The first half of 2014 has been the first time since the crisis that bank credit has been expanding in quantities similar to pre-crisis levels.  However, most of the increase has been through very strong Commercial and Industrial Loan growth.  As real estate credit continues to recover, real growth should continue to get a goose.  I will look at this some more in follow up posts.

Tuesday, August 19, 2014

Conceptual Errors about Risk Trading, Part 1: Defined Benefit Pensions

James Hamilton has a good post on the issues confronting defined benefit pensions.  The San Diego County Employees Retirement Association is facing a shortfall in plan assets.  As a reaction to that, they have approved an investment policy that allows higher risk.

This issue goes to the heart of a prime intractable problem of the modern free world - finance.  In a world of abundance, extensive human capital formation, and longevity, consumption smoothing is necessary, which means, we all have to be financiers.  Finance is a difficult and complex topic, so it is infeasible to expect most people to develop a specialized understanding of the problems of finance.  But, the introduction of agents into such an important and personal issue carries its own problems.

When I am asked about the choice between letting savings ride in a defined benefit (DB) pension or taking the cash value and investing it individually, I sometimes suggest that, in worst case scenarios, DB pensions have plausible deniability.  In other words, in 20 years, when your pension comes up 30% short, do you want your spouse to blame you for it, or do you want to team up with your spouse and blame the pension manager?  I only mean that to be slightly flippant.  Blame avoidance has real utility.

There are at least three levels of risk for a saver, over time:

1) Transitory volatility of returns and asset values.
2) Portfolio-specific permanent negative outcomes.
3) Economy-wide changes in returns and asset values persistent enough to affect lifetime saving results.

DB pensions can, and generally do, solve problem number 1, since distributions are diversified among many beneficiaries over time.  DB pensions could, hypothetically provide some value for problems number 2 and 3, but, because of conceptual errors about risk trading, the way DB pensions are managed may worsen these problems.

One problem is that modern labor and debt conventions create wide expectations of context-specific certainty.  Workers tend to receive $x every hour or every week; bondholders usually receive a set coupon amount for every payment.  Ownership interests receive a premium for accepting all of the near-term volatility.  The problem with normal contracts is that nobody can guarantee all of the risk, so laborers and creditors tend to have binary risk exposure, with the downside being unemployment or default.  This is a much larger problem when it comes to pensions.  In this case, the savers are equity holders, but the terms of DB pensions mimic the near-term certainty expectations that labor agreements have led many people to expect - a broad promise of certainty that becomes catastrophic in unusual outcomes.  The demand for certainty is mostly met with accounting fiction.

And, it appears that pension funds, like the SDCERA, manage their portfolios according to this local-certainty/binary outcome expectation.  They are adjusting their risk profile in order to match a hard target.  This seems suboptimal.  It's clearly not the way someone would manage their own portfolio.  Surely it would be better to allow benefits to adjust with fund outcomes, but principal-agent issues make this difficult.  We wouldn't be able to separate type 2 and type 3 causes, and we tend to want to blame the pension funder or manager for the shortfall.  But forcing expectations of certainty into a context that is inherently risky will always lead to some set of negative outcomes, and hindsight will tend to be brutal in these cases.

We have a bias for certainty in benefits that we don't apply to contributions.  As in DB pensions, this is reflected in the setup of Social Security.  The strength of this bias is clear if we compare the tendency of Social Security benefits to be untouchable while the scale of changes we put up with in contribution rates, program solvency, and implicit rates of return would all be well outside the bounds of acceptable private portfolio management standards.

So, extreme negative outcomes are covered either by taxpayers or by the current workers and shareholders of a corporation with an underfunded pension, which doesn't seem reasonable.  It seems like some sort of pooled defined contribution pension, diversified among managers would create value for savers without creating the moral hazards and accounting gymnastics of DB pensions, but I suspect that there is generally an under-appreciation of how much risk we tend to trade away in our economic lives, and how well-earned the premiums are for taking that risk.  And, this prevents cultural conventions in these arrangements from bending to more flexible arrangements.

I can understand why DB pensions remain in the public realm, where the confiscatory power of the state can back up failures, but it seems like there should be more movement to a pooled defined contribution solution between the typical individual DC programs that the private sector has moved to and the public DB programs that are widely recognized as time bombs.

Saturday, August 16, 2014

EUI, Homeownership, and Wages (updated)

Here is a graph I have shown before.  This has been hidden by low levels of inflation and the broad tendency to view wages as a moral indicator, with higher always being better.  But, in this recession, wages have been very high, considering the level of unemployment we have had.  Since 1967, there has never been a sustained deviation from the trend like this.  This is problematic because unemployment in a recession is, in part, a product of inflexible nominal wages.  Employment would recover more quickly if wages were more flexible, which we normally alleviate through moderate inflation, which allows real wages to moderate without causing nominal wages to moderate as much.  So, some of this may be a product of tight monetary policy, which has allowed inflation to remain very low.

Here is a long-term comparison of measured Average Wages, compared to the average wage we would have had if real wage growth did have a perfectly linear relationship to the unemployment rate (the trendline above).  The trend here is based on the linear regression from 1967-1999, so real wages stayed very near the trend for 9 years out of sample.  Over time, actual wages moved along with expected wages with very little deviation, until the fall of 2008.  Then, actual wages deviated significantly from predicted wages, and have remained high throughout the recession.

Nominal Dollars
I created a new Expected Average Wage series by using the Unemployment Rate minus Emergency Unemployment Insurance (EUI) recipients.  Average Wages are still a little higher than this series would have predicted, but this bridges much of the gap.  With that adjustment, there was a one-time deviation between expected and actual wages between the fall of 2008 and the end of 2010.  The rise in real wages here might be from the contraction in PCEPI, as the timing coincides with the demand shock of 2008 and the beginning of QE2.

These graphs might help to highlight some of the potential tradeoffs of this policy.  Of course, we would hope that monetary policy would allow the economy to proceed without having to make these nominal adjustments.  But given the monetary policy we have, it seems to be adding insult to injury to create policies that explicitly create wage rigidity.

I'm not talking simply about there being a problem of potential workers not lowering their reservation wage enough to become reemployed.  I am sure that this effect is there.  But, as we can see in persistence, both of high relative wages and of unemployment, there has been a lingering problem of market disequilibria.  The larger problem here is the destruction of information.  The wage levels employers are seeing don't reflect the long term equilibrium price of labor.  Labor costs are interwoven with all the other inputs of production, so that this temporary disequilibrium not only prevents able workers from quickly reintegrating into the productive economy, it distorts and seizes up decision making across the economy through the destruction of information.  This is an informational and coordination problem.

This seems like an important problem for economists to discuss, but, at least out here in the blogosphere, we've got left-wing economists who would find it difficult to accept a framing that has a possible conclusion that wages are too high, and right-wing economists who would question a framing that says the central bank is too tight.  Because of these constraints, the topic seems generally ignored.

When employers say that labor markets are tight, it seems like they are being dense or hypocritical.  But, could they simply be recognizing at some level that wages are too high relative to other inputs?  Maybe their heuristics are functionally correct to lead them to be wary of raising wages further in order to expand production.

I don't think this is a magic formula where real wages have to fall back to the long term trend line.  But, I do wonder if we might see a period where real GDP and inflation are both healthy, but wages retrench a little bit while unemployment continues to fall.  The Economist (via Scott Sumner at econlog) points out that this is the current pattern in Japan.

The downside there is probably the danger of populist policies in an election year, to solve the "problem" of wages not keeping pace with economic growth.


It is strange to me how difficult it is for us to imagine that, on the margin, some workers might have discretion about the duration of their unemployment.  Here is an article on the effect of homeownership on unemployment duration. (HT: EV)  They find that homeowners with mortgages have unemployment behavior more similar to non-homeowners.  The extended duration and the tendency to exit the labor force come from homeowners with high equity ownership.  Yet, oddly, they seem to stick with the explanation that homeowners are less mobile and are tied to limited labor markets.

To me, this finding obviously comes from the fact that high equity home owners have more savings, more discretion, and more flexibility about how to re-enter employment or about making work-leisure trade offs.  I don't see any mention of this obvious factor in the paper.  We all know people who have discretion in their labor force decisions.  Why do they disappear when we start thinking about the big picture?

This seems like further evidence that the longer UI is extended, the more it will go to workers with discretion, and that the levels of long term unemployed and wages have been distorted in novel ways, made worse by tight monetary policy.  In the end, if the recovery was permanently slowed and there is hysteresis in gross production and in employment, I am not sure what the adjustments will be.  Where will average wages be in a healthy economy that has moved beyond these distortions?

Here is a post from Dean Baker at CEPR (HT: EV)  He points out that the Retail and Leisure & Hospitality sectors have both shown double digit increases in job openings with stagnant or declining hiring.  This could be a signal of frictions in the low wage spectrum that we might expect to see when there is policy-based wage rigidity.  Further recovery in production and employment might coincide with a normalization of hiring in these sectors, along with a relative moderation in wage levels.  CEPR is also a good window into the sources of the subsequent populist policy responses.

Friday, August 15, 2014

The absurdity of blaming capitalism for inequality - Part 4.

I want to look at this graph from Picketty, again.  Previously, I used the graph for the US.  This one is for the UK:

A driving force in our attitudes toward capital, incomes, volatility, and abundance, is the fundamental tendency toward risk averseness.  The steady state of pre-capitalist economies builds on this foundation.  An extreme current example of the power of this tendency is North Korea, which is a sort of hell-on-earth built on a foundation of risk averseness.  The most chilling part of this video of North Koreans' reaction to being cured of blindness, to me, is recognizing how similar they are to us.  We are confronted with Pascal's Wager continuously, and we, wisely, take the safe bet almost every time.  The problem is that the safe bet has its tradeoffs and, on rare occasions, the safe bet actually leads to hell.

The pre-capitalist, landed elite were mostly earning returns from practically risk-free capital, generally in the form of land.  Without the legal and cultural changes of capitalism, there weren't, in fact, many other options.  As human capital and at-risk physical capital have expanded, and as land values have declined (as a proportion of income), the demand for risk-free capital has expanded.  Homes help to fill this need for most middle-class households.  Developed world government debt also fills this need, in both the developed and developing world.


In fact, if we look at Picketty's estimate of the pre-tax return to capital over time, it is interesting how stable it is.  (I have separated historical data and future projections with red bars.)  The proportion of at-risk capital to low-risk capital must be much larger now than it was in 1700.  Three quarters of physical capital in the UK was land and housing in 1700.  But the total rate of return on capital is not much higher today.  To profit from capital today, we have to take on risk.  In fact, the lowest risk capital - short term inflation-protected Treasury notes have negative real returns.

This applies to human capital, too.  We are the 100%.  The unemployed 40 year old debating on returning to school, and wondering what vocation will still provide a decent income 20 years from now, is faced with the same problem as the private equity investor.  We are all capitalists now.

Old world: Capital: How do we earn additional returns? Choose a family can we join through our children so our descendants will have land income.
Labor:  What career should I choose?  Shovel horse shit like your grandfather did.

Current world: Capital: How do we earn additional returns?  Take risk, but diversify, because who knows what the future will hold.
Labor: What career should I choose? Well, you can either learn to program C++ or you could learn how to rehabilitate a broken hip.  Either skill could be obsolete in 10 years.  Good luck.

Progress is disruption.  This is why when the rubber hits the road, it is hard to find support for things like shutting down the Ex-Im bank.  People don't actually dislike rentiers.  Rentiers represent stability.*

In our own lives, given the opportunity to develop human capital, we take it.  It's too superior to the other options.  But, that leaves us feeling vulnerable.  Being capital isn't so easy, after all.  So, just as we pay a premium as laborers or fixed income investors to have more income stability, we are willing to pay a premium (less growth) for income stability through state policy, which usually creates rentiers (through subsidies, protectionism, regulatory apparatus, etc.).  This creates a sort of collective action problem, though, because in our personal lives, we bear enough of the cost from not specializing and optimizing that we tend to go ahead and take risks.  Those risks create many positive externalities, through our increased amount of innovation and productivity.  But, the cost of collective policies that reduce disruption at the expense of growth falls mostly on the future.  Thank goodness our ancestors chose risk.

Here we are discussing r > g and the permanence of wealth during a time when "r", whether in bond yields or stock returns, has been low for 15 years, when turnover of large firms is as high as ever, and when more than 90% of the Forbes 400 from 1982 didn't make the list in 2012, replaced with a growing list of entrepreneurs.

Revolutionary progress means that legacy capital is overtaken by new capital that arises from the superstars of human capital - in the current instance, this is the equity of Bill Gates, Sergey Brin, Larry Page, etc.  Their riches didn't come from rents on a pile of savings.  The 18th century land barons earned "r", but were simply passed up by the new physical capital.  The 20th century corporate barons earned "r", but were simply passed up by the new human capital.

So, there is inequality that could never have appeared without capitalism - the inequality that comes out of human capital.  Framing the current environment as a problem of "r > g" or of "the rich getting richer and the poor getting poorer" is confusion.

People like Tyler Cowen talk about a future where there is a larger divide between owners and workers and between high and low income workers.  I suspect that if this is correct, the divide won't come from physical capital.  It will come from human capital.  And the problem will be that human capital can't be diversified.  The problem we have is that there is too much economic mobility.  Some kid in his dorm can change the world, and the next thing he knows, he's worth $5 billion.  This is the farthest thing in the world from the inequality of the 18th century, but I suspect that it bothers us more.  The problem isn't that capital is out-earning labor.  The problem is that now we are all capital, and being capital ain't so easy.

I also wonder how foreign this idea of human capital would have been to the tycoons of the mechanical world - the Carnegies and the Rockefellers.  Would they have been able to conceive of a world where a few young adults could end up running the most powerful corporations on the planet without much need for physical capital?  They probably saw themselves as a sort of end of history.  They must have assumed that progress until the end of time would come from accumulated physical capital invested in marginal productivity improvements.  What will come after exponential human capital?  Could we even imagine it?  By the time we are able to judge Picketty's forecast of capital and income in 2100, the world will probably be so foreign to us that, as with the 18th century gentlemen confronted with our world, we won't even recognize their complaints as coherent.  As moralists, we end up fighting the last battle.  In the case of Picketty, we are actually fighting the previous battle that came before the last battle.

I started this series of posts with the title "the absurdity of blaming capitalism for inequality", but in the end, I think what I've found is that it is responsible for inequality.  It's an inequality between generations.  An inequality where one century's baron is the next century's anachronism.  We now live in a world where Kenyans making less than $2 per day send their kids to private schools, and pay the bill with their mobile phones.  I can barely imagine the world we have.  I hope to get a glimpse of what the next type of "inequality" brings.  I hope we choose risk.

* (Take the recent flair up about High Frequency Trading.  People who are not familiar with the institutions of trading come down overwhelmingly against HFT.  Trading costs have come down immensely, and HFT as a whole almost certainly has net positive externalities.  But, it's unpredictable and because HFT'ers aren't living off of limited access rents, they have to exploit tenuous circumstantial trading activities to try to capture profits.  People prefer the old market makers, who pocket a big profit day in and day out and promise to keep things calm.  We'd rather have a 20 cent spread and a rentier's protective hand than to have an anarchic 3 cent spread.)

Thursday, August 14, 2014

The absurdity of blaming capitalism for inequality - Part 3.

I have referenced this data from Russ Roberts before.  It compares poverty rates from 1967 and 2003.  During that time, aggregate poverty has barely improved - from 13.3% to 12.8%.  Here is what poverty rates look like, by family type:

There have been gains against poverty, across the board, since 1967.  The largest decline has been among unwed mothers.  This has been a shared success between a much stronger safety net for vulnerable households and a richer society in general with more opportunities for all family types.

The next graph shows the total number of poor families, by family type, as a proportion of the total. (Blue bar is 1967.  Red bar is 2003.)

It might be surprising to see that the number of households in poverty led by single mothers has grown significantly.  How could this be?  It's because over those 36 years, on net, for every poor single mother who was raised out of poverty by social support or economic opportunity, nearly 6 new single mother households were formed, of which 2 are in poverty.

If there hadn't been an increase in the number of single households with children after 1967 (shown in green), the number of poor single households with children would be nearly half of what it is.  Household formation is a significant part of the story.

Here is a graph of the change in family composition over that time.  Note that in 1967, more than 50% of families were two-parent families with children who were not poor.

People are complicated.  Maybe instead of Picketty, we should be reading Peltzman.

There are a lot of complicated things going on here, at the bottom of the income distribution, including demographics and age-related effects, Pelzman effects related to higher incomes, female empowerment, and a better social safety net.  What we almost certainly are seeing to some extent, is the counterintuitive statistical product of a wealthier, more generous society.  And, it has very little to do with "r".

Here is a graph of the number of households, categorized by the number of earners in the household.
It is followed by a graph of the average household income, by number of earners.  Going from zero to one to two earners in a household roughly doubles the average income with each earner.  And there are more one-earner and zero-earner households, and fewer two-earner households, than there used to be.

Oh, one last thing.  That black line way down at the bottom is domestic corporate profit (after tax) per household.  Yep, that's it.  That's basically "r".  Can you believe that little black line way down at the bottom of that graph is responsible for so many of America's hardships?

That black line is turning America into pre-Victorian England!

Unfortunately, we can tax corporations until the last one leaves for Switzerland, and it's not going to do much, revenue-wise.  The real money is with those two- and three- earner households.  Higher taxes on the marginal income in those households, in reality, are going to fall largely on working women.

Wednesday, August 13, 2014

The absurdity of blaming capitalism for inequality - Part 2.

I was going to post a bunch of details about how asset prices can be high simply as a function of low required returns, how capital taxation can lower growth rates, how the high growth that came with capitalism transformed the world for all its inhabitants, how recent measured inequality is not a product of high returns on legacy capital, how labor compensation is highest and returns to capital are lowest in liquid, transparent markets where you can go about benevolent business activities without being unduly harassed and without wondering if your property will be confiscated at the next shift in political breezes.

But, the strange thing is that I think Picketty generally agrees with this.

Here is his data, some slides, and some course notes.  The subtitle of the course notes is "Is Balanced Growth Possible?", which the notes seem to answer with a qualified "yes".  After looking at it for a little while, I thought maybe I had accidentally found course notes of someone using Picketty's work as a starting point for a wider course, but, no the notes appear to be at his site.

It seems like there is a disconnect between the data and analysis he has gathered, and the conclusions and public discussions, including his quote from the book, which I referenced in the previous post.  I think others have discussed this, and I'm not qualified to add to the discussion of the econometrics.  But, I did have some ideas while looking at these sources that I haven't seen elsewhere, which I will share.

This graph got me thinking about human capital.  (Here, Deirdre McCloskey speaks generally about inequality and goes into the topic of human capital briefly during a video interview.<HT: CafeHayek>)

Picketty notes that slavery actually put a price on human capital.  In the 18th century, slaves accounted for at least a quarter of measured capital.  So, even then, when most workers were either slaves or were earning very low incomes compared to modern standards, total human capital would have dwarfed physical capital in importance.  Human capital is basically the dark matter of economics.  We know it's there.  In the end, it probably is the primary driver of everything that is important.  And, we can't see it.

From a financial perspective, human capital is extremely illiquid, so equilibrium returns on it will tend to be high.  But, even with a high discount rate, it certainly accounts for a far larger value than physical capital.  (In fact, of all the sources, pro and con, affecting inequality today, this is the fundamental driver of increased inequality.)  Having a conversation about future inequality 80 years from now, based on returns to physical capital, is like having a conversation about the inflation of the universe without accounting for dark matter.

Oddly, given the public conversation that this has fed, capital, ex-housing, is relatively flat over a very long period of time in the US, and has been falling since the 18th century in Europe, with both roughly settling at around 300% or less of national income.  (The fall in relative value of agricultural land is the picture of the disappearing rentier class that I described in part 1.  Agricultural land has not become unproductive.  It has just been eclipsed.  The decline in capital in the UK and France happened because agricultural land was 400-500% of national income in those days of limited access governance.)

The housing portion of these graphs represents the consumption of a small portion of human capital.  Using the tools of finance, physical capital can be trade and divided.  The risks can be allocated in degrees and in kind to various constituencies.  It can even be traded in time, pushing or pulling profits between today and the future.

Human capital is very illiquid.  Once you have it, you can't very well sell it.  It is time dependent, and it is difficult to trade either within or across time.  One obvious trade we frequently make is through student loans, where we take the equity position (ownership of our future "profits") and the bank takes a debt position on the human capital that arises from our education.  The subsidies and regulatory concerns around student debt arise because of the illiquid nature of human capital.  Debtors don't have a directly associated physical asset to place a lien against.

Probably the main tool that most people use to trade on their human capital is consumption smoothing, and the main outlet for consumption smoothing is home buying.  The cultural conventions and financial tools that have developed around housing partly serve to make a trade over time between a young family that needs a larger house when they have low income and low savings but large amounts of future human capital and that same family in the future, when they have high income, high savings, and have expended most of their human capital.  The bank serves as an intermediary over time between the present and future family.

We might expect that this sort of activity would represent a fairly stable long term trend.  Different generations of families should tend to trade similar proportions of their human capital over time, all else equal.  So, the "housing" portion of national capital could be seen as a rough gauge of the growth of human capital.  So, in fact, these graphs are demonstrating the continued decline of physical capital as a portion of the total capital held by modern nations.

This does raise some interesting questions.  This implies that total capital (including human capital) is increasing in relation to national income (although much more so in Europe than in the US).  We might divide homes into equity, which is invested past profits from human capital, and mortgage, which is capital borrowed from the future profits of human capital.  Between the end of 1995 and the end of 2005, American households had added $8 trillion in equity to their housing capital and $5.6 trillion in mortgage capital.  This was a period when baby boomers were entering the twilight of their working lives.  So, this reflects what we might expect.  Most of the growth in housing was in equity, which we might expect from an aging population.  Compare this to the previous 10 years, when baby boomers were younger, heavy on yet unearned human capital.  From the end of 1985 to the end of 1995, mortgages increased by $1.9 trillion while equity increased by only $1.5 trillion.

But, I wonder if some of the 1995-2005 growth in mortgages is related to demographics, too.  Even though it is difficult to measure, there must be a complicated web of risk factors in human capital, just as there are in physical capital.  One of those factors would be a maturity premium.  A young person will have a large amount of potential human capital, but because so much of that capital will be realized decades in the future, the discount rate applied to it would need to be higher.  An older worker, however, will have only a few years of human capital remaining to tap, but because of the short maturity, it will have a low discount rate.  So, the lifecycle value of human capital will rise in the mid-to late period of a household life cycle because of these sort of capital gains on unrealized human capital.  In the market for trading between human capital and real estate, not only would middle aged baby boomers be increasing their equity positions, but their potential future human capital, which they might be trading for mortgage debt, would also be at the peak of its value.  This could explain a real estate market that was aggressively expanding in both mortgages and equity, but especially in equity.  (Of course, since human capital is so illiquid, there will be a wide variance of outcomes, with some households experiencing extremely low returns on human capital.  This is another thing to keep in mind about inequality.  Because of the illiquidity of human capital, compared to physical capital, risk sharing is much more difficult with human capital, so it may be, in fact, the declining importance of physical capital that would lead to an increase in experienced inequality.  Public redistributionist policies would actually be a more reasonable part of the policy response to this issue than they would be to the supposed r>g problem.)

Here is a graph of a simple model of human capital over a working life.  The peak in total present value comes early and is sloped more steeply because of the changing discount value.  I submit that this was a factor in the behavior of asset markets in the 2000s, and that we did not manage the descent off of the peak of baby boomer human capital very say the least.

While, in theory, potential dislocations and creative destruction in the marketplace are what lead to potentially inequitable outcomes with regard to unrealized human capital, as the behavior of home equity values in the graph above demonstrates (as would a graph of corporate equities), all capital is susceptible to extreme downside risks.  Poor outcomes among physical capital tend to be felt more widely, however, because they are more liquid and more tradable.

The disconnect in the public discussion leading to the concentration on legacy capital as the key to inequality might relate to the measurement issue.  Physical assets have a market price, so it is easy to imagine confiscation.  And since realized capital gains reflect future earnings, the future can, in effect, be taxed today.  There also is not a work-leisure trade-off, so while taxation might lower future investment, it won't necessarily affect immediate production, and thus the negative growth effects are harder to quantify.  Human capital can't be easily taxed forward in time, and a tax on human capital results in immediate work-leisure trade-offs.

PS. (added):  Hmm.  Maybe we are more clever than we realize.  Maybe the combination of mortgage subsidies and property taxes ends up subsidizing future realized human capital but taxing realized past income on human capital.  This combination of taxes is neutral, so that it wouldn't push households out of the home market.  But I think it might serve to encourage human capital development while taxing the actual (and highly variable) gains from human capital progressively.  I'm not sure if I can figure out all the implications....