Book News

 Lots of book stuff happening.

Scott Sumner's "The Money Illusion" is coming out.  This is an important account of the 2008 recession.  It is the framework for viewing the economy that drew me into my housing work.

Rowman & Littlefield is releasing a paperback version of my first book "Shut Out" this month!  And here is a code you can use to get it for only $18.90.

Use code:  RLFANDF30

Here: https://rowman.com/ISBN/9781538163009/Shut-Out-How-a-Housing-Shortage-Caused-the-Great-Recession-and-Crippled-Our-Economy

And, in January,  my followup book "Building from the Ground Up: Reclaiming the American Housing Boom" will be out.

Should be an exciting few months ahead!

Market Concentration

John Cochrane discusses an interesting paper that claims that, while national concentration has increased, local concentration has decreased.  In other words, each location has more competition within various industries, but the competition is more among national chains than among local firms.  So, there top firms claim a larger portion of the national market, but at the local level, consumers have more choices.

What's going on? The natural implication is that the town once had 3 local restaurants, two local banks, and 3 stores. Now it has a McDonalds, a Burger King, a Denny's and an Applebees; a branch of Chase, B of A, and Wells Fargo, and a Walmart, Target, Best Buy, and Costco. National brands replace local stores, increasing the number of local stores.

Henry George and Affordable Housing

Philip Bess has an article in American Affairs about the benefits of a land value tax (LVT), which was the idea that led to the fame of 19th century thinker Henry George.  There are a lot of interesting thoughts on urban development in the article, and I generally agree with the points made.

Reading the article triggered some thoughts regarding the land tax and housing affordability.  One of George's conclusions, which Bess refers to, is that having a near 100% land tax (which, effectively, is confiscation of unimproved land, but not the improvements and structures, by the government) would prevent speculative bubbles and would improve housing affordability by removing speculative value from the property.  Here is an interesting description, from the article, of how land ownership would look under a comprehensive LVT:

Land speculation would be impossible because only the use of land would have economic value. In turn, though, an LVT would also benefit land titleholders who would not pay tax on improvements to their land or productive activities undertaken thereon. And why would anyone sell land? One would not sell land to make a profit from the sale (which would not be possible), but rather to relieve oneself of a tax liability. That which one cannot or will not use one cannot own save for a fee. “Ownership” of land extends no further than an entitlement to the use of land, and that which an “owner” cannot use he must pay for or “sell” to someone else. “Buying” and “selling” land under a single tax regime therefore assume slightly different meanings than in ordinary discourse because what is really transferred is a land liability equal to land value—a liability virtually no one would accept if they did not plan to use the land.

George focuses on land banking and speculative ownership which is based on expectations of capital gains.   Here, I think my recent work on the housing bubble might add food for thought to this topic.  The point I have frequently made about analysis of the bubble is that there is a sense of attribution error in human nature deep enough to infect the academy. ("I bought a house in Phoenix in 2005 because I was tired of having my rent jacked up every year in LA, but I had to overpay for it because there were thousands of greedy speculators in the market at the time.")  I rarely see homebuyer expectations framed in terms of the present value of future rents.  Usually, especially during the bubble, they were framed in terms of expectations of future home prices.  Removing rental income from the mental framing of home values causes us to exaggerate the effect of speculation as a process unmoored from intrinsic present values.  I think this is the case regarding the idea that a LVT would eliminate land speculation or price volatility.

First, in terms of affordability, I would like to point out that ownership, first and foremost, is a rent hedge.  A Georgist tax would be a pretty harsh Darwinian imposition on homeowners.  California has Prop. 13 because rising home prices meant that older owners with limited incomes were faced with rising property taxes.  A Georgist LVT would impose that tax at a maximum level.  There would be no rent hedge.  It would be the antithesis of tenants rights.  If you couldn't pay the rising tax on a valuable property, you would have to move out.  George sees this as an advantage, and there are benefits to it.

One benefit would be, as a second order effect, that more housing development would be induced because developers would outbid less productive owners and build more improvements on the land, which they could profit from.  So, maybe where current building restrictions are the cause of high prices, this would solve the affordability problem, and little old ladies wouldn't be faced with rising taxes in the first place.

But, the first order effect would be to remove an important source of stability that is fundamental to ownership in our current system.

So, back to my point about speculation and price volatility, if price volatility is unmoored from the fundamentals, then it would be reduced.  However, if price volatility is related to fundamentals (the rental value of a home) then it would not.

Imagine an owner in an untaxed system vs. one in a system with 100% LVT.  Let's say the structure is worth $200,000 and the land is worth $200,000.  It has an annual rental value (after expenses) of $20,000 - $10,000 from the structure, $10,000 from the land.

Untaxed, a buyer pays $400,000 cash and there are no further transactions.  Under the LVT, a buyer pays $200,000 plus an annual $10,000 tax.  We might  imagine that they invest their other $200,000 in a long term fixed income security that pays $10,000 annually.  So, for the buyer, the transaction is essentially the same.  They need $400,000 to own the house.

Now, what if there is a market expectation that the land rental value will grow by 2% annually because of its location?  All the numbers above are the same, but in year two, the tax would be $10,200 instead of $10,000.  So, now, in order to perpetually control the property, the buyer would need enough savings to pay the initial $10,000 tax, and to grow by 2% each year.  So, the buyer would need to pay $200,000 for the house and save $280,000 to cover the taxes.  So, the total "price" would be $480,000.

Now, since rising rent is a liability for the owner, owners would still want to hedge that risk, just like they do today.  So, we might imagine that banks would offer a service.  They might develop a security that they sell, sort of like an annuity.  They would say, "Pay us a set amount, and we promise to make the LVT payments on a property in perpetuity."  So, now, the buyer would go to the bank, pay them $400,000.  The buyer would own the home and the bank would handle the LVT, so the owner would have no further expenses.

And, if the local housing market became valuable, and there was an expectation that land values would rise 2% annually, the bank would still sell the same security, but they would require a payment of $480,000.  And, if someone wanted to buy the property, they would have to purchase that annuity from the current owner, also at $480,000.  If we think of speculators betting on future rental value rather than betting on short term price increases they expect to reverse (presumably after they sell), then there is no difference in that changing value.

(edit: Changing interest rates would also affect the value, just as they do today.  And, of course, we could further imagine that buyers fund their initial payment for the annuity by getting a loan with a 30 year fixed amortization.)

(edit #2: Upon further thought, even unmoored speculation could happen with those annuities.  So, maybe my distinction between fundamental and unmoored speculation isn't that important.  Everything would basically be the same, except that since the government has taken a long position in the land, which it doesn't have in the untaxed version, for these instruments to work, the bank has to have a short position on the land, which is what the promise to pay the tax is, which it doesn't have in the untaxed version of the story.)

So, we can imagine that, to the extent that home values reflect capitalized future rental value, there really is no difference between the taxed and the untaxed market.  I differ from George on these two points.  (1) I think he, like most observers do, overestimates the significance of unmoored speculation on home prices, and (2) by removing a device for capitalizing future rental values, he can imagine that the value doesn't exist.  But, future rent or tax changes have an effect on current owners whether we imagine that they can hedge them or not.

Housing: Part 236 - JW Mason throws a truth bomb.

J.W. Mason at John Jay College, City University of New York, who blogs at the Slack Wire posted an outstanding paper in progress (paper is 2nd link in the linked blogpost) about debt, consumption, and business cycles - specifically the Great Recession.  He really gets at many of the problems with conventional ways of talking about these things that I have been grappling with, and he addresses them at depth and with new data.

He complains about the standard treatment of aggregate debt as if it is consumer debt.  On the idea that income inequality led to debt-fueled unsustainable consumption:

(H)ousehold debt varies positively with household income; low-income households report very little debt. Mortgages, student loans, and to some extent auto loans, are specifically middle-income phenomena. Peak debt-income ratios are found near the high end of the income distribution, between the 75th and 90th percentile by income. Absolute debt levels rise monotonically with income. The most natural result of a more unequal distribution of income, therefore, would be a fall in household debt. Poor households do not own the assets for which most debt is incurred, and rich households can buy them outright...More generally, the fact that debt is primarily incurred to finance asset ownership, not current consumption, must be the starting point for any discussion of household debt.

He also notes that all of the increase in household consumption in the decades before the Great Recession was from third party and imputed expenditures (public health care, employer health care, imputed owner-occupier rents, etc.)  There was no aggregate rise in relative consumption expenditures.  He notes:

(T)o the extent consumption trends have diverged from income trends, it has been in the direction of higher consumption as a share of income among high-income households, and lower consumption relative to income among lower-income households. If a mechanism is needed to explain rising consumption demand in the face of more unequal income in the period before 2007, it should focus on luxury consumption among the rich - perhaps driven by a wealth effect from capital gains - rather than on debt-financed consumption among the bottom 95 percent.

Driven by capital gains.  Most studies find that consumption inequality has increased by more than income inequality.  (And, we know why: Closed Access homeowners are spending their economic rents.)

Mason comments, "As people get poorer, they don't borrow more, they buy less. This decline in living standards among lower-income households is reflected in many indicators of health and wellbeing, such as falling life expectancies. (Case and Deaton, 2015) It is strange that so many of these writers implicitly deny that income inequality has led to falling living standards for poor and working class households, but instead has been cushioned by borrowing."  I also think it's strange that a nation supposedly increasingly floundering in consumer debt would subsequently engage in a bidding war on the most durable middle class asset class.

As with so many of these papers, I must swoop in and replace his conclusion with my own, using my alternative version of the housing boom.  My conclusion would begin with one additional point, which is that rising home values were the result of rising rents in constrained cities, and that capital gains on those homes were capitalized economic rents.  There is nothing unsustainable about those gains as long as we continue to limit entry into our productive core urban centers.  The reason for the trends Mason finds can be very broadly explained with three groups of households.  Legacy Closed Access real estate owners that can realize capital gains and use them for consumption, young highly skilled professionals who had taken out large mortgages to gain access to those Closed Access labor markets and incomes, and households throughout the country with lower incomes who are locked out of those labor markets and who did not take on more debt because they weren't bidding on Closed Access real estate.  Those households have stagnant incomes and consumption growth.

I especially appreciate seeing Mason's treatment of debt, cyclically.  The vast amount of debt is a claim on an asset, not consumption debt.  Equity and debt are two forms of ownership.  Equating the shift of ownership from equity ownership toward debt ownership with some sort of recklessness or unsecured debt-fueled consumption leads, in my view, to an incoherent view of debt and business cycles, and I think Mason gets at the root of that problem here.

Housing: Part 232 - Credit supply, housing supply, and financial crises.

Credit causes financial crises.  How do we know?  Because that is our set of possible outcomes.  Mian, Sufi, and Verner have a new paper out, titled, "Household Debt and Business Cycles Worldwide". (HT: John Wake)

We group theories explaining the rise in household debt into two broad categories: models based on credit demand shocks and models based on credit supply shocks.

They find that when household debt rises, this is associated with a temporary rise in consumption that is followed by a drop in GDP growth.

They dismiss a rational expectations credit demand shock cause because this would mean that higher debt levels are based on optimism about future economic growth, and that doesn't jibe with the predictable decline in GDP growth that happens after household debt grows and the low interest rates that tend to coincide with these periods of rising debt.

What if we expand the set of possible causes to include supply constraints?  Supply constraints lead to rising home prices in cities with productive employment.  The debt is a result of households buying access to constrained future production.  This is why rising household debt is related to low interest rates, rising home prices, and subsequent declining growth rates.

The bidders on restricted housing do have rational expectations for their own rising incomes.  Incomes are rising in those cities.  It is their countrymen who are denied access to those local economies who have stagnant incomes.

Since the credit demand shock story fails this test, MS&V can attribute these results to credit supply shocks, which they attribute to behavioral biases among lenders.

They also note that the relationship is non-linear.  Higher debt/GDP ratios lead to falling GDP growth but lower debt/GDP ratios don't lead to rising GDP growth.  This, again, comports with a housing supply cause.  Elastic housing supply simply allows housing to continue to expand at the cost of construction.  There is a floor on home prices in a functional economy.  Inelastic housing supply where potential incomes are high causes prices and debt to rise and crimps economic opportunity and growth.

It is odd that the supply issue is so invisible in these academic discussions, because, first, it is such an obvious problem right now.  This is not an unknown issue.  And, second, it is generally accepted that for home prices to rise excessively, supply needs to be inelastic.  Even these credit shock models can only cause these results when housing supply is inelastic.  The supply problem is built into the models, at some level.  It's really a sort of rhetorical issue that it isn't allowed to be causal.

Of course, as is the norm on these papers, amid extensive discussions of the role of price expectations in borrower behavior, rent is simply not mentioned as a determining factor in home prices or expected future home prices.  A text search for rent comes up empty.

This leads to a fundamental difference in thinking as the business cycle proceeds.  If we think of the debt as a product of a credit supply shock and overly optimistic lenders and speculators, then their optimism is the source of the problem.  In the Great Recession, this reached outrageous levels by September 2008 when the Fed was still bracing against inflation after home prices had dropped by more than 20% and were still falling by about 1% monthly, nationwide, and the public was beside itself because we were "bailing out" the ones that did this to us.  But, the key period is really back in the 2006-2007 period.

The sharp decline in housing starts and residential investment was welcomed, because obviously the lenders and speculators were overfunding new building.  The initial declines in GDP growth were accepted because, obviously, all that credit had led to overconsumption which needed to calm down.  And, eventually the collapse of the private securitization market - a massive hit to nominal growth - was seen as medicine well-taken, and the GSEs were castigated for attempting to make up for it - just more greedy lenders, and weren't they the problem to begin with?

Long term interest rates which remained very low throughout that series of events, because there was already a flight to safety, and already home equity was not considered safe.  Since we are so strongly led to see credit as causal, this looked like a credit supply phenomenon, and those low rates were interpreted to be stimulative.  It's the central bank and our collective notion of acceptable public policy that has a behavioral bias.  Those low rates were shouting that bad things were on the horizon.  Some will find this unbelievable, but I think that if the Fed had lowered rates in late 2005, and kept the Fed Funds rate at, say, 4%, long term rates would have moved higher, residential investment would have stabilized, buyers would have returned to the housing market, and the CDO boom would never have occurred.  The CDO boom was a product of the flight to safety, both by investors and by home owners fleeing the housing market.  A credit supply shock view meant that we saw a flight from the housing market as a positive - a correction.  But, a negative housing supply shock view would have properly led us to notice that was a sign of severe dislocation.

It seems to me that, in practice, behavioral finance is simply collective attribution error.  We were convinced that there were these massive forces of irrational actors in the marketplace, and given any support, they would re-enter the housing market and push everything out of whack.  MS&V attribute the end of the boom to changing sentiment.  Surely this is true.  The difference in interpretation here is whether we encourage that change in sentiment to disastrous ends or work to counter it and stabilize it.  At that point, monetary and credit policy become endogenous, and our interpretations of these cycles become self-fulfilling prophecies.  They note, by the way, that these crises tend to be worse in economies with constrained monetary policy.  Yet, since the cause of the crises is determined to be excess credit, this interpretation of the cycle leads us to put self-imposed limits on monetary and credit policy.  With that interpretation, it would seem like madness to try to provide stability if that is only going to encourage more borrowing.

MS&V note that GDP forecasts tend to be too optimistic going into the bust, in that they don't reflect what MS&V find to be predictable declines after the boom in household debt.  To the point above, it seems that forecasts which did shade lower would also become endogenous, because this would encourage more growth oriented monetary and credit policies.  I wonder if forecasts in 2006 had been lower, would we have accepted looser monetary policy?  I'm not sure we would have.  The drop in growth comes from this paradigm that views credit as a disease and stability as dangerous.  The drop in growth was a choice, even if it was a choice we didn't admit or understand we were making.

It is telling that the howls of protest in late 2008 weren't complaints that stabilizing monetary policy had been tardy.  The complaints were that policy should have been tighter in 2004 or 2006 or 2008.  And the chorus of ad hoc inflation phobia that claimed inflation was actually high in 2004 and 2005 if you counted home prices as part of the basket of consumer prices suddenly turned to silence when home prices were dropping by double digits.  To do anything about that "deflation" would be a "bail out" don't ya know?  And it would only encourage that dangerous credit supply that leads to crises.  The credit supply thesis has an endogeneity problem.

Maybe you could say the housing supply thesis has an endogeneity problem too, and that Canada, Australia, etc. are just kicking the debt can down the road.  At least their result has option value.

Peter Conti-Brown on the Fed

I just got around to listening to this Macro Musings podcast with Peter Conti-Brown about the history of the Federal Reserve.  Fascinating throughout.  It is clear that Conti-Brown has a thorough deep and broad understanding of the history and inner workings of the Fed, and I thought his descriptions of some of its history were entertaining and interesting.

Highly recommended for finance nerds.

Randal O'Toole's American Nightmare

I was recently made aware of Randal O'Toole's book on the housing bubble, "American Nightmare".  I'm embarrassed to say it had escaped my vision before now.

I have developed a sort of "everyone is wrong about everything" attitude about this topic.  But O'Toole basically gets it right.

Most of the book is a brief review of the history of homeownership and urban housing policies, capped off with an explanation of how that history led to the bubble because of disastrous supply constraints that are always at the heart of housing affordability problems.  The credit issues were a result of that problem, not the cause.

He has a 10 point prescription for fixing the problem that is generally pretty good.  It includes more skepticism about FHA, the GSEs, and the rating agencies than I generally hold.  But, his skepticism includes the point that in high cost areas, where low down payments were used to help usher new buyers into homes, we should probably have been requiring higher down payments because constricted housing creates more volatility.  That's a good point, worth considering.  And, he notes that those sorts of measures would be unnecessary, if not for the supply problem itself.

In general, I think ownership should be more about self-selection than about affordability.  Transaction costs are high, so there is a natural self-selection of buyers who expect to own long enough to amortize transaction costs.  Beyond that, it's not like families are choosing between buying a home or living under a bridge.  They will be renting if they aren't buying.  Affordability is only a problem in high inflation contexts because of mortgage conventions and money illusion.  Obstructing ownership for affordability reasons isn't coherent.  Typically, the decision to own reflects some deferred consumption, because of the front-loaded nature of mortgage cash outflows.  The notion that we have to keep households with moderately low incomes from access to mortgage financing, because they will become reckless speculators if we don't, is policy from attribution error.  High down payments are an added obstacle that prevents households from gaining control over their living space.

But, as O'Toole notes, low down payments are really mainly a problem in Closed Access contexts.

I have generally thought well of O'Toole's work on topics like mass transit.  After reading this book, my estimation of the quality of his work on topics that I am not as informed about just went up.  He got the big picture right on this one where others rarely have.

Stock picking vs. diversification

I've seen a lot of recent references to this great paper (pdf) from Hendrick Bessembinder at Arizona State.  The paper notes that all of the net gains from equity ownership over time come from a very small sliver of the market.  Most firms underperform over time.

Here is a graph from the paper.

There are two contrary conclusions we can reach from this.  From the paper:

These results reaffirm the importance of portfolio diversification, particularly for those investors who view performance in terms of the mean and variance of portfolio returns...The results here show that underperformance can be anticipated more often than not for active managers with poorly diversified portfolios, even in the absence of costs, fees, or perverse skill.

At the same time, a preference for positive skewness in portfolio returns is not necessarily irrational, and it is known that diversification tends to eliminate skewness from portfolio returns. The results reported here also highlight the fact that poorly diversified portfolios occasionally deliver very large returns. As such, the results can justify a decision to not diversify by those investors who particularly value positive skewness in the distribution of possible investment returns, even in light of the knowledge that the undiversified portfolio will more likely underperform.  

The lesson for diversification is clear.  But, it seems like there is an additional factor here having to do with rebalancing.  For the fully diversified investor, rebalancing would be important - even a source of profit.  But, for the less diversified investor, the positive skew would favor momentum.

I wonder, for the non-diversified investor if the idea that there is a tradeoff between positive skew and average underperformance is necessarily true.  It would depend on the balance between winners and losers.  If an investor took a sort of barbell approach, only investing in equities with highly variable potential outcomes, it seems that there could be a large advantage created by that skew for portfolios that maintained positions without rebalancing.  It would come down to skill, in the end.  Small differences in the ability to pick winners - say, picking 60% winners instead of 40% - would make a huge difference in returns.

This seems like another piece of evidence that the real losers are the sort of reputation-based, semi-active portfolios that basically follow the indexes, with minor adjustments, or a sort of middle-of-the-road safe basket of tactical portfolio adjustments that are fairly conventional.  These are the sorts of portfolios over time that tend to have net losses after costs.  But, both fully passive and highly selective portfolios can do well.  Fully passive is certainly recommended for most investors, but highly selective seems to be a reasonable choice, if the risks are known, with tremendous potential upside, and I suspect the benefits of that kind of portfolio tend to be underappreciated because it gets lumped in with "active" portfolios, which sophisticated observers who appreciate EMH are supposed to understand are a loser's bet.

We are the 100% follow up.

Earlier, I was lazy, and I compared compensation and capital income over time with a measure of capital income that included corporate tax.  But, over the long term it is after tax capital income that will equilibrate in domestic incomes.  So, I subtracted corporate tax from the "operating surplus" measure.  This makes the relationship stronger.  Over time, real compensation and real capital income before tax have a .9724 correlation.  Compensation and real capital income after tax have a .9756 correlation.  This is especially interesting, since corporate taxes are pro-cyclical, and so on a cyclical level, corporate income is more noisy after taxes.  (Effective corporate tax rates go up during contractions because losses aren't fully and immediately deductible.)  Even with that extra cyclical noise, removing tax from capital profit strengthens the relationship.

Taxing capital income is not an effective way to break us apart.  We are the 100%.

PS: As commenter Blissex pointed out on the earlier post, this should probably also be adjusted for population.  Adjusting both income levels with the size of the labor force reduces the correlation to about 92%.

We are the 100%.

Eons ago, I told commenter TravisV that I intended to look at this paper, and I finally have.  The abstract is:

Three mutually uncorrelated economic disturbances that we measure empirically explain 85% of the quarterly variation in real stock market wealth since 1952. A model is employed to interpret these disturbances in terms of three latent primitive shocks. In the short run, shocks that affect the willingness to bear risk independently of macroeconomic fundamentals explain most of the variation in the market. In the long run, the market is profoundly affected by shocks that reallocate the rewards of a given level of production between workers and shareholders. Productivity shocks play a small role in historical stock market fluctuations at all horizons.

This would appear on the surface to push against the notion that we are the 100%.  Over the long term, fluctuations in stock market value come from reallocation between workers and shareholders.

The actual findings of this paper are interesting and useful, but I think we need to be careful about how they are interpreted.  Much like the Mian & Sufi findings about the housing boom, mostly what is going on here is that they have adjusted away almost the entire story, and they are analyzing the small sliver that is left.  They have detrended the data exponentially.  For instance, take a look at this graph from the voxeu article:

Over the long term, we can see here that fluctuations from the trend largely correlate with changes in the share of income to shareholders.

From the article's conclusion:

Technological progress that raises aggregate consumption and benefits both workers and shareholders plays a small role in historical stock market fluctuations at all horizons...
Indeed, without these shocks, today's stock market would be about 10% lower than it was in 1980. The shocks responsible for big historical movements in stock market wealth are not those that raise or lower aggregate rewards, but are instead ones that redistribute a given level of rewards between workers and shareholders.

This seems like misleading interpretation to me.  We are talking about a 10% fluctuation over a period where the trend growth was something like 700% in real terms.

Here is a scatterplot of real capital income and real compensation since WW II.  If you want to know what capital income will be in a given year, an extremely good proxy would be knowing the level of compensation in that year - and vice versa.  The correlation is .97.

So, whatever we might learn from this paper - and there are things to learn from it - it seems very important to keep in mind that this paper is about a 3% portion of the total story.

It seems to me that the quote above should be prefaced with the sentence: Technological progress that raises aggregate consumption and benefits both workers and shareholders explains general growth in stock market values, which is about 97% of the growth in income and wealth.  Shifting factor shares might explain much of the other 3%.

It's a shame that the human psyche is so drawn to battles over relative status.  The story of human history and human advancement is a story of the battle to overcome this mental defect.  We are the 100%.  How much social attention is paid to the 97% of the story versus the 3%?

The largest risk of economic dislocations, like what we have seen over the past couple of decades, isn't the actual shocks themselves.  It is the human tendency to retreat into battles over relative status.  Notice that their measure of the effect of factor shares on stock wealth has declined since the late 1990s.  How's that workin' for ya?  Is there any disagreement that 1968 and 1998 were better for both shareholders and workers than 1978 or 2008?

Follow-up

The liberty agenda

Will Wilkinson has a great piece up at Vox that is a nice summary of the need for reforms and the unifying and important message of classic liberalism regarding today's problems.

The nut of the issue:

The problem is that, as the law stands today, economic liberties are not considered "fundamental" enough to merit special legal protection. And that means regulations of the economic sphere are subject to the least demanding level of legal scrutiny — "rational basis." They are considered justified, more or less, simply by virtue of the fact that they have made it through a legislature or city council.

....

And that, in a nutshell, is how the economy got rigged — from bottom to top, from occupational licensing for hair braiders to ironclad intellectual property protections for tech billionaires. American law does not consider economic liberties to be "fundamental" in the way that, say, the right to have an abortion or the right to get a same-sex marriage are fundamental, and so regulations of economic life aren’t required, as matter of law, to have any practical relationship to the goals they are supposed to achieve.

And that means there has been very little to keep interest groups, large and small, from slowly rigging our economy with self-serving regulations under the guise of the public interest. 

You rig an economy or a society by taking away the presumption of rights.  This is obvious to everyone in contexts outside of commerce.  The loss of that presumption in commerce is the key to so many of our social dilemmas.

Happy 4th of July

I recently was reading Laura Ingalls Wilder's "Farmer Boy" with my kids, and I found the ending to be an interesting view into the difficulty of defining "freedom" and how changing technology and economics change our fundamental points of view.  Here, the encroachment of an economy based on specialization and trade are clearly seen as threats to rugged individualism.  It's funny how in our transition away from agriculture, that idea has been reversed and now those who emphasize the importance of a functioning flexible and free economy are associated with rugged individualism.

Today, I hear people exhort college students to avoid the private economy and to go into public service in order to better help others.  Yet, Almanzo's mother exhorts him to avoid the private economy and to remain on the farm because, in the private economy, he would be forced to help others and would lose his independence.

If you google this passage, you will generally find people applauding Almanzo's mother and bemoaning the direction we have traveled since then.  To the contrary, I think Almanzo's mother's position highlights the moral progress we have made.  But, then, I also must confess that we are much less free, in a sense, than Almanzo was, and we are better for it, even as the extension of cooperation and dependency to an unfathomable breadth creates stress for our senses of self and of safety.  There is, unfortunately, no settled ground on which our human nature can rest.

I especially like Almanzo's response to the dilemma, which also seems to shine a light on the human condition.  To paraphrase: "So, Almanzo, do you want progress or independence?"  "Really, Dad?  I can choose what I want?"  "Yes, Almanzo.  What do you want?"   "I want a horse!"

From "Farmer Boy":

Father told her that Mr. Paddock wanted to take Almanzo as an apprentice.
Mother's brown eyes snapped, and her cheeks turned as red as her red wool dress. She laid down her knife and fork.
"I never heard of such a thing!" she said. "Well, the sooner Mr. Paddock gets that out of his head, the better! I hope you gave him a piece of your mind! Why on earth, I'd like to know should Almanzo live in town at the beck and call of every Tom, Dick and Harry?"
"Paddock makes good money," said Father. "I guess if truth were told, he banks more money every year than I do. He looks on it as a good opening for the boy."
"Well!" Mother snapped. She was all ruffled, like an angry hen. "A pretty pass the world's coming to, if any man thinks it's a step up in the world to leave a good farm and go to town!" How does Mr. Paddock make his money, if it isn't catering to us?" I guess if he didn't make wagons to suit farmers, he wouldn't last long!"
"That's true enough," said Father. "But--"
"There's no 'but' about it!" Mother said. "Oh, it's bad enough to see Royal come down to being nothing but a storekeeper! Maybe he'll make money, but he'll never be the man you are. Truckling to the people for his living, all his days -- He'll never be able to call his soul his own."
For a minute Almanzo wondered if Mother was going to cry.
"There, there," Father said, sadly. "Don't take it too much to heart. Maybe it's all for the best, somehow."
"I won't have Almanzo going the same way!"
Mother cried. "I won't have it, you hear me?"
"I feel the same way you do," said Father. "But the boy'll have to decide. We can keep him here on the farm by law till he's twenty-one, but it won't do any good if he's wanting to go. No. If Almanzo feels the way Royal does, we better apprentice him to Paddock while he's young enough."...
..."He's too young to know his own mind," Mother objected.
Almanzo took another big mouthful of pie. He could not speak till he was spoken to, but he thought to himself that he was old enough to know he'd rather be like Father then like anybody else. He did not want to be like Mr. Paddock, even. Mr. Paddock had to please a mean man like Mr. Thompson, or lose the sale of a wagon. Father was free and independent; if he went out of his way to please anybody, it was because he wanted to.
Suddenly he realized that Father had spoken to him. He swallowed, and almost choked on pie. "Yes, Father," he said.
Father was looking solemn. "Son", he said, "you heard what Paddock said about you being apprentice to him?"
"Yes, Father."
"What do you say about it?"
Almanzo didn't exactly know what to say. He hadn't supposed he could say anything. He would have to do whatever Father said.
"Well, son you think about it," said Father. "I want you should make up your own mind. With Paddock, you'd have an easy life, in some ways. You wouldn't be out in all kinds of weather. Cold winter nights, you could lie snug, in bed and not worry about young stock freezing. Rain or shine, wind or snow, you'd be under shelter. You'd be shut up, inside walls. Likely you'd always have plenty to eat and wear and money in the bank."
"James!" Mother said.
"That's the truth, and we must be fair about it," Father answered. "But there's the other side, too, Almanzo. You'd have to depend on other folks, son, in town. Everything you got, you'd get from other folks.
"A farmer depends on himself, and the land and the weather. If you're a farmer, you raise what you eat, you raise what you wear, and you keep warm with wood out of your own timber. You work hard, but you work as you please, and no man can tell you to go or come. You'll be free and independent, son, on a farm."
Almanzo squirmed. Father was looking at him too hard, and so was Mother. Almanzo did not want to live inside walls and please people he didn't like, and never have horses and cows and fields. He wanted to be just like Father. But he didn't want to say so.
"You take your time, son. Think it over," Father said. "You make up your mind what you want."
"Father!" Almanzo exclaimed.
"Yes, son?"
"Can I? Can I really tell you what I want?"
"Yes, son," Father encouraged him.
"I want a colt," Almanzo said....
..."If it's a colt you want, I'll give you Starlight."
"Father!" Almanzo gasped. "For my very own?"
"Yes, son. You can break him, and drive him, and when he's a four-year-old you can sell him or keep him, just as you want to. We'll take him out on a rope, first thing tomorrow morning, and you can begin to gentle him."

Housing Part 110 - Housing and Incomes

I have recently been reviewing an interesting paper from the Boston Fed.  (HT: Jason Schrock, the Chief Economist of Colorado Governor's Office of State Planning and Budgeting)  From the abstract:

Using a logistic migration model, this paper examines the relative role of economic factors—namely labor market conditions, per capita incomes, and housing affordability—in determining domestic state-to-state migration flows....

 

...The model’s estimates show that while all three measures of relative economic conditions are significant determinants of migration, the magnitude of their impact varies. The estimates also show that the impact of these economic factors on state-to-state migration flows has changed considerably over time. For example, the importance of per capita income as a determining factor has fallen considerably since the late 1970s, while that of housing affordability has risen.

I'll get back to that.  From page 1:

Although the region’s unemployment rate was below the national rate as of May, New England had not recovered all of the jobs it lost during the 2001 recession before entering the current economic downturn, largely because of sluggish employment growth in Massachusetts (see Figure 1). At the same time, real house prices jumped 50 percent in New England between 2000 and 2005, compared with an increase of only 33 percent nationwide (see Figure 2). Moreover, household incomes did not keep pace with the run-up in house prices, causing housing affordability to decrease during this period in every New England state (Sasser, Zhao, and Rollins 2006).

Throughout the paper, they do this weird economist thing where they route the causality of constricted housing through prices and elasticities.  In some ways, I am sure that helps to think about things properly.  But, if there is a hamlet with 20 houses renting for $1,000, and 5 years later, the hamlet still has 20 houses, now renting for $1,500, it seems strange to me to think about it in terms of price.  There were 20 households there before and there are 20 households there now, because households need a  house.  The change in price is a reflection of other factors.  Generally, they reach the same conclusion either way.  Housing constrictions have become the bottleneck in most of New England.  But, I think this way of thinking about the effects of housing through elasticities instead of simply through supply may create more heat than light.  If Boston adds enough housing to add 100,000 new workers, normal employment levels will rise by roughly 100,000.  They seem to be thinking about causality as:

More houses => lower home prices => inflow of workers => higher employment

But, I suspect that it makes more sense to think about it, at least in the current situation, as:

More houses => inflow of workers (and employment) => lower local incomes => lower home prices

I think the elasticity that is important here is the elasticity of demand for labor services that gain an advantage by being located in Boston.  Thinking about it this way also makes it more clear how deeply local self interest would cut against any solution to the problem - even if that self interest is intuitive.  Heck, even if intuitions are completely off base about this, simply the causation of a housing solution leading, invariably, to lower local incomes, will create political pressures against it.  If a local political faction institutes a broad set of policies that include a housing solution, they may be run out of office when incomes start to drop, even if not a single voter understands that falling incomes are a necessary part of a housing solution that makes the city livable for middle income families.

Here is a line I will quibble with a bit (also from page 1):

If greater out-migration from New England is related to high housing costs that stem from excessively restrictive zoning regulations, then policymakers might consider expanding the use of statutes such as Massachusetts’s 40B, 40R, and 40S, which require or encourage the building of affordable housing.

This is kind of the nub of the problem.  This statement would be inordinately more true with the removal of the word "affordable".  In fact, with the word "affordable" it may not be true at all.  I expect there is a nearly perfect negative correlation between cities with "affordable" housing statutes and cities with affordable housing.  Likewise, a nearly perfect positive correlation between cities that encourage affordable housing and cities with affordable housing.

Page 3:

During the 2001 recession, the net number of individuals leaving the region increased as expected, yet the exodus continued to accelerate through 2005, reversing course only recently (KE: 2009).

That reversal is likely due to increased utilization of the housing stock because there is little building in the rest of the country.  Since the constraints to building in Closed Access cities are regulatory and since those constraints maintain the value of land that is approved for development well above its alternative uses, the constraints created by national policies since the crisis have had a much more devastating effect on building in Open Access cities than they have in Closed Access cities.  Ironically, even though everyone was concerned about housing affordability, the policies we have imposed only continue to undercut homebuilding in the most affordable places.  Those also happen to be the places where the supposedly irrationally exuberant homebuyers were building before we imposed macro-prudence on them after 2005.

This explains the strange divergence of average new home prices from existing home prices and the subsequent convergence.  Seeing the housing boom from a credit-side perspective, it might have seemed as though the relative decline of new home prices was the result of an influx of many low income borrowers.  But, there weren't an influx of low income borrowers, in the aggregate.  This divergence was a product of location.  There are several ramifications of this.  I'll go into this some more in another post.


In this post, I want to go back to the finding in the paper from the Boston Fed.  They found that migration flows were sensitive to incomes in the late 1970s and 1980s, but that in more recent years, housing affordability has become more important while income has become less important.

But, I think this poses a problem, because the defining characteristic of the period since 1995 is that there is a small subset of cities which have become extreme outliers in both incomes and housing affordability.  In prior periods, higher incomes would induce in-migration, which would induce housing expansion.  In that regime, incomes would correlate with in-migration.

But, in the housing-constrained regime, higher incomes induce in-migration, which induces rent inflation.  So, this paper appears to measure a small in-migration effect from higher incomes and a small out-migration effect from higher home prices.

I think there is probably a more useful way to look at this.  Here is a table of estimated effects from Unemployment, Income, and Housing Affordability, from the paper:

I hope this is readable for you.  The column on the far right estimates the effect, in thousands of residents, of a one standard deviation change in the factor.  The proxy for unemployment is unemployment insurance claims.

From 1977 to 1986, a rise in local unemployment led to out-migration of 209,000 residents, a rise in local income led to in-migration of 789,000 residents.  Housing affordability had negligible effects.

By the 1987 to 1996 period, the unemployment effect remained similar, but now the income effect was small, and there was a small countervailing housing affordability effect.

By 1997 to 2006, a rise in local unemployment appeared to lead to out-migration of 69,000 residents, a rise in local income appeared to lead to in-migration of 32,000 residents and a rise in home prices appeared to lead to an out-migration of 89,000 residents.


I think the way to look at this is that housing supply is largely unresponsive to demand.  So, net relative migration from these factors is forced to zero.  The early period represents the effect of employment and income on migration flows in an Open Access setting (or something resembling that).  I think the measures should be taken as constants for the later period.  The net out-migration of 69,000 residents due to rising local unemployment may be the net effect of falling employment prospects mitigated by falling home prices.  We might think of it as out-migration of about 269,000 residents due to employment shocks and an in-migration or retention of about 200,000 residents because of the directly related relief in housing affordability.

Similarly, rising incomes in the later period might draw about 750,000 residents to the area, but since the area can't take more residents, this leads to higher housing expenses, until about 700,000 residents out-migrate.

It may be that gross coefficient of migration induced by higher incomes that is the most informative.  In 1979, the median income in Boston was about 9% above the US median.  By 1995, it was 27% above, and in 2015 it was 42% higher.  In 1995, Median Income net of Median Rent in Boston was 24% higher than the US median.  By 2015, it had grown to 33% of the US median.  The median household in Boston has only kept about half of their relative income gains since 1995, and Boston has fared better than the other cities that I call "Closed Access" in this regard.

The question this paper poses, to my mind, is, "In gross terms (without the countervailing influence on migration from the constricted housing supply), how much in-migration was induced by a 30% rise in relative incomes?".  That is roughly how much of an increase in housing would be required to make Boston affordable again.

Interesting Article on Non-Emotional Investing

CFA Institute Magazine printed an interview with C. Thomas Howard, director of Athena Investment Services.  He has an extreme style of investment, meant to eliminate all emotional biases.  Some of his ideas are definitely outside the mainstream.  He makes a good argument that the Prudent Man Rule, and even modern portfolio theory itself, are, in some ways, the institutionalization of emotion-driven investing, so that even our ethical and academic frameworks are damaging to optimal investing.

I think he makes some great points, and has some challenging ideas about how to invest wisely.

In the end, the problem comes down to the fact that optimal investing is hopelessly bound up with uncertainty on many levels.  We can never cleanly separate temporary and permanent changes, losses from mistaken tactics and losses from volatility, etc.  So, while the best long term investment needs to be unconcerned with volatility, there will always be the possibility, at the nadir of volatility that is likely to be mean-reverting, that it is actually only the beginning of the consequences of a very poor or very unlucky position.  That includes tactics as broad as having a diversified exposure to the global productive economy.  And, that problem is multiplied many times over when your portfolio is under the management of a 3rd party.

Even when a portfolio does well, it can be for reasons that are unclear.  For instance, the Athena Pure portfolio has gained an average annual return of 25% over 12 years. Howard attributes this to his non-emotional, behavioral finance approach.  But, it just so happens that part of his theory regarding this approach is that he prefers firms with high levels of debt and large dividends.  How much of his gains have come from behavioral finance insights, and how much has come from the happenstance that this profile might do very well in a context of falling interest rates?  (I haven't researched the fund's holdings.)

Here is the link (pdf).  An interesting article, with food for thought, and several good ideas, in any case.

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.

Interest on Reserves in 2008 and now

Interest on Reserves in 2008 - Highly Contractionary

I was reading this paper from Peter Ireland about Interest on Reserves (IOR).  Reading that paper, and thinking through the effects we should expect from IOR, I am thinking that the Fed Funds Rate (FFR) is still the overwhelming factor with regard to monetary policy.  If I have his argument correct, given the current level of reserves, a rising FFR along with a rising IOR rate should basically have the same effect as a rising FFR in an environment where there weren't excess reserves.  If there weren't excess reserves, I imagine that IOR could move around below FFR without much effect on the money supply.  So, it appears that they can use IOR to manage the reduction in the Fed balance sheet.  But, it seems to me that the level of FFR relative to natural interest rates would work basically the same way that it has without IOR.

This leaves the question, however, of whether the implementation of IOR in 2008 was that contractionary to begin with.  Generally, IOR is considered to be a floor for FFR because if IOR was higher than FFR, banks could borrow at the low FFR and hold it as reserves, pocketing the difference in rates.  They would bid the FFR up to a level near the IOR rate, in that case.

 

In October 2008, the Fed implemented IOR, and over the course of a month, ratcheted up the IOR rate until it was equal to the FFR target.  But, throughout this period, the effective federal funds rate was volatile, and tended to run below the FFR target.  So, from November 5, when the Fed pegged the IOR rate to the FFR, until December 16, when the FFR (along with IOR) was finally reduced to 0.25%, the effective FFR was running 0.5% to 0.75% below the IOR rate.  During this time, the Fed had accumulated a substantial amount of non-traditional assets, but it was not purchasing treasuries, and in fact would not start adding to securities held outright until March 2009.

There were so many things going on at the time with the Fed balance sheet, and I am no expert on the micro structure of trades between the Fed and commercial banks.  But, something in November and December 2008 was pushing the effective FFR well below the IOR rate while excess reserves ballooned.  It looks to me like the Fed should have pushed the FFR to 0% in October with no IOR, since the market risk free rate was in free fall, and the economy was desperate for cash.  Instead, the Fed sucked all the panicked cash out of the economy with IOR above the market risk free rate, to the tune of more than half a trillion dollars.


IOR and Excess Reserves at the End of QE

With regard to the amount of excess reserves currently outstanding, I wonder if there is a point where rising short term rates with stable IOR rates would actually be expansionary.  Further, if reserves aren't the only constraint on bank lending, then I think short term rates could rise even while excess reserves remain in the system.  With FFR, IOR, and the level of securities on the Fed balance sheet, there are several moving parts to consider now, but I think, regardless of Fed policy in the very short term, natural short term interest rates might behave fairly typically as the economy continues to recover.  It looks like the Fed is planning on raising IOR and FFR together. But, normally a rising FFR rate resulting from the Fed selling securities would be contractionary.  In the current environment, if the Fed raised FFR but held IOR constant, some of the sterile excess reserves at the banks would be injected into the economy, so that a rising FFR resulting from some Fed selling could still be expansionary.  If this is the case, then the liquidity effect of Fed open market operations would have a very different shape in the context of high excess reserves.

I'm not a banking expert, but it seems like if capital constraints on the banks led to an increase in short term interest rates while reserves remained high, deposit interest rates would remain low, incentivizing depositors to purchase securitized assets from the banks or loan funds outside the banks until the interest rate, new bank assets, and reserve levels reached a new equilibrium.  Peek and Rosengren at the Boston Fed show that for capital constrained banks, loans can expand in response to monetary tightening, or at least that capital constrained banks will not markedly change their credit activity in response to monetary policy.  Is it possible that velocity would be self-correcting as excess reserves decline?

It seems unlikely for the expansionary counter-effect to be greater than the original contractionary effect of reduced reserves.  But, if I imagine an extreme world with $15 trillion in excess reserves with only $1 trillion in treasuries left in private hands, it seems clear to me that a rise in interest rates due to Fed OMO could happen with a large amount of reserves still in place, leading to a strong increase in credit and velocity.  So, at some quantity of excess reserves, a reduction in the Fed's asset base must be expansionary.

I had been wondering if rates would rise slowly as we leave the zero lower bound, but now I am starting to wonder if this context, market rates could rise, which would require the Fed to either overshoot the FFR or raise IOR rates along with FFR in order to counter these odd expansionary effects.  If that is the case, there shouldn't be a drag on the rise in short term rates - at worst they would rise at a pace typical of past recoveries.

Please let me know in the comments if I'm completely out of my element here, but be gentle with me.

Labor force participation trends and assumptions

John Taylor references research by Christopher Erceg and Andrew Levin (this link is to an April 2013 version of the paper Taylor references with a September 2013 date) (HT: Marcus Nunes).  I am disposed to agree with Taylor that the recovery has been slow, partially, due to economic policies.  But, here he is saying that labor force participation (LFP) is low because of these cyclical pressures, and that the economy is much worse than the unemployment rate (UER) would make it seem.  My past reviews of the topic have convinced me that the LFP decline reflects some very typical cyclical movements, and that all of the unusual decline has a demographic source.  So, I took his opening comment: "Research by Christopher Erceg and Andrew Levin is providing solid evidence that the decline in the labor force participation rate since 2007 has been due to cyclical factors" as a challenge.  How could reasonable research coming from the Federal Reserve reach such a different conclusion from what I have found?  Maybe I'm getting it wrong.

I think there are two main factors that are leading to the different conclusions.  My version of the difference is:

1) The study relies on November 2007 projections of LFP from the BLS.  In hindsight, the BLS got it wrong.

2) The minimum wage increases of 2007-2009 pulled a lot of younger workers out of the labor force.  I would agree that this is bad policy, and it led to a kind of cyclical drop in LFP, but the marginal effect of that policy on the rate of change in today's LFP should be small.  The continued downward drift of LFP today is due to demographics.

LFP Trends

Two items from the paper that make this clear are:

First, we can see that the unexpected drop in LFP does not come from workers 55 years and older.  They roughly followed the trend that the BLS forecasted in 2007.

16 to 24 year olds took a huge hit from trend.  We could expect this age group to have more cyclical behavior, but I believe much of this is due to minimum wage increases.

The vast majority of the hit to LFP, in absolute numbers, comes from the 25-54 age group.  The paper acknowledges that there had been a long term downward trend in these age groups.  So, I would expect the actual drop in LFP of -1.5% to reflect the long term trend of -.5%, plus a drop in LFP of about 1%, which would represent about .5% of cyclical movements above and below trend as the economy switched from a very hot labor market with 4.5% UE to a recessionary market with up to 10% Unemployment.  But, strangely, the BLS had projected an increasing LFP for this age group.


Stacking Error on top of Error

Treating the top of the labor market boom of the 2000's as the new normal caused a dual error - forecasts from 2007 started too high, and the trend slopes were adjusted too high.  Here, I will simply compare the least squares linear trend of the long term LFP rates of each age group to the trends set by the BLS in 2007.

Here, we see that, compared to long term trends, the 2007-2012 period looks perfectly normal for 35+ year olds.  The 25-34 year old group has an unusually sharp cyclical deviation, which is now reverting to the mean.  But, the 2007 BLS forecasts all either start above the trend mean or have an inflated slope, or both.  In hindsight, in a data series with such a long pattern of linear behavior with mean reversion tendencies, it was clearly an error to forecast LFP's that would accelerate from a frothy labor market.

The trends in the female LFP's aren't as long, but in 2007, there was a good 10 years of data suggesting a very similar pattern of falling within each age group at a rate of 1% to 1.5% per decade (the coefficients in the trendline equations are based on quarterly units).

Perhaps, due to the shorter history of linear behavior, the BLS can be forgiven for expecting more positive movement from the female series.

In either case, I'm afraid that any analysis that uses the 2007 BLS forecasts as a baseline is simply measuring the understandable failure of the BLS to predict the exact timing of the business cycle.

In hindsight, the naïve linear trends appear to be a much more reasonable baseline than the BLS forecasts.  In every case, the BLS forecasts predict higher LFP's than the naïve trendlines, generally overstating expected levels by 1 to 3 percentage points by 2012, compared to the naïve trends.


Cyclical Decreases in LFP

The Fed paper includes this graph:

The regression produces the following result:

LFP = -0.40 - 0.30*UER

Of which the authors comment:

These regression results provide stark evidence that cyclical factors have been crucial in explaining the recent decline in prime-age LFPR. The coefficient on the lagged change in prime-age unemployment is highly significant (t-statistic of -3.9); that is, the state-level data exhibit a strong negative correlation between changes in LFPR and lagged changes in unemployment for prime-age adults. In contrast, the regression intercept is not statistically significant from zero (t-statistic of -0.97), indicating that the data provides no support whatsoever for structural interpretations of the drop in prime-age LFPR. In effect, the state-level data indicates that the aggregate decline in prime-age LFPR since 2007 can be fully explained by the persistent shortfall in labor demand.

 

That seems like a really strange conclusion to me.

1) The bulk of the long-term trend in declining LFP comes from workers aging out of the prime working age.  Right now, in 2013, there is a downward trend from that effect, and it will be a headwind for the aggregate LFP, regardless of what cyclical issues there are among the prime age group.  These inter-age-group changes cut about 0.65% off of aggregate LFP from 2007-2012.  I don't see how finding cyclical LFP changes within an age group addresses this.

2) Using 25-54 year olds as the prime age group is a problem, because 45-54 year olds have a markedly lower LFP than 25-44 year olds.  Right now, baby boomers are bulking up the 45-54 year old category, so there is a temporary downward trend among this group that amounted to about 0.55% during this period.

3)  They conclude that the intercept, -0.40, is not statistically significant from zero, so they proceed to attribute the entire decline in LFP to cyclical factors.  I would say that -0.40 is not statistically significant from -0.55, which is the secular decline in LFP we would have expected from this age group over this time period.  So, roughly 30% of the LFP decline among 25-54 year olds was the result of long term aging trends.

4) If statistical analysis can come that close to the expected intercept (-0.40 compared to -0.55) and still be interpreted as having an intercept that is not significantly different from zero, then I have doubts about the ability of that analysis to say anything at all.


Taylor attributes this graph to the authors:

This graph looks to me like the Unemployment Rate line assumes that the "normal" LFPR would be practically flat.

On the contrary, the graph below shows a LFP trend line based on long term age-group trends.  This downtrend is accelerating.  Currently, LFP is declining by about 0.1% a year due to long-term trends across the prime age groups, and by about 0.2% a year due to aging baby boomers.


LFP went from about 0.75% above trend in 2007 to about 0.75% below trend at the end of 2012.  This is not outside the range one might expect from a deep recession.  It is about the same as the drop during the 1980-1982 recession, but that recession has a growing LFP trend, due to the entrance of more women into the labor force, so if you don't correct for trend, it looks like there was no LFP retrenchment during that recession.

At the rate the LFP is naturally declining, we will be back to trend by early 2016, even if the Employment to Population Ratio doesn't increase at all.  We are the mirror image of the period of the 1980-82 recession.  At that time, a cyclically rising LFP rose very quickly, and a cyclically dropping LFP looked flat.  Today, a cyclically rising LFP is flat, and a cyclically dropping LFP drops like a stone.  So, comparing the 2007 inflated BLS trends to 1980 is like stacking errors on top of errors on top of errors.

I would agree that policy issues have made this worse, but not in a cyclical way.  JOLTS measures (hires, quits, openings, etc.) are still at low levels, but they have been growing at rates similar to rates in the previous recovery:

I have attributed the entire drop below LFP trend to the minimum wage.  And, the remaining unusual level of unemployment is attributable to the minimum wage and emergency unemployment insurance.  I would call these pro-cyclical structural problems.

Both demand-side Fed solutions and supply-side economic structural solutions can help a little bit, but I think only a little bit.  On the other hand, the pro-cyclical nature of these policies should eventually create some catch-up growth in the labor force and in employment.

Required Returns, P/E Ratios, and Wealth Illusion

There is a really interesting article in the current Financial Analysts Journal by William J. Bernstein.  From the abstract:

both theory and long-run empirical data support the notion that economic growth lowers security returns by reducing impatience for consumption and altering the supply–demand dynamics of capital—the price of living in an increasingly prosperous, safe, healthy, and intellectually gratifying world.

I would boil his argument down to the idea that when increased growth comes from capital growth, the extra returns don't accrue to the legacy capital owners, because the growth is accomplished through what is, or can be thought of as, share dilution.  Further, there are diminished returns to additional capital inputs as a proportion of the economy, so the new growth produces a lower rate of return on invested capital.  So, more wealth and economic growth can lower expected returns.  Put in a simpler way, more supply of capital will bid down the return.

These changes take place over decades or centuries, with a lot of noise.  Even over a lifetime, noise and business cycles can overwhelm these longer term effects.  Bonds saw a spike in yields in the 1970's, followed by a long fall, but I don't see a longer downward trend in real short term bond yields in the post-WW II era.  But that is probably not long a enough period of time to see it in that data series, since bonds have long term noise reactions to demographics, inflation regimes, etc.

But, I think it is interesting to look at equity returns here.  Bernstein refers to the long term trend in the Shiller 10 year Cyclically Adjusted P/E ratio (CAPE).  The t-statistic for a rising trend is only 1.65, so this could be statistically stronger, but since P/E is the corollary to yield, we would expect to see this trend in the face of long-term yield declines.

Separately, I have looked at past S&P 500 returns, in nominal, real, total return, and index returns (w/o dividends), and I haven't found a decline in returns over time.  A sine curve can be fit over any version of the S&P 500 or Dow Jones Industrial Average with a pretty good fit.  Here is the nominal index value of the DJIA back to 1928 with a sine curve fitted to it.  As can be seen in the next graph, the annual return of that sine curve has a slight incline.  After adjusting for inflation and for total returns, the returns over time tend to be flat, but none of the long term trends have a long term decline.

This outcome, together with rising P/E ratios, suggests that the declining market yield has been roughly offset by the resulting gain in valuations.  This is analogous to the bond market of the past 30 years.  In the case of bonds, yields have fallen so quickly that the resulting price increases have resulted in a 30 year bull market.  Going forward, bonds will inevitably see lower returns from the flipside of this phenomenon.  Yields may rise, but since they are starting from such low levels, and since the rise itself will create price losses, there is no mechanism that will allow bonds to match the returns of the previous 30 years.

Normally, references to the concern over the long term rise in the PE ratio would relate to a comparison of fundamentals versus price inflation.  But, I think Bernstein's notion invites a more subtle reading.  Bernstein refers to the Gordon growth model as a simple way to think through this.

If this long-term relationship between capital supply and rates of return holds, then as available capital grows, the required rate of return (k) will decline and growth (g) will decline.  The effect on stock values is indeterminate, but for the broad market, the P/E ratio would increase, since it would move inversely to k.

If capital accumulation continues to grow, and this effect on rates of return exists, then the continued increase in P/E ratios is sustainable.  In fact, it should be expected.  Looking at the first chart, with the long term trend in the CAPE, the trend P/E ratio would equate to a real yield of 7.35% in 1881, 6% in 1950, and 4.9% in 2012.

The trend in PE expansion would add about .3% to the annual return, for a total current expected return of 5.2%.  If trends in required returns over the next 60 years match the previous 60 years, with a required return decreasing to 4% by 2070, the P/E ratio in 2070 would be 25, and the real return on invested capital over that time would be 5%.

These are broad numbers, but my point is that if what we are seeing is a long term downward trend in required returns, then the actual returns over generations will still be very stable, and can be partially sustained by slow inflation in P/E ratios, which itself is a reasonable product of the slowly decreasing return to capital.

There are a lot of confounding factors here.  International capital flows might be increasing US corporate equity returns.  Demographic and cyclical factors will affect interest rates and equity risk premiums over the next few decades to a degree that overpowers this very long-term trend.  But, the point remains that of all the concerns we might have about US equity markets heading into the coming decades, an unsustainable increase in P/E ratios may not be one of them, despite the apparent evidence to the contrary.

There is a concern to consider, though.  This phenomenon involves a kind of wealth illusion, similar to the effect of low rates on bond and home prices in the past 15 years.  The high prices of homes and bonds were justified in the 2000's because of very low long term interest rates.  But, since we conceive of wealth through nominal spot prices, our perception of our level of wealth became very volatile as those prices were whipsawed through the financial crisis.

The relationship between required returns and stock values has the same characteristic.  So, if there is a regime shift in capital behavior in the US that reduces the capital stock, future returns to the remaining capital might increase.  But, those increased future returns will manifest themselves through lower P/E ratios (and lower prices) in the spot market for US equities.  Savers who had experienced a slight boost in their returns as they lived through a period of slightly declining return expectations will suddenly see those gains retracted in this case.

In summary, returns and asset values can experience sustainable boosts from increasing P/E ratios, as long as very long term (centuries long) normal trends remain in place.  P/E ratios will rise and fall through short term and medium term market fluctuations.  The fact that those peaks and valleys are trending higher is not necessarily an immediate concern.  But, this boost comes at the expense of greater pain if we experience an extreme outlier event of a regime shift that includes a capital retrenchment.

Other than typical diversification of regional and asset class exposures, there may not be much that one can do to prepare for an extreme regime shift in capital behavior.  Within the regime that capital planning can manage, the long trend in increasing P/E ratios does not require a significant reduction in our expectations for equity returns over the next generation.  To the extent that far-future returns become significantly lower than the returns we now consider normal, it will because our descendants will be living in a world where capital is not scarce.  That will be a good thing, and it will likely happen long after we have passed.

Real Rates vs. Inflation regarding Housing Prices

Tyler Cowen linked to two pieces on asset prices from Bordo and Landon-Lane looking at asset prices in relation to monetary policy, which got me thinking more about home prices.  Here is a simple chart I put together to help visualize the relationship.

The pieces linked by Tyler seem misguided to me.  It looks to me like the core idea is a tautology - that the market value of assets move inversely to interest rates.  Then, they attribute the movements in those interest rates to monetary policy, with low rates reflecting loose policy and vice versa.

This seems dangerous to me.  Durable assets should have a strong inverse reaction to real long term interest rates.  But, these rates are not dependably related to monetary policy.  To the extent that durable assets act as inflation hedges, a loose monetary policy could reduce their real value by changing the skew of the inflation risk.  And, as I have pointed out with the housing market, inflation can reduce home prices by decreasing demand through high nominal mortgage rates.

The dangerous part is that if rates are low, not because of short term central bank maneuvers, but because of a lack of investment demand or some other structural economic problem, then calls for central banks to tighten monetary policy as a reaction to low rates/high asset prices, would be needlessly damaging.  In fact, it appears as though this is what happened in 2007-2008.

The lowest inflation and NGDP growth rates in the 1970's were higher than the peaks in the 2000's.  Isn't it clear that the low real rates and high asset prices, at least in the 2000's, are driven by something other than loose monetary policy?