tag:blogger.com,1999:blog-66381871135442414812024-03-10T23:23:07.962-04:00SynthenomicsEconomics and Finance BlogYichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.comBlogger135125tag:blogger.com,1999:blog-6638187113544241481.post-84472276447373097282014-02-08T10:56:00.002-05:002014-02-08T10:56:58.135-05:00Why Monetary Policy Should Ignore Financial StabilityFinancial stability is apparently the new hot reason to tighten monetary policy, and in this article for Quartz I go in on some reasons for why this is a horrible idea. <a href="http://qz.com/171741">An excerpt</a><blockquote>
Janet Yellen’s confirmation hearing showed signs that US monetary policy will soon adopt a third mandate. She said: “Overall, the Federal Reserve has sharpened its focus on financial stability and is taking that goal into consideration when carrying out its responsibilities for monetary policy.” While Yellen has traditionally downplayed this mission, the December FOMC meeting minutes also revealed a growing chorus of FOMC participants who believe that monetary policy should do more than just ensure full employment and price stability. Rather, they believe that monetary policy should look out for bubbles and pop them before they jeopardize financial stability. </blockquote>
<blockquote>
At first glance, this sounds like a good idea. After all, who wants financial instability? </blockquote>
<blockquote>
But back in 2002, Bernanke outlined several reasons why tightening monetary policy in response to bubbles is unlikely to work in practice. First, there’s no reason to believe that the Fed can accurately identify bubbles in advance. Second, even if a bubble appears, it’s not clear that raising short term interest rates could pop it. Third, even if monetary policy ends up bringing asset prices down, it is likely to do so only through hurting the livelihoods of average Americans.</blockquote>
Something that should be added, though, is that I still believe research on how monetary policy affects financial stability can be useful. Such research can help us better understand how monetary policy transmission might work, and what things regulators should look out for as the monetary policy landscape changes. However, none of this is any reason why the central bank should base the stock of money on the caprices of the financial markets.Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com3tag:blogger.com,1999:blog-6638187113544241481.post-82098619773065599612014-01-23T15:33:00.005-05:002016-03-19T14:22:03.242-04:00Milken Institute Review: China's Latest Growing PainAfter writing a <a href="http://qz.com/112920/how-chinas-poorest-regions-are-going-to-save-its-growth-rate/">Quartz</a> article on Chinese regional development over the Summer, the Milken Institute Review approached me to write a longer article on the history of Chinese regional inequality, and what the Chinese government can do going forward. My basic argument was that the last decade of growth, unlike the decade prior to that, was one of convergence among provinces. However, to ensure that this can continue going forward, it will be important to continue the process of urbanization and expansion of social services. Read more <a href="http://assets1b.milkeninstitute.org/assets/Publication/MIReview/PDF/28-38_MR61.pdf">here</a>.Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com5tag:blogger.com,1999:blog-6638187113544241481.post-13744433239879290072014-01-09T00:14:00.004-05:002014-01-09T00:14:33.305-05:00Quartz: "Stop the taper talk—the Fed has actually done too little"<div class="tr_bq">
In light of the recent monetary/fiscal policy debate, here's an excerpt of my take from the end of November on monetary offset in the context of the Taper on <a href="http://qz.com/150592/stop-the-taper-talk-the-fed-has-actually-done-too-little/">Quartz</a>:</div>
<br />
<blockquote>
In its recent minutes, it appears that the US Federal Reserve has been preparing to taper. Yet given the outsize role the Fed has played in supporting the recovery, that would almost certainly be a mistake. Unemployment has been ticking down, yet long-term unemployment is still very high and labor force participation is still low. While the recovery has made progress, it is still not guaranteed, and the Fed’s accommodation will be critical if the economy is to secure the gains it has made. </blockquote>
<blockquote>
The key to understanding the argument is to understand a concept central to economic analysis: the counterfactual. Counterfactuals are alternative histories of what could have been. In military history they are the answers to questions like “What would have happened if Napoleon had won the battle of Waterloo?” In this case, the key counterfactual is “What would have happened to the economy if the Fed hadn’t done quantitative easing?” Throughout this recovery, the federal government has been tightening its belt. Indeed, as MKM Partners chief economist Michael Darda has repeatedly noted, net government outlays have fallen for two consecutive quarters during this recovery, making the recent bout of austerity the biggest since the Korean War demobilization. Had the Fed not offset such a large contraction in spending, the US almost certainly would have been sent into another recession.</blockquote>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com5tag:blogger.com,1999:blog-6638187113544241481.post-44508797340707280582013-12-04T00:45:00.002-05:002013-12-04T11:52:43.326-05:00A Reply to Steve Williamson -- Why Dynamic Stories are Important<a href="http://newmonetarism.blogspot.com/2013/12/the-intuition-is-in-financial-markets.html">Steve Williamson</a> caused a firestorm in the blogosphere over his modeling results that helicopter drops in liquidity traps reduce the inflation rate. While hist first few posts were filled with mathematical equations, he was gracious enough in a recent post to present a story of what's going on in the model (my emphasis is bolded)<br />
<blockquote class="tr_bq">
Next, conduct a thought experiment. <b>What happens if there is an increase in the aggregate stock of liquid assets</b>, say because the Treasury issues more debt? <b>This will in general reduce liquidity premia on all assets</b>, including money and short term debt. But we're in a liquidity trap, and the rates of return on money and short-term government debt are both minus the rate of inflation. <b>Since the liquidity payoffs on money and short-term government debt have gone down, in order to induce asset-holders to hold the money and the short-term government debt, the rates of return on money and short-term government debt must go up</b>. That is, <b>the inflation rate must go down</b>. Going in the other direction, <b>a reduction in the aggregate stock of liquid assets makes the inflation rate go up</b>.</blockquote>
<div>
Translated further, Steve's story is as follows:</div>
<div>
<ol>
<li>The central bank prints more money</li>
<li>People don't want to hold onto that money</li>
<li>To make sure people hold onto that money, the inflation rate must fall (to make holding money more attractive)</li>
<li>Hence, printing money lowers the inflation rate.</li>
</ol>
Any cursory scholar of monetary economics should find that counterintuitive. I would suggest that it's counterintuitive because it's, well, wrong. In particular, the jump from (2) to (3) isn't clear at all. If everybody receives a helicopter drop, and nobody wants to spend it, then how does inflation fall? Or in the words of <a href="http://krugman.blogs.nytimes.com/2013/12/02/immaculate-stability-wonkish/?_r=1">Paul Krugman</a>: "How does this requirement translate into an incentive for producers of goods and services — remember, we’re talking about stuff going on in the real economy — to raise prices less or cut them?"</div>
<div>
<br /></div>
<div>
On the other hand, a much more realistic view would be a "<a href="http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/12/helicopter-money-does-not-cause-deflation.html">monetary disequilibrium</a>" <strike>or otherwise stated as David Hume's price specie flow mechanism</strike> as described by David Hume in his essay "On Money". At the moment that people get more money, the inflation rate is fixed. Hence the rate of return isn't high enough to hold money, and so people spend that money. This causes prices to rise and generates inflation.</div>
<div>
<br /></div>
<div>
Here's the fundamental problem with Steve's model: he acts as if equilibrium conditions are enough to explain causality. Sure, in <i>equilibrium</i> it must be that the inflation rate must equal the liquidity value of holding onto money. But that can happen in two ways. Either the inflation rate could fall (Steve's story), or <i>people could hold <strike>less cash</strike> lower real cash balances, </i>thereby raising the marginal value of their liquidity holdings. Dynamic stories matter, and if you can't explain how you get to equilibrium, you may end up on the wrong side of truth.<br />
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<b>Edit: </b>Adjusted for a few comments from Nick Rowe</div>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com3tag:blogger.com,1999:blog-6638187113544241481.post-28676931544254888132013-10-27T20:26:00.002-04:002013-10-27T20:26:25.633-04:00Quartz: China can boost consumption by moving children and the elderly into citiesHere is a link to my <a href="http://qz.com/133292/china-can-boost-consumption-by-moving-children-and-the-elderly-into-cities/">fourth</a> Quartz article, which was on Chinese urbanization and how it relates to the whole consumption/investment debate. An excerpt:<br />
<blockquote class="tr_bq">
The first chapter of Chinese urbanization was a story of migrant workers. The next chapter will be about their families.<br /><br />As China continues to grow, rich, effective urbanization will require more than just providing job opportunities. It will require new policy initiatives to bring more children and elderly from the countryside into the city. By doing so, the Chinese government can begin to address Chinese income inequality, rebalance the economy toward services and consumption, all the while setting the stage for further economic reforms.<br /><br />According to population data from the Chinese National Bureau of Statistics, over the past 30 years the proportion of Chinese people living in cities has more than doubled from around 20% to over 50%. Most of the migration into the cities has been in the form of migrant laborers leaving the countryside in search of higher wages.<br /><br />As a result, prime age laborers are overrepresented in the cities while children and the elderly are underrepresented. According to the 2009 population survey, the proportion of people in cities between the ages of 0-19 was about 2 percentage points lower than in the villages. This number was reversed for people between the ages of 20-39. When mothers and fathers move to the cities in search of higher wages, they leave their children behind to be taken care of by grandparents. As such, if urbanization is going to continue, it will need to bring these groups into the fold.</blockquote>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com4tag:blogger.com,1999:blog-6638187113544241481.post-56733161597098708532013-09-25T03:50:00.004-04:002013-09-25T03:52:03.533-04:00Quartz: Emerging markets need to stop focusing on their exchange ratesHere's a link to my <a href="http://qz.com/122794">3rd Quartz article</a> on how much of the emerging market sell-off was about monetary policy failures in the emerging markets themselves. In particular, by trying to maintain exchange rate policies, central banks in these countries overexpose themselves to foreign economic conditions. The highly positive response to the recent delay of taper serves as further evidence that many of these emerging economies need better ways of insulating themselves from foreign monetary shocks. Much of the work, draws on blog posts from Lars Christensen. His examples comparing monetary policy in Australia and South Africa versus policy in Brazil and Indonesia were particularly helpful. A few excerpts:<br />
<br />
<blockquote class="tr_bq">
The sell-off in emerging markets is not an omen of a prolonged economic contraction. Although capital flows were also turbulent after the 2008 financial crisis, growth in emerging markets continued. Nor is this a sign of financial crisis. “One thing most people seem to agree on is that this is not a replay of the late 1990s,” writes Ryan Avent in the Economist. A combination of exchange rate flexibility and low external debt means that emerging markets are unlikely to experience the same level of carnage as was seen in the 1997. Rather, the sell-off is a statement about how monetary policy has been unable to stabilize output in emerging markets and the importance of monetary reform. </blockquote>
<blockquote class="tr_bq">
...Since all capital controls eventually leak, emerging markets can commit to stabilizing either the exchange rate or domestic output—not both. Economists Joshua Aizenman, Menzie Chinn, and Hiro Ito (pdf) have shown that this tradeoff is real. In the 1972 to 2006 time period, “Greater monetary independence [was] associated with lower output volatility while greater exchange rate stability [implied] greater output volatility.” </blockquote>
<blockquote class="tr_bq">
Between these two options, the answer should be clear. Central banks in emerging markets need to focus on domestic output, and not the exchange rate.</blockquote>
<br />Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com5tag:blogger.com,1999:blog-6638187113544241481.post-71500778622352916862013-09-10T02:08:00.000-04:002013-09-10T02:08:02.999-04:00Some Noahpinion Posts: Gold, Macro, and Bubbles<div class="tr_bq">
I just wanted to remind my readers that I am spending this fall guest blogging at Noahpinion, and so far I have three posts up. </div>
<br />
First, I have one on the determinants of the <a href="http://noahpinionblog.blogspot.com/2013/08/what-determines-return-on-gold.html">value of gold</a>. A key excerpt:<br />
<blockquote>
Gold glitters, but from an investment perspective it does little else. It is backed by neither cash flows (like stocks are) nor a value at maturity (like bonds are). It's just a metal that, historically, has always been highly valued: a value that exists beyond its role in jewelry or in industry. </blockquote>
<blockquote>
So what gives? Broadly speaking, when people make a bull case for gold, they tend to talk about two catalysts. First, they argue that because central banks are engaging in expansionary monetary policy, this will lead to massive levels of inflation that will drive gold prices higher. Second, they argue that gold is valuable because it acts like a panic button and serves as insurance against crisis. These in fact, were the primary motivators behind Paulson's famous bet on gold. In this post, I hope to show that the theory underlying (1) is flat out wrong, and that the logic behind (2) does not correspond to the actual challenging facing the world right now.</blockquote>
Second, I had a post on an elementary outline of general equilibrium theory as it applies to macro. I particularly enjoyed writing the post because I had the chance to play around with drawings to <a href="http://noahpinionblog.blogspot.com/2013/08/macroeconomics-illustrated-edition.html">illustrate the theory</a>. In the post, I argue:<br />
<blockquote class="tr_bq">
Any macroeconomy can be broken down into two main markets: a real market for current goods and services, and a financial market for claims on future goods and services. For brevity, I will reduce the model for financial assets to the market for money, which, because of money's role as a store of value and medium of exchange, captures the notion of "claims on goods". To simplify further, I take all the markets for goods and reduce them down to one composite market, say, for apples. From this caricature, we can start thinking about how markets fit together.</blockquote>
Third, I had a post arguing that there is little evidence for a <a href="http://noahpinionblog.blogspot.com/2013/08/popping-bubble-bubble.html">current bubble in stock prices</a>. I think this was the weakest of the three posts, but I took a look at both forward and backwards PE ratios and concluded that the evidence did not smell of a crisis.<br />
<blockquote class="tr_bq">
Without a doubt, QE has been an incredible boon for financial markets. Backed by QE3, the SP500 stock index has risen by more than 12% year to date. Yet in spite of this increase in the stock market, overall real economic conditions remain relatively stagnant. Year over year inflation as measured by the core PCE price index ticks in at only 1.2% YoY, and last quarter's real GDP grew by only 1.4% YoY. This disconnect is a bit unsettling, because it suggests that bullishness in the stock market has failed to translate into broader growth. On this basis, some commentators, such as <a href="http://coppolacomment.blogspot.com/2013/05/inflation-deflation-and-qe.html">Frances Coppola</a>, have argued that quantitative easing does nothing for the broader economy and worsens economic inequalities. But this concern can be reduced to an even simpler question: Has recent stock market growth just been a bubble?</blockquote>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com0tag:blogger.com,1999:blog-6638187113544241481.post-60607664164535303712013-08-26T22:47:00.002-04:002013-08-26T22:47:32.538-04:00Not Quite Blogging<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhLRfU9234BYU7swU0J604qOj35LCT5VbhttW2oa70p-FRdWdqKsSOxu3qqi5vx-4RZ_lds5G9ICAzjuMsOEl82wjGJbmBMxF6mIPrJv3fB521hMy2GLaXPrW9Lyal0tmNKNduz6m_J5-k7/s1600/image.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhLRfU9234BYU7swU0J604qOj35LCT5VbhttW2oa70p-FRdWdqKsSOxu3qqi5vx-4RZ_lds5G9ICAzjuMsOEl82wjGJbmBMxF6mIPrJv3fB521hMy2GLaXPrW9Lyal0tmNKNduz6m_J5-k7/s640/image.jpg" width="640" /></a></div>
<br />
This is a good time to announce that I am taking a break from writing economics blog posts on this blog for the Fall Term. Instead, I will be featured on <a href="http://noahpinionblog.blogspot.com/">Not Quite Noahpinion</a>! Our team profile can be found <a href="http://noahpinionblog.blogspot.com/2013/08/noahpinion-becoming-not-quite.html">here</a>, and I already have a post on <a href="http://noahpinionblog.blogspot.com/2013/08/what-determines-return-on-gold.html">gold returns</a> up.<br />
<br />
But don't worry, this blog won't completely die out. I will be writing more technical pieces for this blog. In particular, I want to write some tutorials on some R functions, as I have accumulated a good bit of experience with them over the summer and I hope to make the beauty of R more accessible to my fellow college researchers.<br />
<br />
I encourage you to follow Noah's blog, and as always, you can stay in touch with me through Twitter (<a href="https://twitter.com/yichuanw">@yichuanw</a>). Tune in for more economics come winter!Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com0tag:blogger.com,1999:blog-6638187113544241481.post-76135956711183840492013-08-22T22:00:00.002-04:002013-08-22T22:00:22.412-04:00Quartz: High-speed rail is at the foundation of China’s growth strategyThis is a link and data supplement to my second (solo) Quartz column, which was about <a href="http://qz.com/116190">China's high speed rail system</a>. The thrust of the column is that, even though high speed rail is oft maligned as an overinvestment, it actually serves many crucial roles to help China both grow in absolute terms and rebalance towards consumption. I feel like this argument will be a gold mine for China infrastructure bulls like Scott, as by digging through some <a href="http://news.cnhubei.com/hbxw/ycxw/201206/t2125636.shtml">Chinese news articles</a> I found nuggets like this (my translation)<br />
<blockquote class="tr_bq">
Wan Xiao [the train station manager] explained, at 10 PM on June 25th, after the railway administration released the news on the website that the line would open on July 1st, that evening around 50,000 people called to ask about the train, and over 14,000 messages were left.</blockquote>
<blockquote class="tr_bq">
(You can check my translation of "<span style="background-color: #f7fcff; font-family: 宋体, arial; font-size: 14px; line-height: 23px;">万晓介绍,6月25日晚上10点,当铁路局通过官方网站发布汉宜铁路7月1日开通的消息后,当晚的访问量就达到了其上限人数5万人次,留言达到1.4万多条。")</span></blockquote>
I had a lot of fun reading these Chinese news articles, and I'm sure my parents got a kick out of seeing me finally reading Chinese of my own accord.<br />
<br />
There were three points from the column that I wanted to elaborate on.<br />
<br />
First, instead of focusing on some kind of Rail/GDP number, I decided to focus instead on Rail Turnover/Length of Rail. I felt that this statistic was more descriptive because it captured the idea of rail intensity, or how much each stretch of rail was being used. In many of these overinvestment narratives, you hear about how there are all these train stations that aren't being used and how it's all just overbuilt. But when you look at the sheer amount of people and cargo that are being moved on the rails, it makes you question whether the problem is excess capacity or actually excess demand.<br />
<br />
Second, while I partially addressed ridership concerns in the article, I wanted to go further into the effect of high speed rail on the composition of transportation infrastructure in China. Obviously, if China builds more rail, airlines become less competitive. I see this as an advantage because it allows China's infrastructure to grow in a more environmentally friendly manner. Additionally, better rail infrastructure takes the burden off of highways by moving more passengers onto the faster moving trains. Therefore, by emphasizing the trains, China can take the burden off of the "planes and automobiles" part of its transport strategy.<br />
<br />
While this may seem self evident now, there were actually concerns high speed rail would actually worsen the highway situation. In an editorial criticizing Chinese rail, China expert <a href="http://chovanec.wordpress.com/2011/01/14/chinas-high-speed-rail-dilemma/">Patrick Chovanec</a> outlined a bear scenario in which the introduction of high speed rail crowds out slow speed passenger rail (which it has). The migrant workers, who then cannot afford to pay for these high speed rail tickets, then opt for bus travel, further crowding the highways.<br />
<br />
But given the ridership statistics I pointed out in my article, that just doesn't seem to be the case. Moreover, recent evidence suggests that rail has had the benefit of crowding out auto travel. One example I found was from the <a href="http://www.qjren.com/simple/?t341821.html">Qiangjiang news</a>,
which reported that after the opening of the Wuhan-Yichang rail line, demand for bus service from Qianjiang -- a city alongside the high
speed rail tracks – to Wuhan fell by nearly 60 to 70%. The Yichang transport station this year also saw its ground transport volume unchanged from one year ago at 45,000 passengers. Given the massive growth in rail, this suggests that the bear case outlined by Mr. Chovanec hasn't come to pass.<br />
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Third, while my article focused on the passenger side of rail development, freight rail has also become more intense. In particular, freight intensity in many inland provinces, such as Guangxi, Hunan, and Qinghai has been growing at a steady pace. This bodes well for the development of inland infrastructure, as it means more freight needs to be moved, and high speed rail will help open up the capacity for that to happen.<br />
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As always, a link to the data is on the data page. Please reach out if you have any questions.</div>
<br />Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com2tag:blogger.com,1999:blog-6638187113544241481.post-72598574394983072712013-08-22T01:24:00.001-04:002013-08-22T09:29:16.123-04:00A Primer On General Equilibrium, or Why Money MattersThis post is meant to be a short summary of how to think about macroeconomics in terms of general equilibrium. During my conversations with Michael Darda this past summer, it became painfully apparent that clients tend to struggle with how to put money and goods markets together. As a result, I thought I should put together a little piece on my basic approach to thinking through these kinds of "across market" effects, and why it matters for some of the policy debates of our day.<br />
<br />
Any macroeconomy can be broken down into two main markets: a real market for current goods and services, and a financial market for claims on future goods and services. For brevity, I will reduce the model for financial assets to the market for money, which, because of money's role as a store of value and medium of exchange, captures the notion of "claims on goods". To simplify further, I take all the markets for goods and reduce them down to one composite market, say, for apples. From this caricature, we can start thinking about how markets fit together.<br />
<br />
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj9xO7XFS5QolC8Bz20FeyAydXjL5kyT0JQ4btcTImMC_wgWGPvL8rb6AV_vOUnn3fdw9KMA4DkEgZEQ4GvPlkkjioNf2CF2ka2yCBB7rGUhmTxXS0_yxtdKCf4RkcNBrCvecQs6musUXej/s1600/photo+1.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj9xO7XFS5QolC8Bz20FeyAydXjL5kyT0JQ4btcTImMC_wgWGPvL8rb6AV_vOUnn3fdw9KMA4DkEgZEQ4GvPlkkjioNf2CF2ka2yCBB7rGUhmTxXS0_yxtdKCf4RkcNBrCvecQs6musUXej/s640/photo+1.PNG" width="640" /></a><br />
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In normal times, people receive apples and money from the sky in the form of endowments (i.e. their wealth), and they make decisions about how to balance their cash and apple balances. Apples are transacted, bellies are filled, and life is good.</div>
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<br /></div>
<div class="separator" style="clear: both; text-align: left;">
But suddenly, a recession hits. What does this look like? By definition, a recession is when there is a general glut of goods that aren't consumed. In this toy economy, this corresponds to a situation in which some people have apples but choose not to eat them! This may seem peculiar, but remember that the market for apples in this model represents a composite of all goods markets. So it could be the case that while everybody has apples, some want Red Delicious while others are looking for the tartness of Granny Smith. In more formal economic models, this is glibly incorporated by requiring that people do not consume their own endowment and instead trade for consumption. In any case, apples aren't eaten and we have a rotten general glut.</div>
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But this seems peculiar -- aren't markets supposed to clear? Not necessarily. Prices don't always adjust instantly, so we can have excess supplies and excess demands. However, economists do have a way to constrain what this non-clearing state looks like. In particular, according to <a href="http://en.wikipedia.org/wiki/Walras%27_law">Walras' law</a>, assuming everybody spends all of their wealth, if there are excess supplies (i.e. too much produced) in some markets, then they must add up to excess demands (i.e. too little produced) in other markets. In other words, even if supply does not equal demand <i>in each </i>market, supplies must add up to demands <i>across</i> markets.<br />
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The requirement that everybody spends their endowment is crucial. It means that Walras' law doesn't apply just to the market for apples because not everybody spends all their wealth on apples. Instead, some people may put their wealth in money. But once we include the money market, we do have the condition that everybody spends their endowment, and therefore Walras' law <i>does</i> apply to the entire macroeconomy of apples and money.<br />
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This leads to the most important conclusion from general equilibrium theory as related to monetary economics:<br />
<br />
<b><span style="font-size: large;">If there is an excess supply of goods, it must be the result of excess demand for money.</span></b><br />
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The goods market by itself is not enough to generate a recession with a general glut of goods. Only when there is the possibility of excess demand in money markets can recessions actually occur. Therefore the market for money is what gives a macroeconomy its business cycle feel. This is why money is so important for macro -- fluctuations in the money market are the proximate cause for any general fluctuation in the goods market. This is why, as Miles Kimball says, money is the "<a href="http://blog.supplysideliberal.com/post/31655212753/the-deep-magic-of-money-and-the-deeper-magic-of-the">deep magic</a>" of macro.<br />
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While this "apples and money" approach is the canonical presentation of general equilibrium, it is not the unique representation. For another interpretation, think about what the financial market really is. Since it represents the entire universe of claims on future goods, finance can be understood as a veil between the present and the future. So instead of focusing on the relationship between goods and financial markets at <i>one </i>point in time, we can cut out the middle man and instead think of general equilibrium as <i>a sequence</i> of goods markets that occur across multiple points in time. In this version, there is no financial market per se, but buying an apple in "tomorrow's goods market" represents buying a financial contract in the canonical model. Therefore, instead of thinking about the markets for <i>goods and money</i>, we can instead think about the markets for goods <i>today and tomorrow</i>.<br />
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The same excess supply and demand relationship works in this model. If there is an excess supply of goods today, then it must mean that there's an excess demand for goods tomorrow. So in this version of the model, the reason apples aren't eaten today is because people want to wait and eat apples tomorrow. So we get a corollary to the above conclusion:<br />
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<b><span style="font-size: large;">If there is an excess supply of goods today, it must be the result of an excess demand for goods tomorrow.</span></b><br />
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Each of these stories has its own strength. Since the first goods-money model includes actual money, it can help us understand how the price level is determined through monetary neutrality. On the other hand, since general equilibrium is only concerned about relative prices, and since individual dollars are not transacted in the second story, the second story has no "goods/money" relative price -- i.e. the second story cannot pin down an aggregate price level. However, the second story does a better job of being explicit about intertemporal choice. And for now, this intuition about relative prices between the past and the future will be powerful enough that I will focus on this second approach.<br />
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So if recessions are caused by an excess demand for goods tomorrow, how does policy fix a recession? Here, our microeconomic intuition will suffice. If we want to reduce excess demand for a good tomorrow, all we need to do is raise its price relative to today. And since the price of an apple tomorrow is just the amount of money I need to save to afford it tomorrow, lowering the rate of interest between today and tomorrow is sufficient to raise the relative price of tomorrow's apple and get me to consume today. Note that this has an analogue in the first "goods/money" story. By lowering the interest rate on financial assets (and expanding the supply of money), this makes financial assets less worthwhile to hold. People then pivot away towards the goods market, and the general glut is consumed.<br />
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If recessions are generated by this process, the interest rate story shows why monetary policy can be politically difficult. Monetary policy, in this model, just tries to change the relative price of consumption today and tomorrow to resolve the general glut. But just when people most want to save, the interest rate falls and it becomes more expensive to do so! This is part of the more general political difficulty of the price system. Under a price system, the most desired objects are the most expensive. While this may be unpleasant, it's certainly efficient and necessary for avoiding recessions.<br />
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Now, one question that arises is why the real rate of interest doesn't automatically equilibrate to solve these excess demand problems. This is actually a very good question, and is the reason why monetary economics is so important. The primary explanation is that the Federal Reserve may not move fast enough to provide enough money to serve as claims on tomorrow's goods, and therefor the real rate spikes when a crisis hits. This is why we invest so many resources into studying monetary economics, because it is the proximate cause of most recessions.<br />
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So here we close the loop. From a relatively simple model, we now have a theory of employment (apple recession), interest (relative prices), and money (in the canonical representation).<br />
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Now we get to the fun part -- applying this framework to some of the policy debates of the day.<br />
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Let's start with monetary policy. By visualizing a macroeconomy through a sequence of markets, it becomes apparent why forward guidance matters. Even if the interest rate for today is zero, future interest rates may not be. Therefore, by promising to hold rates low for an extended period of time, that makes future apples more expensive relative to current apples. Now, the exact adjustment path may not be ideal, but so as long as we lower the interest rate enough to create enough excess supply in the future, we will be able to restore demand today.<br />
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Interestingly enough, quantitative easing is not in this picture. However, that's a long conversation that will receive its own post in the future.<br />
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We can also think about fiscal policy in this framework. If a recession is just a sign that there's excess demand for goods tomorrow, then for fiscal policy to work, it must convince people to bring some of their future consumption into the present. The conventional old-Keynesian approach to this (i.e. the Intro macro approach), is to argue that by giving people more money today, that makes them want to consume more today, which then directly solves the recession. But the actual mechanism is more subtle, and the efficacy of fiscal policy is entirely determined by its effect on intertemporal choice.<br />
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The Ricardian critique of fiscal policy also pops out of this framework. Ricardian equivalence, roughly speaking, argues that since consumers will take the future costs of taxation into account, therefore fiscal policy will have little effect. In this model, this future cost of taxation means people don't reduce their excess demand for goods tomorrow. Because they know the government will take away those apples, the agents are trying to save up so as to have enough to eat when tomorrow comes. Therefore the whole Ricardian effects/positive multiplier debate again just comes down to whether fiscal policy is actually effective at changing the patterns of consuming today and tomorrow.<br />
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In this context, the <a href="http://blog.supplysideliberal.com/post/24014550541/getting-the-biggest-bang-for-the-buck-in-fiscal-policy">Federal Lines of Credit</a> proposal from Miles Kimball makes a lot of sense. By extending lines of credit to those people who need it most, Federal Lines of Credit can persuade people to reduce their demand for goods tomorrow in favor of goods today.<br />
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I'm not entirely satisfied with this model. In particular there are the glaring omissions of rigorous foundations for inflation or intertemporal <i>production</i>. However, I do think it does serve as a baseline for understanding why intertemporal choice is so important for understanding macro, and I hope to expand on it in future posts.<br />
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<i>Pictures were drawn in <a href="http://www.fiftythree.com/paper">Paper 53</a>.</i>Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com3tag:blogger.com,1999:blog-6638187113544241481.post-36326979387529972292013-08-19T09:13:00.000-04:002013-10-28T23:45:23.523-04:00A Practitioner's Thoughts on Market MonetarismThis summer, I have been working at MKM partners with <a href="http://www.mkmpartners.com/economic.html">Michael Darda</a> doing a wide range of macro research. Since Michael is one of the leading street economists who uses a lot of market monetarist concepts in his work (monetary offset, nominal GDP targeting, market signals), I have accordingly been doing a lot of work on monetary policy and nominal GDP during my time here. This blog post is meant to talk about some problems I have encountered as I have tried to write about these market monetarist concepts in my reports for Michael, and I hope this can be useful for fellow market monetarists -- especially fellow practitioners.<br />
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Before I delve into the specific problems, it might be useful to consider a summary of key propositions that recur in market monetarist discussions. In no particular order, they are summarized below:<br />
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<b>1. Interest rates are an unreliable indicator of the stance of monetary policy.</b> As Milton Friedman reminds us, low interest rates typically indicate that monetary policy has been too tight, and high interest rates typically indicate that monetary policy has been too easy. For example, monetary policy throughout Japan's lost decade was too tight as the central bank would raise interest rates at the first sign of inflation. But as a result, Japanese interest rates have held steady at very low levels. On the other hand, monetary policy in the United States during the 1970's was far too easy, and as a result interest rates were very high. This is because the level of the 10 year nominal rate is determined more by money velocity than anything else. <br />
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<b>2. The only reliable indicator of the stance of monetary policy is a nominal aggregate, such as nominal GDP.</b> Given that interest rates are an unreliable guide, we are left with judging a policy stance by its outcomes. Since the goal of monetary policy is to provide a nominal anchor, then the stance of monetary policy is determined by how the nominal aggregate performs relative to the target. So if nominal GDP is above trend, monetary policy is too tight, and if it is above trend, then policy is too easy. </div>
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<b>3. Market signals serve as the optimal forecast of future economic conditions.</b> Since the price of securities typically reflect all available information, they can serve as a high frequency measure of market expectations. This is particularly attractive because it means a relatively small firm like MKM can abstract away from building a structural forecasting model and instead focus on interpreting the price signals in individual markets. </div>
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<b>4. Never reason from a price change.</b> Clients struggle with this one, but it's really quite simple. In economics, whenever there's a change in conditions, it's because a curve -- supply or demand, liquidity preference, etc. -- has shifted. As a result, a quantity or price changes. But for any given increase in price, whether quantity goes up or down depends crucially on whether the change in price is caused by a supply or demand shock. This sounds like trivial microeconomics, but people often forget it when they start talking about finance. Clients tend to go straight to questions such as "how does this rate hike affect housing markets?" or "how will this increase in crude prices affect the economy?" without asking "why are rates rising?" <br />
Looking back at some of the work I did this summer, I have two takeaways -- one positive, one negative -- from these four core ideas.<br />
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First, the positive. The notion of market signals and of reasoning from curve shifts (i.e. 3 + 4), and not price changes, led me down an interesting path of trying to identify curve shifts from financial market data. This led to my "<a href="http://synthenomics.blogspot.com/2013/07/a-market-monetarist-approach-to.html">Market Monetarist Approach to the Interest Rate Puzzle</a>". The core idea here is that you can use three financial indicators -- the SP500, the TIPS spread, and the 10 year treasury -- as proxies for three "real" economy indicators -- nominal GDP, the inflation rate, and the risk free rate. Now, the stock market one is a bit difficult because equity values are not only a positive function of cash flows (~ nominal GDP), but also a negative function of the risk free rate (because of discounting). Nonetheless, it's one of the few real time metrics we have for growth expectations.<br />
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With these three changes, I interpreted the recent change in the relationship between the 10 year inflation breakeven and the SP500 as a sign of an aggregate supply shock. This was my conclusion from some time series analysis that showed the slope of the relationship between the SP500 and the TIPS spread has not changed, but the intercept has increased. Statistically, this translates to the statement "at all levels of expected inflation, the stock market has higher returns." If we accept the above dictionary into real economy terms, this translates to "at all levels of inflation, nominal GDP is higher" -- the smoking gun of a supply shock.<br />
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I did some follow up work on interpreting these structural shifts in the <a href="http://synthenomics.blogspot.com/2013/07/a-market-monetarist-approach-to.html#comment-form">interest rate puzzle</a> post.<br />
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But now, the negative. Identifying the stance of monetary policy by the outcome leads to circular statistics. If you attribute all fluctuations in nominal GDP to bad monetary policy, then of course monetary policy will seem like a big issue! Put another way, you can observe the positive relationship between nominal GDP and real growth without requiring that monetary policy drives nominal GDP. The tight correlation between nominal GDP and a whole host of other aggregates does not identify a market monetarist viewpoint of the world. And because of the Lucas critique, monetary policy may be unable to exploit this relationship to restore real growth. Perhaps if you use a good bit of economic history, you could identify certain scenarios of exogenous monetary contractions. But in the end, focusing on nominal GDP to determine the stance of monetary policy makes it hard to do any kind of systematic statistical analysis.<br />
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But that doesn't mean there isn't any statistical evidence.<br />
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In my view, one of the more robust pieces of evidence for the power of monetary policy comes from an analysis of fiscal multipliers in open and closed economies. To see why this matters, we need to think about Mundell's impossible trinity. The impossible trinity states that no economy can simultaneously have free flows of capital, a pegged exchange rate, and a sovereign monetary policy at the same time -- you have to give up at least one. Given that most countries have been dismantling their capital controls (especially since capital controls eventually become porous), you can identify whether a country has a sovereign monetary policy by seeing if it has a pegged exchange rate regime. Econometrically, the exchange rate regime serves as an <i>instrument </i>for effective monetary policy that avoids the problems inherent in using interest rates.<br />
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With a few more assumptions, we'll be going places. Suppose that central banks with sovereign monetary policies tend to maintain some kind of nominal stability -- whether inflation or nominal GDP. Then as a result, these central banks would tend to offset fiscal policies more, as those central banks under pegged exchange rates would have to subjugate their monetary policy to maintaining the exchange rate. As a result, if monetary policy matters for real growth, then countries with pegged exchange rates (and therefore no sovereign monetary policy) should exhibit higher fiscal multipliers. This is because these countries have no potential for fiscal offset. By this chain of logic through Mundell's policy trilemma, I have reduced the problem of "Does monetary policy matter for real growth?" to "Are fiscal policy multipliers higher in pegged exchange rate regimes?"<br />
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And are they? Most certainly. In an NBER working paper titled "<a href="http://www.nber.org/papers/w16479">How Big (Small?) are Fiscal Multipliers?</a>", the authors find that the long run multiplier for countries under pegged exchange rates is around 1.4, whereas the multiplier for countries under floating exchange rates is statistically no different from 0. In fact, the authors themselves come to this conclusion about monetary policy. In particular, they show that the monetary offset if floating rate regimes doesn't come through the current account, but rather through private consumption. Their conclusion is that "consumption responds positively to government consumption shocks only when the central bank accommodates the fiscal shock" -- a sure sign that monetary policy is an important force governing the nominal (and real) economies in the short run.<br />
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This pegged/floating exchange rate example bears itself out through the natural experiment comparing austerity in the Eurozone and the United States. Because Eurozone monetary policy has been much more tepid, they can be identified as lacking a responsive monetary policy. So although both economic areas have undergone savage austerity, only the Eurozone has really suffered -- more evidence that monetary policy really does matter.<br />
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(Note, an older version of the plot with government spending was used, but data concerns were raised by Mark Sadowski and David Beckworth. In particular, Beckworth pointed out the correct measure of austerity is the change in the cyclically adjusted primary balance, as provided by the <a href="http://www.imf.org/external/pubs/ft/fm/2012/02/fmindex.htm">IMF Fiscal Monitor</a>)<br />
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However, one consequence of this kind of analysis is that it's hard to quantify the effect of monetary policy on nominal GDP growth -- there's little guidance on how much QE translates into how much growth. Perhaps the expectations channel means that this effect is impossible (and maybe even meaningless) to quantify, but it is a limitation of this mode of analysis.<br />
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Once we accept this analysis and think of monetary policy as driving nominal growth, then the market monetarist mindset of using deviations of nominal GDP to track monetary policy starts to make sense. Once you establish the empirics through other means, the theory of market monetarism comes into play.<br />
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Overall, I find the core ideas espoused by Scott Sumner and fellow market monetarists very powerful. In some regards, they lend themselves easily to financial econometrics and help to organize a a coherent explanation of the macro environment. But some of these ideas need more formal empirical backing -- something that becomes very apparent when talking to clients.</div>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com11tag:blogger.com,1999:blog-6638187113544241481.post-63525592313667184982013-08-08T00:05:00.001-04:002013-08-08T08:38:22.199-04:00China's Growth: A Look Inland - Data SupplementToday my Quartz column on the changing economic geography of China was <a href="http://qz.com/112920">published</a>. In this post I intend to cover some extensions of the article that did not make the cut, and in addition go through some of my <a href="https://www.dropbox.com/sh/llipdg1pwpaqybm/Ce0czPqx_i/China%20Quartz">data analysis procedures</a> so as to provide a resource for fellow students doing similar research.<br />
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A central idea is that the base unit of analysis for the Chinese economy should be the province. This is because China's massive size make its provinces as large as entire countries. For example, Guangdong, a coastal province, has 108 million residents. In comparison, Mexico only has 112 million residents and the entire Western United States only has 71 million residents. The entire continent of Europe has only around 740 million people -- a little less than half that of China's 1.3 billion. As such, lumping all the Chinese provinces together into one entity called "China" papers over so much heterogeneity in income levels and growth rates -- resulting in a very misleading picture about the actual economic situation.<br />
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To get an idea of these massive income differences and why it's important to look at provincial data, consider the stories of Guangdong and Guangxi, two neighboring provinces in southern China. In 2011, Guangdong, the relatively rich coastal manufacturing center, had per capita income of about 51,000 yuan (~$8,300 USD). Yet Guangxi, an inland province right next door, had nominal per capita income of only 25,200 yuan (~$4,100). Does it really seem plausible that Chinese growth will slow down so suddenly that two neighboring provinces whose names differ by one Chinese character* will maintain such a large income gap into perpetuity? Given that Guangxi's per capita income increased by a factor of 3.36 from 2001 to 2011 and Guangdong's per capita income only increased by a factor of 2.06, I would have to say no. Moreover, even if income levels do not completely converge, income growth should. Since Guangxi's income growth rate is still so high, I have to conclude that it's growth will likely be sustained for some time. Had I not analyzed the provincial data, I would have instead seen a downward trend in national real GDP growth numbers and concluded that China will suddenly slow down. But by taking into account the way growth rates evolve across provinces, I arrive at a more optimistic GDP number.<br />
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Geography is especially important given that many of the arguments made by <a href="http://www.nytimes.com/2013/07/19/opinion/krugman-hitting-chinas-wall.html?_r=0">Krugman</a> and a recent <a href="http://www.imf.org/external/pubs/ft/wp/2013/wp1326.pdf">IMF working paper</a> center on Chinese labor markets. The argument is that since China has become richer, China has reached "<a href="http://ashokarao.com/2013/07/30/preparing-for-peak-peasant/">peak peasant</a>" and can no longer sustain such high levels of growth. But I'm left asking -- which provinces have hit this peak? Given that the inland provinces are still relatively poor, there still seems to be a lot of room for these provinces to grow. Although the move towards manufacturing in inland provinces may be a sign that coastal provinces are facing labor shortages, the "reach for peasants" suggests that inland China still has plenty of labor market slack left As a result, I am left quite skeptical about these dramatic bear stories for a sudden slowdown the Chinese economy.<br />
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I also want to add one more graphic to this conversation about China's growth. While the scatterplot in the column does a good job of showing convergence, I wanted another plot to just show how much individual Chinese provinces have grown in the 10 years spanning 2001 to 2011. I settled on the chart below. Besides the components in the legend, the small numbers to the left and right of each dot is the <i>nominal</i> per capita income (in thousands) for the specified province and year. The black number in the middle of the band is then the ratio between 2011 and 2001 levels of real GDP.<br />
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The nominal number is useful because it allows relatively quick conversions into U.S. dollars. As such, it seems that the per capita income in Shanghai is around $13,300 -- a level slightly ahead of <a href="http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)_per_capita">Mexico's per capita income</a> of $10,247 and the U.S. poverty line for a <a href="https://en.wikipedia.org/wiki/Poverty_threshold#National_poverty_lines">single person household</a> of $11,344. The black multiple then emphasizes how much individual Chinese provinces have grown. These above-three multiples correspond to over 12% growth, so if a child entered elementary school in 2001, then by the time he or she goes into elementary school, GDP in that province would have doubled.<br />
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Of course, there are risks to the bull case that I present in my Quartz column.<br />
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Chief among these risks is if there's an environmental constraint prevents the inland provinces from obtaining the same levels of income as the coastal provinces. The Solow model (on which convergence is based) does not take into account natural resources, so if natural resources run out this process of convergence could fall apart. This does not have to be a hard scientific constraint either -- public outcry against environmental destruction would have a similar effect. While I agree that China does face serious environmental challenges (particularly in air and water pollution), I don't think protests will play as large of a role that people suggest. Remember that the <a href="http://www.bloomberg.com/news/2013-07-14/south-china-city-cancels-6-billion-uranium-plant-after-protests.html">recent large scale environmental protests</a> -- in Zhejiang against a petrochemical plant and in Guangdong against a nuclear plant -- have taken place in the richer coast. Therefore inland China still has a way to go before this environmental constraint becomes more severe.<br />
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Others may raise the issue that the Chinese provincial data are a dangerous form of "science fiction". Indeed, it is a bit peculiar as the sum of all the provincial GDP numbers does not equal the total national GDP. But as Princeton professor <a href="http://www.princeton.edu/~gchow/">Gregory Chow</a> notes, while year to year GDP growth rates may be easy to manipulate, levels are not. Since the levels are recollected every year, measurement errors accumulate and therefore any kind of fake data becomes unsustainable. As a result, I focused on a 10 year average growth rate to resolve the issue of year to year measurement errors. Moreover, a recent San Francisco Fed economic letter found that national Chinese data seems to be accurate and consistent with a <a href="http://www.frbsf.org/economic-research/files/el2013-08.pdf">wide variety of indicators</a>. Thus it seems doubtful that the main convergence result was just the result of data manipulation.<br />
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The bottom line is that China's great size means that attention needs to be paid to the individual provinces. On the basis of the provincial levels of growth, I am left quite optimistic about the future of Chinese growth.<br />
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If you want to try and replicate it (please do), just consult the <a href="https://www.dropbox.com/sh/llipdg1pwpaqybm/Ce0czPqx_i/China%20Quartz">public dropbox folder</a>. The workflow goes from running all the STATA do files first and then transitioning into solowQz.R file to draw all the pictures. I have also included a Makefile to go through this workflow. (A Makefile executes all the code in order according to the dependencies. If you plan on doing any major work with code you really should learn a little bit on how to use them)<br />
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The one interesting methodological issue was how I used convergence to forecast future provincial growth. What I did was run a weighted least squares regression of average growth rate against initial log income, in which data was weighted by population and the estimator minimized the sum of weighted square residuals. On the basis of this regression, I assumed that the same relationship between initial income and growth continued into the next ten years and constructed measures of what growth should look like. After I had per capita income estimates, I assumed that population in each province would stay, and on this basis calculated total real GDP numbers by adding up the GDP in each province.<br />
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I had a fun time drawing the maps as well. I used R to interface with the <a href="http://www.gadm.org/country">GADM databases</a>, and you can look at the code in chinaMap.R to get a better idea of what's going on.<br />
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If there are any more questions on code, please reach out. My email can be found on my About Me page.<br />
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*Guangxi and Guangdong literally translate to the western and eastern expanses, respectively. They are really are two sides of a lingual coin.Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com2tag:blogger.com,1999:blog-6638187113544241481.post-54410286591157830962013-07-27T15:16:00.003-04:002013-07-27T15:17:03.367-04:00China's Circularity ProblemIn the context of future looking monetary policy, the circularity problem refers to the problem that central banks face when they try to use market signals to guide policy. The general problem is that the market signals may include expectations of future policy in addition to their expectations of future shocks, so that the market signals fool the central bank into pursuing inappropriate policy. For example, if the private sector believes there will be a large shock to consumer demand in the future, but also believes that the central bank will fully offset the shock, then market expectations of inflation may not change. If the central bank looks at the inflation expectations and concludes that there is no threat to aggregate demand, the central bank may end up not offsetting the shock, and the markets fall in response.<br />
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The most recent example of this in U.S. financial markets is the Fed <a href="http://www.themoneyillusion.com/?p=22070">taper</a>. Before the Fed taper talks, the general expectation was that quantitative easing would continue into the indefinite future and that there would be no premature tightening. As a result, the stock market seemed very resilient because there were expectations of strong growth <i>conditional on Fed easing</i>. The Fed misinterpreted these expectations as independent of the Fed's policy of QE and decided to tighten.</div>
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However, fiscal authorities can also face the same circularity problem. If an economy is highly dependent on government spending, then real economic conditions may be determined <i>conditional </i>on expected future fiscal easing. And if the fiscal authority sees the strong current economic conditions as a justification for austerity, then this too may cause a fall in growth in the same way that a premature monetary contraction can slow growth.</div>
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The Chinese government is currently facing this fiscal policy circularity problem. In an interview on June 18th with the <a href="http://www.bloomberg.com/video/imf-s-rodlauer-says-china-faces-major-challenges-SM8PXCL~Rm2ZVzh3xlkFpg.html">IMF mission chief for China</a> Markus Rodlauer, he notes that high frequency data such as retail sales, investment growth all point to moderate growth. Even thought the <a href="http://www.bloomberg.com/news/2013-07-24/asian-stocks-poised-to-halt-two-day-gain-as-xx.html">PMI may have faltered</a> a little bit, it's well within historical ranges. Rodlauer takes this and makes the conclusion that there's really no need for stimulus. </div>
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While he may be right, it is also likely that the Chinese government could fall into a fiscal circularity problem. Especially since Chinese fiscal policy has the ability to reallocate a large amount of resources, much of business is conducted on the basis of expectations of future government policy. Under these conditions, concluding that economic conditions are strong on the basis of high frequency data may cause the fiscal authority to be too sluggish in responding to a slowdown in growth.</div>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com4tag:blogger.com,1999:blog-6638187113544241481.post-81553430065020552262013-07-24T23:26:00.001-04:002013-07-24T23:26:33.724-04:00Casting and Melting with Paired DataToday's post is not about economics, rather it's a note from an R programming struggle that may be helpful for fellow undergraduate researchers.<br />
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I'm often testing forecasting models, and what this ends up creating is a bunch of "forecasted" variables that are paired with the "actual" values. R has fabulous faceting capabilities, and I have often wanted to reshape the data in a way where the category of forecasted variable as an identifier, and then two columns that list the forecasted and actual variables. In other words, if the code starts from something like<br />
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<span class="Apple-style-span" style="background-color: #002b36; border-collapse: separate; border-spacing: 0px; color: #93a1a1; font-family: 'Ubuntu Mono'; font-size: 14px; line-height: 16px; white-space: pre-wrap;"></span><br />
<pre class="GNVMTOMCABB" style="-webkit-user-select: text; border: none; font-family: 'Ubuntu Mono'; font-size: 10.4pt !important; line-height: 1.2; outline: none; white-space: pre-wrap !important;" tabindex="0"> aAct aPred bAct bPred id
1 1.2076384 -0.6735547 1.4994464 -1.0691975 1
2 0.4999706 -0.7188215 -0.3601551 0.7224729 2
3 1.0340859 -0.1108304 -0.5941295 0.5027085 3</pre>
<pre class="GNVMTOMCABB" style="-webkit-user-select: text; border: none; font-family: 'Ubuntu Mono'; font-size: 10.4pt !important; line-height: 1.2; outline: none; white-space: pre-wrap !important;" tabindex="0"></pre>
And I want to convert it where one column has an id, another one identifies whether I'm forecasting a or b, and a third column that has the forecasted value, and then a fourth column with the actual value.<br />
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The procedure in R involves "melting" the data frame and then "casting" it. Melting is rather simple -- you provide a set of identifiers, and then the data frame is melted down to only that identifier, the values, and another indicator variable that tells you what the value is supposed to represent. In the above example, if we let df be the data frame described above, I would run:</div>
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<span class="Apple-style-span" style="border-collapse: separate; border-spacing: 0px;"></span><br />
<pre class="GNVMTOMCABB" style="-webkit-user-select: text; border: none; font-family: 'Ubuntu Mono'; font-size: 10.4pt !important; line-height: 1.2; outline: none; white-space: pre-wrap !important;" tabindex="0"><span class="Apple-style-span" style="border-collapse: separate; border-spacing: 0px;"><span class="GNVMTOMCHAB ace_keyword" style="background-color: white;">df.m = melt(df, id.vars = 'id')</span></span></pre>
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<pre class="GNVMTOMCABB" style="-webkit-user-select: text; border: none; font-family: 'Ubuntu Mono'; font-size: 10.4pt !important; line-height: 1.2; outline: none; white-space: pre-wrap !important;" tabindex="0"><span style="background-color: white;"><span class="GNVMTOMCHAB ace_keyword">
</span> id variable value
1 1 aAct 1.2076384
2 2 aAct 0.4999706
3 3 aAct 1.0340859
4 1 aPred -0.6735547
5 2 aPred -0.7188215
6 3 aPred -0.1108304
7 1 bAct 1.4994464
8 2 bAct -0.3601551
9 3 bAct -0.5941295
10 1 bPred -1.0691975
11 2 bPred 0.7224729
12 3 bPred 0.5027085</span></pre>
<pre class="GNVMTOMCABB" style="-webkit-user-select: text; border: none; font-family: 'Ubuntu Mono'; font-size: 10.4pt !important; line-height: 1.2; outline: none; white-space: pre-wrap !important;" tabindex="0"><span style="background-color: white;">
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<pre class="GNVMTOMCABB" style="-webkit-user-select: text; border: none; font-family: 'Ubuntu Mono'; font-size: 10.4pt !important; line-height: 1.2; outline: none; white-space: pre-wrap !important;" tabindex="0"><span style="background-color: white;">
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<span style="background-color: white;">Now I need to "unmelt" part of the data frame to get the forecast/actual pairings. In R, this is known as casting and I know that I personally had a pretty hard time decoding the documentation. The function goes along as</span></span></div>
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<span class="Apple-style-span" style="border-collapse: separate; border-spacing: 0px;"><span style="background-color: white;"><br /></span></span></div>
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<pre class="GNVMTOMCABB" style="-webkit-user-select: text; border: none; font-family: 'Ubuntu Mono'; font-size: 10.4pt !important; line-height: 1.2; outline: none; white-space: pre-wrap !important;" tabindex="0"><span style="background-color: white;">cast(df.m, <IDENTIFIERS> ~ <VALUES>)</span></pre>
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The second part is known as the casting formula and is the part that I have struggled with. But in its most simplest form, the casted frame will look like something with all the identifiers added together as uniquely identifying units ,and then the <VALUES> variables being the labels for the actual value column. If that sounded confusing, I apologize. Perhaps solving the example would help.</div>
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First, I need to find a way to identify whether a row is looking at a or b, and whether it is a forecast or an actual variable. So I first create these variables:</div>
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<pre class="GNVMTOMCABB" style="-webkit-user-select: text; border: none; font-family: 'Ubuntu Mono'; font-size: 10.4pt !important; line-height: 1.2; outline: none; white-space: pre-wrap !important;" tabindex="0"><span style="background-color: white;">df.m$var = substring(df.m$variable, 1, 1)</span></pre>
<pre class="GNVMTOMCABB" style="-webkit-user-select: text; border: none; font-family: 'Ubuntu Mono'; font-size: 10.4pt !important; line-height: 1.2; outline: none; white-space: pre-wrap !important;" tabindex="0"><span style="background-color: white;">df.m$type = substring(df.m$variable, 2) </span></pre>
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Which gives me the data frame:</div>
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<span class="Apple-style-span" style="background-color: #002b36; border-collapse: separate; border-spacing: 0px; font-family: 'Ubuntu Mono'; font-size: 14px; line-height: 16px; white-space: pre-wrap;"></span><br />
<pre class="GNVMTOMCABB" style="-webkit-user-select: text; border: none; font-family: 'Ubuntu Mono'; font-size: 10.4pt !important; line-height: 1.2; outline: none; white-space: pre-wrap !important;" tabindex="0"><span class="Apple-style-span" style="background-color: #002b36; border-collapse: separate; border-spacing: 0px; font-family: 'Ubuntu Mono'; font-size: 14px; line-height: 16px; white-space: pre-wrap;"><span class="GNVMTOMCDBB ace_keyword" style="white-space: pre;">> </span><span class="GNVMTOMCHAB ace_keyword">df.m
</span> id variable value type var
1 1 aAct 1.2076384 Act a
2 2 aAct 0.4999706 Act a
3 3 aAct 1.0340859 Act a
4 1 aPred -0.6735547 Pred a
5 2 aPred -0.7188215 Pred a
6 3 aPred -0.1108304 Pred a
7 1 bAct 1.4994464 Act b
8 2 bAct -0.3601551 Act b
9 3 bAct -0.5941295 Act b
10 1 bPred -1.0691975 Pred b
11 2 bPred 0.7224729 Pred b
12 3 bPred 0.5027085 Pred b</span></pre>
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Now I can cast the frame. In this case, I would use the formula</div>
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df.mc = cast(df.m, id + var ~ type)</span></pre>
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This is how you interpret the formula. Id + var means that every observation is uniquely identified by it's id code and the variable we're forecasting -- a or b. Then "type" on the right side represents the new variable names that will be filled by the values.</div>
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Hope this is useful to others so they don't end up spending hours agonizing over the issue as did I.</div>
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Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com1tag:blogger.com,1999:blog-6638187113544241481.post-89968024702723509682013-07-22T20:28:00.000-04:002013-07-22T20:32:57.271-04:00More on Growth and Convergence Within CountriesIn my last <a href="http://synthenomics.blogspot.com/2013/07/chinas-provinces-and-why-national-data.html#comment-form">post</a> on China, I touched on the issue of Chinese growth by showing a graph with the distribution of Chinese per capita incomes by province, and arguing that there is a strong convergence story pushing China towards more growth. In the comments, Tamar makes a note that many countries do not converge. For example, per capita incomes in Mississippi and Connecticut differ by a factor of about 2, even though the United States is a relatively developed Country. He also suggested that I take a look at Brazil. And so I did. I took a look at the distribution of province per capita income divided by country per capita income for three emerging market economies: Brazil, Mexico, and China, and found that indeed, they were quite close!<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhLaWcTOvbXgepx7bWxQVwLRQSTI2HcpCko1LABtmiXVkeh5sWFPCjhQrpht_rhU4NWSGPR1JYkXmU5w4YwI1FAdmENKybGvd7sEn07D6O3UbZysNTc3xVBRuIf5HXWIuwP_Y3tE-C1yEO/s1600/allDist.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhLaWcTOvbXgepx7bWxQVwLRQSTI2HcpCko1LABtmiXVkeh5sWFPCjhQrpht_rhU4NWSGPR1JYkXmU5w4YwI1FAdmENKybGvd7sEn07D6O3UbZysNTc3xVBRuIf5HXWIuwP_Y3tE-C1yEO/s640/allDist.png" width="640" /></a></div>
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I wondered if it was because I didn't weight for populations, so I downloaded some Mexican population data from their government's website. I didn't have time to do Brazil, but even comparing China and Mexico I found that the distributions were quite similar.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgdCsBuKrX353D9eKcpPky7aFYs25qb_IbuVw6_dTO2cKRo3_lztU7kUlSBgJM21uC207aILYRyyaA80rn32VBu_SkeFxTbrsWijHuCsIhARCGHgPZOa7kTVQ5BlSoetZPmOwwS0zQlO11G/s1600/weightHist.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgdCsBuKrX353D9eKcpPky7aFYs25qb_IbuVw6_dTO2cKRo3_lztU7kUlSBgJM21uC207aILYRyyaA80rn32VBu_SkeFxTbrsWijHuCsIhARCGHgPZOa7kTVQ5BlSoetZPmOwwS0zQlO11G/s640/weightHist.png" width="640" /></a></div>
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On first pass, this bodes poorly for a convergence hypothesis.</div>
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But let's think back to the Solow model. We should only observe convergence in income levels if technologies and savings rates are all identical. But it's entirely plausible that these can differ across provinces, and that they differ for extended periods of time. Therefore a better metric to evaluate convergence is not whether they converge in <i>levels</i>, but rather if they converge in <i>growth </i>rates. In the Solow model, at the steady state, all countries grow at a rate equal to the rate of population growth plus the rate of technological change. If they're all bound together (eg if they're all large counties in one country), then g should be similar across them, and demographic trends typically do not differ hugely among provinces in the long run.</div>
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So if we look at growth rates, now we see convergence at work. As a technical note, I only had data for Mexico from 2003 to 2010. So I got the ratio by exponentiating the 7 year ratio by 10/7. </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglf285e70fYB3ht6VZ7CAJVEc6S_sl85xCM0K-VOMZmUWUnW_cWCpu8cppbSlOszjCYvVRMfn1wjDtDaQSqRANDPcQy-mH_rgW594ADpqupjb3J1rwqGYqyy-tuK9ycUsCy9ymyvwiNLfa/s1600/growthHist.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglf285e70fYB3ht6VZ7CAJVEc6S_sl85xCM0K-VOMZmUWUnW_cWCpu8cppbSlOszjCYvVRMfn1wjDtDaQSqRANDPcQy-mH_rgW594ADpqupjb3J1rwqGYqyy-tuK9ycUsCy9ymyvwiNLfa/s640/growthHist.png" width="640" /></a></div>
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So even though Mexico and China have similar distributions in terms of their with country income levels, they have widely different distributions for growth. Therefore I stand by my original belief that China still has a lot of long run growth potential to go as the poor provinces catch up to the rich.</div>
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<br />Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com4tag:blogger.com,1999:blog-6638187113544241481.post-85099440513594422962013-07-22T06:00:00.000-04:002013-07-22T20:16:27.278-04:00China's Provinces and why National Data can MisleadClose your eyes and think of China. What do you see?<br />
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If you were like me, you saw a large metropolis filled with high rise apartment buildings, inked with chronic air pollution, humming along to the sounds of millions of residents getting through their days.<br />
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I believe this is also the image many economic commentators have in their minds when they talk about an upcoming "Chinese" slowdown. But what I want to do in this short little post is to demonstrate why thinking this way neglects one of China's most important quality: its size.<br />
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China has a total of 1.34 billion people spread over 23 provinces, 4 municipalities, and 5 autonomous regions. Individual provinces in China can have as many people as entire countries. The coastal province of Guangdong has a population of 105 million -- just shy of Mexico's 112 million and far exceeding every country in the European Union. Sichuan, an inland province (known for its spicy food), has a total of 80 million inhabitants -- larger than the entire <a href="http://en.wikipedia.org/wiki/Western_United_States">Western Untied States</a> combined. In this sense, it's better to think of China as a collection of smaller countries united under a currency union called China, and not as a uniform economic entity.<br />
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For example, consider the following map from <a href="http://en.wikipedia.org/wiki/File:GDP_per_capita_China_2004.png">Wikipedia</a> showing per capita income by province.<br />
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<a href="http://upload.wikimedia.org/wikipedia/en/6/67/GDP_per_capita_China_2004.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="522" src="http://upload.wikimedia.org/wikipedia/en/6/67/GDP_per_capita_China_2004.png" width="640" /></a></div>
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As can be seen, there are vast disparities in income. Whereas the coastal provinces are quite rich, the inland ones are quite poor. However, the chart understates these differences because it uses a log color scale. Below is a histogram of the 2012 per capita income and population statistics pulled from the <a href="http://chinadataonline.org/">China Data Center</a> associated with the University of Michigan.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhXRtBJMHcYn7UlS7kLu5aSdnkvVR5zL1ufC6LNo7nvTSsUc3HfmBoTg1csYdN3ds4nZH-fF-Tuj943Z18nJCZcctuz0gtbhqDmBBDyOL877P1bCE7uyrE2BW1CnTTjjbqbW-tcxFT733El/s1600/gdpDist.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="457" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhXRtBJMHcYn7UlS7kLu5aSdnkvVR5zL1ufC6LNo7nvTSsUc3HfmBoTg1csYdN3ds4nZH-fF-Tuj943Z18nJCZcctuz0gtbhqDmBBDyOL877P1bCE7uyrE2BW1CnTTjjbqbW-tcxFT733El/s640/gdpDist.jpeg" width="640" /></a></div>
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GDP per capita in Shanghai was 85,000元 whereas GDP per capita in neighboring Anhui was only 28,792元. Translated into market exchange rates this means an average GDP per capita of $13,848 in Shanghai and only $4690 in Anhui. If we take the Solow model seriously, what this suggests is that there is a massive potential for convergence within China. Even if the inland provinces do not face <i>as favorable</i> conditions as the coastal provinces did when they got rich, do you really expect the 80 million residents of inland Sichuan to stay at 60% of coastal Guangdong's income forever? Especially since China does do so much manufacturing, Dani Rodrik's work on <a href="https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CC8QFjAA&url=http%3A%2F%2Fwww.hks.harvard.edu%2Ffs%2Fdrodrik%2FResearch%2520papers%2FUnconditional%2520convergence%2520rev%25205.pdf&ei=JkbsUc6pCNi84AOgyYGICw&usg=AFQjCNGTQQ4nX49dAoDQra7UZjIL8_lS2w&sig2=FFMCUFdobL-NP1nNeYxpSA&bvm=bv.49478099,d.dmg">unconditional manufacturing convergence</a> suggests that these poorer provinces will inevitably partially catch up with the richer provinces. There's just not enough income for them to get caught in a middle income trap.</div>
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There is also no systematic relationship between population and income. No matter the combination of big or small, rich or poor, there is a Chinese province that fits the description.</div>
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Recognizing this heterogeneity also provides a good reason for why looking at China's GDP per capita statistics provide an overly rosy picture of China's wealth and an overly dour prospects of China's future growth. Because there are a few provinces that are now somewhat rich while most provinces are still very poor, mean GDP per capita for the nation does not accurately represent the plight of most provinces. You can see this by the fact that most provinces in the above scatter plot are below the regression line that approximates the mean level of GDP per capita. As a result, we underestimate the role convergence has to play in bringing more Chinese economies out of poverty and therefore underestimate the true growth potential that China has.</div>
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Bottom line is that "<a href="http://google.com/#q=Krugman+China+Lewis+Point">turning point</a>" arguments that fail to consider the subtleties of individual provinces will lead us astray. Too often, we associate China with middle income images of massive apartment complexes, where in reality much of China is still very poor. Any serious evaluation of where China is going requires careful consideration of how we think growth in individual provinces will evolve. And based on the provincial data, I am quite optimistic.</div>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com4tag:blogger.com,1999:blog-6638187113544241481.post-76710650594840463512013-07-19T00:08:00.000-04:002013-07-19T01:10:23.616-04:00A Market Monetarist Approach to the Interest Rate PuzzleWhat’s going on with real rates, inflation breakevens, and the stock market? From the beginning of 2010 to the end of 2012, these three variables have affected each other in a predictable way. Higher inflation breakevens pushed up the stock market as they served as a sign that aggregate demand was rising. Growth in real rates was associated with increases in the stock market as the real rates served as a predictor of future growth. However, these relationships have broken down in this first half of 2013. In this post, I aim to explain why. By combining movements in market data with traditional economic theory, there is convincing evidence that the recent change is due to a positive aggregate supply shock, and therefore bodes well for economic growth looking forward.<br />
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This post will proceed in three acts. In Act One, I introduce some work that has already been done on this question. In Act Two, I present a new approach to process the market data and the theory that justifies the observations. And in Act Three, I address any residual concerns. Let us now begin.<br />
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<b>Act One -- The Work that Has Been Done</b></div>
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Recent trends in financial markets since 2010 are summarized below. In it we have the movement in the 10 year real interest rate, the 10 year inflation breakeven, and the SP500. During the 2010-2012 time period, the 10 year inflation breakeven was very tightly correlated with the SP500, and if you squint you will notice that increases in the 10 year treasury yield also were correlated with increases in the SP500. However, this seemed to reverse itself starting in 2013. Even as inflation expectations were falling, the SP500 still gained steady ground. Also, when the 10 year real interest rate spiked in recent weeks, we saw a temporary fall in the SP500.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjqoHMNTlr6wOyVqdpiqEVm0RKZkZu6ctwZjveX1COkcDGHxJeR7mgq6_Zb84ZlUQceB18jSqHwCpxM2II_pZuvLabPk2bs_S2qaA786Up-giXIutyZjce6jxAiDBHAlviNdLk_fbssmzQK/s1600/tight.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjqoHMNTlr6wOyVqdpiqEVm0RKZkZu6ctwZjveX1COkcDGHxJeR7mgq6_Zb84ZlUQceB18jSqHwCpxM2II_pZuvLabPk2bs_S2qaA786Up-giXIutyZjce6jxAiDBHAlviNdLk_fbssmzQK/s640/tight.png" width="640" /></a><br />
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Evan Soltas has documented the breakdown of the interest rate <a href="http://esoltas.blogspot.com/2013/06/why-interest-rates-are-rising.html">relationship</a>. There are two signals communicated by a rising rate. First, it could be a signal of stronger future growth -- which should send the SP500 up. On the other hand, it could be a sign that monetary policy will be too tight -- which should send the SP500 down. By looking at 90 day rolling correlations between the daily percent change in the 10 year treasury yield and the SP500 stock index, we can tell the difference. Evan has observed that the correlation coefficient between the two changes is quickly approaching zero. According to <a href="http://esoltas.blogspot.com/2013/07/interest-rates-quick-update.html">him</a><a href="http://esoltas.blogspot.com/2013/07/interest-rates-quick-update.html">,</a> this signals that “over the past 90 days, monetary tightening has<a href="http://esoltas.blogspot.com/2013/07/interest-rates-quick-update.html"> </a>been as important to rates as has been macroeconomic strengthening”. The June survey of primary dealers further confirms this <a href="http://esoltas.blogspot.com/2013/07/is-it-economy-or-fed.html">hypothesis</a>.<br />
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Brad <a href="http://delong.typepad.com/sdj/2013/07/the-largest-and-most-rapid-shift-in-expected-us-monetary-policy-since-1994-the-largest-and-most-rapid-contractionary-shift.html">Delong</a> and Matt <a href="http://www.slate.com/blogs/moneybox/2013/07/11/stealth_monetary_tightening.html">Yglesias</a> have both come into this debate on Evan’s side, arguing that the Fed has been engaging in a stealth monetary policy tightening. To them, these trends are signs that growth could suffer again in the upcoming months as the Fed decides to tighten too early.</div>
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On the other hand, I have looked at the relationship between inflation <a href="http://synthenomics.blogspot.com/2013/07/the-taper-and-growth-reply-to-brad.html">breakevens</a> and the SP500 and believe what we’re really looking at is a positive supply shock. I find that even though 2013 has been characterized by falling inflation breakevens alongside a rising SP500, marginal increases in the TIPS spread still have a positive effect on equity prices. The only difference is that the SP500 seems to have a higher trend growth level -- an alpha with respect to inflation, if you will. I interpret this as an expectation of higher output at every level of inflation. I identify this with a textbook increase in aggregate supply, and thus argue against the monetary tightening hypothesis.<br />
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<b>Act II - Another Look at the Data</b></div>
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One unfortunate oversight of the analysis Evan and I have each done is that we don’t fit our stories together. He says tightening, I say aggregate supply, and we each point to our individual data. But an open question remains: how do our theories explain the other person’s data?<br />
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To try and estimate this, I roll with Evan’s calculations, but with slight modification. Instead of calculating correlation coefficients, I instead compute rolling regression coefficients. I look at week to week changes in inflation breakevens, the 10 year TIPS yield, and the SP500. For each week I compute regressions of percent changes in the SP500 against percentage point changes in the TIPS yield and inflation breakevens for the past 26 week window. The regression slopes measure the response of the SP500 to either interest rate changes or expected inflation. It corresponds loosely to the correlation coefficient Evan calculates. The regression intercept measures the “intrinsic” trend growth of the SP500, independent of interest rates or inflation. By looking at these coefficients in context, I will try and construct a more holistic vision of what the financial markets are trying to say.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEht7dHYiNFuN6IGjAyccznffWBwNMdv_zBYZsZILKyh3mT5YlQKK98kRiKroYV-atSdYRyQEnzWjpOks-ZJEP3jaqQ3Yschw7QBpZ_Lp27M3lKXDboS_3Bhd9WXJkjdLO99XuuLHedZH5gq/s1600/panel.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="512" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEht7dHYiNFuN6IGjAyccznffWBwNMdv_zBYZsZILKyh3mT5YlQKK98kRiKroYV-atSdYRyQEnzWjpOks-ZJEP3jaqQ3Yschw7QBpZ_Lp27M3lKXDboS_3Bhd9WXJkjdLO99XuuLHedZH5gq/s640/panel.png" width="640" /></a><br />
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First, let us take a look at the right side panels which describe the responsiveness of the SP500 to expected inflation. In some sense, changes in the SP500 represent changes in expected future nominal GDP. Therefore, when we look at the relationship between inflation expectations and the SP500, this serves as a proxy for the relationship between inflation and nominal GDP. <br />
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In my view, the spike in the TIPS breakeven intercept is a smoking gun for a positive aggregate supply shock. Think about what the higher intercept means. The regression is of changes in the SP500 against changes in the TIPS breakeven. Therefore an increase in the intercept means that the SP500 grows faster for every level of expected inflation. This effect is quantitatively important as well. In comparison to the 6 months ending 2012, the intercept for the past 6 months suggests that the SP500 has kicked it up from about 0% weekly trend growth that is independent of inflation expectations to about 0.8%. Meanwhile, the slope for the breakeven-SP500 relationship is still positive. This all suggests a more permanent aggregate supply shock is driving the intercept up, whereas day to day aggregate demand shocks keep the slope positive. A diagram of this is shown below.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEisk1npKDsTNbX6YbbXC83PhpICAvk4hyUJmi5wdoI3b969w9_T2KxxYlHA-QZYbIFLdVpbWDmHXMySl-WQD_HnuGPN7kWuYRbqt5ld01_tZq4hyphenhyphenu1pBDrQwRDGbAf2Sgz7SXupVr3S669k/s1600/AS-AD.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="640" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEisk1npKDsTNbX6YbbXC83PhpICAvk4hyUJmi5wdoI3b969w9_T2KxxYlHA-QZYbIFLdVpbWDmHXMySl-WQD_HnuGPN7kWuYRbqt5ld01_tZq4hyphenhyphenu1pBDrQwRDGbAf2Sgz7SXupVr3S669k/s640/AS-AD.PNG" width="480" /></a></div>
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However, careful readers will note that you can get “more output at every price” from a story with a structural shift in aggregate demand with marginal shocks coming from aggregate supply. However, this hypothesis fails on two counts. First, if marginal changes in inflation reflected changes in aggregate supply, not demand, then because aggregate supply shocks send prices in the opposite direction of output, we should expect the TIPS breakeven slope to be negative. Second, the AD story does not match up with the changes in levels. As I showed above, inflation expectations have fallen while the SP500 has risen. If there were a large aggregate demand shock, then we should have seen both the SP500 and TIPS breakeven rise in levels. Therefore, a positive aggregate supply shock provides the most natural interpretation for the right hand panels.<br />
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Now comes the out of sample test. Can an aggregate supply shock explain the low slope and moderately higher intercept in the SP500-real rate relation? Absolutely.<br />
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To see how, I appeal to a version of the IS-MP (Investment Savings, Monetary Policy) model, pictured below. In the diagram, nominal GDP growth is on the x-axis and the real interest rate is on the y-axis. The IS curve is the standard IS curve from intro macro. It describes various combinations of interest rates and nominal GDP levels that give equilibrium in the goods market. At lower levels of the real interest rate, people want to hold onto less money and consume more goods. This results in higher levels of nominal GDP and a downward sloping curve. The MP curve is slightly different because it describes not equilibria but a central bank reaction function. At higher levels of nominal GDP, the Fed sets higher a higher interest rate in order to prevent rapid inflation. These two curves now give a unique equilibrium characterized by an interest rate and a level of nominal GDP.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg1jERQEVoRl3qMlAvSw4RtwrcqIWmOrNuLq8DTNPcpEj3iF5szIXxkK05WMw1-QjxtWDDEvbYO_ZexzlOSpNymt-vVRfiJGJ6joMkGimsYsN1T9gmJ29hODPJ0UzlL4SludP4LAj8Ke2bi/s1600/growth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="640" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg1jERQEVoRl3qMlAvSw4RtwrcqIWmOrNuLq8DTNPcpEj3iF5szIXxkK05WMw1-QjxtWDDEvbYO_ZexzlOSpNymt-vVRfiJGJ6joMkGimsYsN1T9gmJ29hODPJ0UzlL4SludP4LAj8Ke2bi/s640/growth.jpg" width="480" /></a></div>
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Now what happens if there is a supply shock? The increased productive capacity, on first approximation, has no effect on the IS curve. To see why, suppose the monetary authority does not react. Then because a supply shock leaves nominal GDP relatively unchanged, then the IS curve should not move. However, because the Federal Reserve is an inflation targeting central bank, the MP curve shifts down. Now that every unit of nominal GDP consists of more real growth and less inflation, monetary policy becomes easier. Therefore, the new monetary policy curve will look something like MP(2) in the picture above.<br />
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This matches two more details from the regression. <br />
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First, the downward shift of the MP curve means that at every interest rate you observe more output. This matches the somewhat higher regression intercept on the interest rate graph.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjoQizL23YgrcyblGcaHMBUqgt043jH-Agb_cw-t74CyB3zX-GK9CAFAEyDxtl3-e5fP3cHir6GS_jsdlfUBzV5fCMbuxcv2U_TFwMmyvrC2SX7fGzRM2B6bBZW16sCE6H-XeeGsspIfD8D/s1600/noCorr.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="640" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjoQizL23YgrcyblGcaHMBUqgt043jH-Agb_cw-t74CyB3zX-GK9CAFAEyDxtl3-e5fP3cHir6GS_jsdlfUBzV5fCMbuxcv2U_TFwMmyvrC2SX7fGzRM2B6bBZW16sCE6H-XeeGsspIfD8D/s640/noCorr.jpg" width="480" /></a><br />
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Second, since the MP curve is moving, we should expect a weaker correlation between interest rates and output. This is illustrated above. If the MP curve is held constant while the IS curve shifts back and forth, then we will observe a strong correlation between interest rates and output, as shown by the blue line. On the other hand, if the MP curve is moving to MP(2) at the same time, we may end up observing the red dots and finding that the correlation drops. We also should expect this correlation confusion to be a bigger deal for the monetary policy shift than for the aggregate supply shift. As Bernanke is finding out, shifts in MP are linked to relatively unstable market expectations whereas a positive AS shock from something like oil discoveries is much more predictable. The theory behind this explanation of the fall in the correlation is illustrated in the sketch below, and it is actually exactly what we observe in the markets during the first half of this year.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi_OfnzwBgWNdN6YFYr2yP9rF5SxgCn-tzG7zs8DHxqQ9-FVmbdd8suz375_tGbU3ehttS7MTSEpaMBTd7pVGrHSn1pokN2nqpJSy0y9xfF4javk0Ia6vz_qrksqkxKBXvZB6EJnO3BfRAl/s1600/breakdown.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi_OfnzwBgWNdN6YFYr2yP9rF5SxgCn-tzG7zs8DHxqQ9-FVmbdd8suz375_tGbU3ehttS7MTSEpaMBTd7pVGrHSn1pokN2nqpJSy0y9xfF4javk0Ia6vz_qrksqkxKBXvZB6EJnO3BfRAl/s640/breakdown.png" width="640" /></a></div>
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The final step is to get the higher interest rate from the taper, and this can be seen as just the effect of a slight Fed tightening along with a slight rightward shift of the IS curve as business confidence requires. In the end, you have higher growth, higher rates, even though the Fed has tightened (as per the Dealer survey) relative to where it was before.<br />
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<b>Act 3 -- Addressing Additional Concerns</b></div>
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While I believe the above story is the one most consistent with the regression data, there are always additional concerns.<br />
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Most importantly: what is the positive supply shock? I believe the most plausible supply shock could be the further discovery and development of unconventional oil and gas reserves. Therefore when compared to the counterfactual of perpetually rising oil prices, the new discoveries makes it easier for policy makers to respond to energy shocks and improve the economy’s productive capacity.</div>
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An important note is that a rise in oil prices, when it occurs alongside a rising SP500, does not contradict the aggregate supply hypothesis. An aggregate supply shock is characterized by a general fall in inflation as output rises. But if aggregate demand is moving at the same time, we could end up observing higher prices with even higher output. Therefore we identify an aggregate supply shock by seeing higher output *for any given level of inflation*. And this is precisely what we see from the rolling regressions.<br />
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Also, I have somewhat of a harder time explaining the past movements in the intercepts and slopes. Fortunately, the intercepts seem to move up and down together, whereas the slopes do the same. Moreover, the intercepts often go in opposite directions when compared to the slopes. This suggests that supply shocks may be more recurrent than we are led to believe.<br />
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Others may criticize the above approach as too ad-hoc. While to some extent, it certainly is, I believe I have done justice to the spirit of the AS/AD and IS/MP models. Furthermore, if you break down all the layers of abstraction and ad-hoc econometrics, the story is quite simple:<br />
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The massive increase in U.S. petroleum resources has expanded aggregate supply, allowing the economy to attain higher levels of output at every level of inflation. This serves as a massive tailwind for equity markets that no longer depend on aggregate demand inflation to grow. This requires a muddled monetary policy adjustment -- reducing the previously observed correlation between interest rates and growth. Nonetheless, the aggregate supply shock has increased trend growth, making the fluctuations in interest rates matter less.<br />
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Fin.</div>
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Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com3tag:blogger.com,1999:blog-6638187113544241481.post-40178479629357443552013-07-16T23:32:00.002-04:002013-07-19T12:00:53.773-04:00The Reach for Real Bills<div class="separator" style="clear: both; text-align: left;">
Awash with liquidity and starved of paper, must financial markets slip out of control? This is the central question behind the “financial stability” argument against additional monetary easing. According to this objection, the zero bound on interest rates means that the Fed’s easing can do little for the real economy, and the cash created by open market operations just fuel a speculative excess termed a “reach for yield”. I have addressed <a href="http://synthenomics.blogspot.com/2013/07/where-did-reach-for-yield-go.html">one reason</a> why this theory is incorrect. If QE indeed spurred a reach for yield, then the taper talk should have reversed this and caused a flight to safety. Yet after the taper dust settled, we saw cyclicals rally strongly with safe assets falling -- indicating that QE was likely encouraging healthy risk taking and not an anomalous reach. However, this evidence primarily came from equities. In this post, I want to take a different approach to expand the scope of my argument against financial stability concerns. I will start with some monetary history and discuss why thinking in terms of financial stability can be very misleading. In short, adopting financial stability approach to monetary policy is unwise and will likely worsen both the business and financial cycle.</div>
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First, let’s consider the motivating evidence for the financial stability position. Below is a chart prepared by UM alumni <a href="http://www.macrobeat.com/">Naufal Sanaullah</a> charting the loan deposit gap into US commercial banks. According to Naufal, this shows that the usual lending mechanism that we learn in intro macro doesn't work any more. No more loans are going out, and therefore nothing makes it to the real economy. And while the real economy is unaffected, this domestic savings glut drives a reach for yield as banks still need to pay their depositors. <br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi3ok73i5Xu3eJOeDstYR7XlWVagusv58286nT-ATnyMx9cCT2fissc1TboPQIGSV-gAHnbC6IuA5_3_JxrS1JiYiht5fNcVfYl5uAmvmX2X5PpCn9m7oVFawPNEFD4OQVYDPGSodbGjQld/s1600/loandepositgapfedlsaps.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="338" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi3ok73i5Xu3eJOeDstYR7XlWVagusv58286nT-ATnyMx9cCT2fissc1TboPQIGSV-gAHnbC6IuA5_3_JxrS1JiYiht5fNcVfYl5uAmvmX2X5PpCn9m7oVFawPNEFD4OQVYDPGSodbGjQld/s640/loandepositgapfedlsaps.png" width="640" /></a><br />
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If this theory is correct and monetary policy is completely ineffective, the Fed should taper earlier. If the costs to financial markets are great enough, and if the benefits to real economies are small enough, it may be worth it for the Fed to fumigate any excess risk in markets by raising interest rates. <br />
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Thinking in terms of financial stability may seem novel, but the Federal Reserve actually had the same debate during the Great Depression. Julio <a href="http://users.nber.org/~confer/2013/SI2013/FED/Rotemberg.pdf">Rotemberg</a>, in his recent paper for the NBER monetary policy conference, does a wonderful job summarizing the literature on the thought process of the Fed at that time.<br />
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Friedman and Schwartz (1963) stressed instead the substantial declines in the money supply that followed. These were, in part, the result of the Fed’s refusal to lend to banks subject to runs. In addition, and in spite of the exhortations of various Federal Reserve officials at various times, *<u>the Fed resisted embarking in large-scale open-market purchases to offset the declines in banking.8 Under pressure of Congress, such a program was started in April 1932, though it quickly ended in August of the same year. <b>This was rationalized on the ground that conditions were “easy” since there were ample excess reserves. Some officials thought the increase in excess reserves</b> (and reduction in borrowing from the Fed) <b>proved that the program was ineffective</b>.9</u>* </blockquote>
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Given subsequent developments, it seems likely that some members also viewed excess reserves with fear. As excess reserves accumulated in the mid-1930s these fears were openly discussed, and Friedman and Schwartz (1963, p. 523) quote extensively from a 1935 memo that clarifies their nature.* <u>In effect, the Fed worried that banks would use these funds for <b>speculative purposes that would ultimately be costly</b>. *Or, as the 1937 Annual Report put it, the Board feared “an uncontrollable increase in credit in the future.”10 </u>*These concerns were sufficiently intense that the Fed raised reserve requirements by 50% in August 1936. Further increases in 1937 left them at double their 1935 values (Meltzer 2003, p. 509).*</blockquote>
If you look closely, the parallels to the Fed’s dramatic QE policies and current financial stability concerns are uncanny. In both stories, the recession was identified as the result of speculative excess. In response to the crash, both times the Federal Reserve embarked on a program of monetary easing. However, in both instances excess reserves failed to budge, and this was interpreted as a sign that banks just didn’t want to lend -- the Fed was pushing on a string. Finally, as excess reserves persisted, the threat of “speculative purposes” was used to bully the Fed into tightening. The key difference between now and then is that we have a Fed that recognizes its role in supporting the real recovery. Those in 1936 were not as lucky.<br />
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Why did the Fed go on such a destructive path in the 1930’s? Rotemberg identifies the tightness of policy as a consequence of something called the “real bills doctrine”. Under the real bills doctrine, the Fed saw its role as providing credit so that there was enough, and no more, credit to invest in “productive uses”. Since the Great Depression was preceded by a speculative stock bubble, then Fed officials put a premium on making sure credit was put to “productive uses”; The real bills doctrine was the result. According to this doctrine, monetary policy should tighten in recessions when demand for credit falls so as to make sure what credit remains is put towards productive uses. Conversely, monetary policy should ease in booms because firms are looking to find credit to fund their projects. In other words, the real bills doctrine prescribed a procyclical monetary policy.<br />
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This goes to show that we need to avoid framing effects when thinking about monetary policy. Because the Great Depression was the result of an equity bubble, then the economists of the day were so concerned about bubbles that they pursued destructive monetary policy. It is just as important to not make the same mistake today. As the real bills doctrine shows, using the tools of financial economics to solve monetary problems can be very destructive.<br />
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In particular, the concern about excess reserves or a loan-deposit imbalance comes about from ignoring general equilibrium. Walras' law states that the value of excess demands add up to zero across all markets in an economy. So if there is a lack of demand in goods, it must be the result of an excess demand for money that goes into savings. But if the interest rate is low enough, it may no longer be worth it to hold onto the money as savings and people will spend it. In the limit, if people knew that all of their cash would disappear when the next day started, they would certainly spend today. There must be a real interest rate, perhaps negative, that would make people want to give up enough money to equilibrate the goods market. This conclusion now recasts the question to whether that negative rate is attainable. Once you can reach any arbitrary rate, then the money markets and good markets are sure to equilibrate.<br />
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Of course if the Fed was stuck at the current interest rate it could never attain the negative rate. But that’s where forward guidance comes into play. What forward guidance allows the Fed to do is pin down the future price level -- even if there appear to be no tools right now. This is the well known escape clause in Krugman’s original analysis of the liquidity <a href="http://www.brookings.edu/~/media/projects/bpea/1998%202/1998b_bpea_krugman_dominquez_rogoff.pdf%20%5D">trap</a>. If the Fed can commit to a future policy path, the zero lower bound no longer matters.<br />
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To get a more intuitive feel for this argument, you should think in terms of an observable Fed policy rate (r) and an unobservable Wicksellian, or full employment, rate (w). The full employment rate is so named because it is the interest rate at which all resources are fully employed. In this example, I set both interest rates to be nominal, so r cannot be lower the zero. At any given instance in time, the stance of monetary policy is determined by where the policy rate, r, is relative to the Wicksellian rate, w. If the Fed rate is higher than the Wicksellian rate, the Fed is tightening. If it is lower, the Fed is easing. Dynamically, the Fed's policy stance is determined by the blue area minus the red over all time.<br />
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This gives a natural interpretation for why forward guidance works at the zero lower bound. Even though the Fed’s rate, r, is stuck at zero and is currently above the Wicksellian rate w, the Fed can still generate inflation by promising to keep Fed policy easy in the future, even when the Wicksellian rate rises. This then can move the economy to a different equilibrium. With higher expected inflation, the nominal Wicksellian rate rises since means people are willing to part with their money (read: have no excess demand for money) at higher interest rates. As a result, even though the Fed is constrained right now, it still has power over the future policy path. This goes to show that the zero lower bound is not a serious reason to discount the Fed's ability to conduct monetary policy.<br />
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To get back on track, the Fed must commit to keeping rates low until the price (or nominal GDP) level is back to trend. On the other hand, if the Fed were to raise interest rates now, this would collapse expected inflation, lowering the Wicksellian curve and knocking the economy into a low output, low interest rates environment. So even if you think the low rates environment is causing financial distortions, the only way to get higher rates in the future and to solve the apparent financial distortions of low interest rates is, ironically, to promise to keeping short rates low now.<br />
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The financial stability view gets off track because it ignores general equilibrium effects. In partial equilibrium analysis, when there's an excess stock of something, such as bank reserves, the natural response is to cut supply. But this is misleading analogy for bank reserves, because an excess supply of bank reserves actually represents an excess demand for money. Therefore the proper response is to maintain lower rates and not prematurely tighten.<br />
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Therefore the real bills/financial stability doctrine fails for three reasons. First, it identifies excess reserves as the result of reduced borrowing that the Fed cannot control, whereas the excess reserves actually are symptoms of an excess demand for money that easier monetary policy can address. Second, this misdiagnosis means we are left thinking the Fed is powerless, whereas the Fed can pin down the price level through forward guidance. Third, it ignores the general equilibrium relationship between money and goods. By prematurely raising rates, this actually depresses interest rates in the long run and worsens the excess demand for money. Bottom line? Worrying too much about financial stability concerns can exacerbate the business cycle and actually prolong a period of low rates. Instead, the Fed should keep its eyes on the real economic prize, and keep financial decisions separate from its monetary ones.Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com8tag:blogger.com,1999:blog-6638187113544241481.post-108922180666391972013-07-11T22:48:00.001-04:002013-07-11T22:48:03.264-04:00Micro and Macro Benefits Should Stay SeparateRecent posts by Mark <a href="http://economistsview.typepad.com/economistsview/2013/07/government-consumption-versus-government-investment.html">Thoma</a> and Michael <a href="http://greedgreengrains.blogspot.com/">Roberts</a> have spurred me to think more about how to evaluate fiscal policies at the zero lower bound. Both Thoma and Roberts make arguments that because crowding out is less severe at the zero lower bound, certain government investments become much more desirable. For Thoma, this policy is increased infrastructure investment, whereas Roberts focuses more on investments in environmental policy. As such, Roberts asks: “how do we more generally evaluate the costs and benefits of public policies in a depressed economy?” This post will be an attempt at answering that question. My core thesis is that while government investment can be more desirable at the zero lower bound, it is no more desirable when the economy is at the zero lower bound than when it is not.<br /><br />Why is the zero lower bound important anyways? One argument against fiscal policy is that government spending can crowd out private spending, leaving net expenditure unchanged. This can happen through two ways. First, it can happen through direct channels -- when the government builds a new school, this may crowd out a private school that was built in the region. Second, there is an interest rate channel. To finance the new spending, the government has to borrow from financial markets, crowding out private borrowing and thereby attenuating any positive effect of fiscal policy. However, when the economy is at the zero lower bound, private investment is typically weak and interest rates are low. These conditions mean that government spending will likely result in “crowding in” as multiplier effects stimulate more activity. This was the major argument behind the <a href="http://delong.typepad.com/20120320-conference-draft-final-candidate-delong-summers-brookings-fiscal-policy-in-a-depressed-economy-1.32.pdf">DeLong and Sumner</a> paper about fiscal policy at the zero lower bound. Therefore government investment spending carries a “double dividend” at the zero lower bound; it boosts output, long run growth, while also avoiding crowding out effects. <br /><br />I see two major problems with this argument. First, it ignores the Sumner Critique about monetary policy offset. If monetary policy controls the nominal growth path of an economy, then there’s no point in trying to get more aggregate demand with government investments. Any multiplier effect will just be canceled out by the monetary authority passively tightening in response. While we haven’t seen as much tightening in the U.S. economy, we have seen this process work in reverse. Even as the government has severely tightened fiscal policy, signs of aggregate demand have held surprisingly <a href="http://www.themoneyillusion.com/?p=22147">steady</a>. A <a href="http://macromarketmusings.blogspot.com/2013/06/what-great-natural-experiment-reveals.html">comparison with Europe</a> -- a continent going through a similarly savage bout of austerity -- leads us to conclude that monetary policy still has a wide latitude in determining aggregate demand even at the zero lower bound. Japan’s recent spike in growth has also shown that monetary policy can have an effect even after a long period of zero rates. This contradicts the assumption made in the DeLong and Summer paper that assumes monetary policy becomes powerless at the zero lower bound, means that any multiplier effects of government investment are minimal. Therefore multiplier or “crowding in” effects do not serve as a sound basis for evaluating government investment.<div>
<br />Now suppose for some reason that the monetary authority has imperfect credibility and cannot pull the economy out of the zero lower bound. Does government investment become more attractive as a result? Still no. This is because the proper benchmark is not the absence of government spending, but rather the next best government spending option. When considering all these investment proposals, we should remember that the government could always spend its money on “firework shows” or “<a href="http://krugman.blogs.nytimes.com/2011/08/24/coalmines-and-aliens/">alien defenses</a>”. This (inefficient) policy scheme would capture all the multiplier expenditure effects with none of the long run growth effects. But as a result, the dividend of using government investment are no greater at the zero lower bound than when interest rates are positive.<br /><br />Some others have made the even more radical argument that the zero lower bound means aggregate supply reducing policies, such as more stringent environmental regulations, can actually have macro benefits at the zero lower bound by increasing inflation. However, a look at forecast data in Japan around the time of the tsunami and in the U.S. around the time of the Libyan oil shocks shows that adverse supply shocks are, well, <a href="http://www.econbrowser.com/archives/2013/06/just_how_helpfu.html">adverse</a>. Output doesn't rise in response to supply shocks -- even at the zero lower bound.<br /><br />So where do we end up? While the “double dividend” hypothesis might be a strong political argument for government investment, the core, apolitical economic analysis suggests that the zero lower bound does not make investment more desirable than usual. As a result, focus needs to be directed towards identifying the efficiency costs of low investment, not low output -- focus on the Harberger triangles, not the Okun gaps.</div>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com0tag:blogger.com,1999:blog-6638187113544241481.post-57300233873770296372013-07-10T23:04:00.001-04:002013-07-11T07:56:48.532-04:00The Taper and Growth -- A Reply to Brad DeLong<div class="separator" style="clear: both; text-align: left;">
Intellectual honesty means disagreeing with even those who are “on my side”. So when the arguments I have made against <a href="http://synthenomics.blogspot.com/2013/07/where-did-reach-for-yield-go.html">Reaching for Yield</a> are also arguments against doomsday predictions for the taper, I have to speak up.</div>
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In this case, I have <a href="http://delong.typepad.com/sdj/2013/07/the-largest-and-most-rapid-shift-in-expected-us-monetary-policy-since-1994-the-largest-and-most-rapid-contractionary-shift.html">Brad DeLong</a> in mind. In a post today, Brad sees the recent rise in real interest rates as measured by the 10 Year TIPS yield and the fall in inflation expectations as measured by the 10 year breakeven as cause for alarm, claiming that “Not since 1991 have we had such a large and rapid contractionary shift in the market's belief about what the Federal Reserve's reaction function.” <br />
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Reading his post, it almost sounds like Fed policy is going to collapse growth. But I would argue that while Fed policy is failing to promote maximum employment, it hardly follows that growth will collapse. I come to this conclusion also by looking at financial data. Below I reproduce a plot of the real interest rate, inflation breakeven (both 10 year), and add a plot of the SP500. I focus in on 2013 to see the recent dramatic changes.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg6TKQw-Uys6p5iG-Hd8b7h7lMbgpM-8eWNRYBcllSq5TSlEJl6B7cEvWaE77s8Lzzj7foZFiOiEaSHTQR7zh0esR_-ee2-52APOHzdY513HFwbxLNFPNVSqAzIWA0ceBRKV-eATrvMAtU9/s1600/tight.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg6TKQw-Uys6p5iG-Hd8b7h7lMbgpM-8eWNRYBcllSq5TSlEJl6B7cEvWaE77s8Lzzj7foZFiOiEaSHTQR7zh0esR_-ee2-52APOHzdY513HFwbxLNFPNVSqAzIWA0ceBRKV-eATrvMAtU9/s640/tight.png" width="640" /></a><br />
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We can make some stylized observations. First, the real interest rate has been on a steady rise since May. Second, the inflation breakeven has been on secular decline since about March. Third, in spite of all of this, the SP500 has been steadily growing, rising more than 10% on a year to date basis.<br />
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How should we interpret this? If we accept the uncontroversial proposition that stock market movements reflect expectations of future growth, it should be clear that the fall in inflation expectations does not reflect a fall in expected future nominal GDP. This is a break from the trends from 2010 to 2012. But if inflation is not moving in the same direction in output, it must be that a positive supply shock is the driving factor behind the fall in inflation breakevens. <br />
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The natural candidate for the positive supply shock is the fall in oil prices. The recent slowdown in emerging markets and massive <a href="https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CDIQqQIwAA&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424127887324682204578517271965827876.html&ei=FB_eUeOrG5Wp4AOu1ICIAw&usg=AFQjCNHPjydJixd6OOtz1YdSNqh_cWXNlg&sig2=tF6gOfvLvOP_TBjnYOgJSQ&bvm=bv.48705608,d.dmg">expansion in oil production</a> has lowered energy costs for the United States. This is a textbook expansion in aggregate supply, and we should naturally expect output to rise, inflation to fall -- precisely what we observe above.<br />
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<a href="http://research.stlouisfed.org/fredgraph.png?g=kst" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="384" src="http://research.stlouisfed.org/fredgraph.png?g=kst" width="640" /></a><br />
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Nonetheless, I still agree that more monetary stimulus is desired. To see this, we should consider the first differences in inflation expectations and the SP500. In the plot below, I have plotted weekly percent changes in the inflation breakeven and the SP500. Blue denotes points in the 2010-2012 time period, and red denotes the points on a year to date basis. Note that in both samples there is a positive relationship between changes in inflation expectations and changes in the SP500. However, the year to date group has a higher intercept, reflecting that the SP500 has shifted to a higher trend growth path relative to the 2010-2012 period. Indeed, if you run the regressions on the first differences, you find that in the 2010-2012 period, the SP500 would gain only 0.23% in a week if inflation expectations were unchanged. However, in 2013, the value is 0.76% -- almost triple what the previous trend growth rate.<br />
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These facts show the simplest version of the aggregate supply/aggregate demand model in action. If inflation falls while nominal GDP rises, then it must be a positive supply shock. For every level of inflation we achieve a higher level of output. But even after the positive supply shock, aggregate demand policy still plays a role -- i.e. any marginal rise in inflation still translates to a rise in output.<br />
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What went wrong in DeLong’s original analysis was that he reasoned from a price change. He started by talking about inflation and interest rates and then translated that into a statement about monetary policy. On the other hand, I started with a quantity -- the SP500 -- and used that to interpret the price changes. This allows me to fit the data into the standard AS/AD model.<br />
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I can then break down potential data changes to events in the AS/AD model. DeLong writes out a list of four possibilities to interpret changes in the real interest rate and the inflation breakeven. II have produced a similar table below that translate the AS/AD arguments I made above. My version provides endogenous predictions for the real interest rate -- the market indicators are inflation expectations and the SP500.<br />
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In my view, the economy is in state (4). Inflation is weak, but growth will be strong. These growth prospects are also corroborated by the relative strength of cyclical stock sectors relative to safe ones. Investors are ramping up -- not buckling down -- as expectations of future nominal GDP rise. Bottom line? The taper isn't going to knock growth far off track.<br />
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This rate story shows how important markets are in market monetarism, TIPS spreads and movements in the SP500 make for an easy breakdown of aggregate supply aggregate demand. We should take them seriously, even if it’s politically inconvenient for those of us arguing for monetary easing. Interest rate movements signal changes in the reactions of the Fed. But since it's unlikely that the Fed will screw up so badly so as to have elevated interest rates for an extended period when the economy is suffering, rising long rates almost always indicate higher expected nominal GDP. These financial indicators provide policy makers with forward looking data on which to base policy -- a cornerstone of market monetarism.<br />
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I want to end on what the above means for monetary policy and advocates of monetary easing, such as myself.<br />
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First, the recent fall in inflation breakevens should not be interpreted as a monetary tightening -- the change is not being driven by demand, but rather by supply. Second, the Fed is severely failing its dual mandate. Now that inflation is falling, the Fed should have even more latitude to pursue its full employment objectives. In this light, the taper is madness. Third, advocacy for monetary easing should focus on the human costs, not financial costs, of tight money. Wall Street will move on, but Fed complacency in the face of half a decade of slow job growth will leave scars on Main Street for <a href="http://www.bloomberg.com/news/2013-07-05/don-t-get-too-excited-about-today-s-jobs-data.html">years to come</a>.</div>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com5tag:blogger.com,1999:blog-6638187113544241481.post-91233340296201112922013-07-09T21:08:00.001-04:002013-07-09T21:16:27.004-04:00Debt Is Not Damning. Debt is Just DebtThis post is meant to add a little few final goodies to the work I did with Miles Kimball on the <a href="http://qz.com/88781/after-crunching-reinhart-and-rogoffs-data-weve-concluded-that-high-debt-does-not-cause-low-growth/">Reinhart and Rogoff results</a>. In short, Miles and I took another look at the RR dataset as prepared by Herndon et al. and found that the long run effects of debt on growth were vanishingly small. The major innovation driving our finding was to look not at contemporaneous growth, but rather at growth 5 to 10 years out in either direction. We ended up finding that while low past growth does a good job of predicting high current debt, current debt does a rather poor job predicting low future growth.<br />
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The column had a <a href="https://www.google.com/#q=kimball+wang+debt+growth">very strong response</a>, and as such we each had a few follow up posts. Immediately after the first article, Miles started addressing new points brought up by various commentators, and these can be seen <a href="http://blog.supplysideliberal.com/">here</a>. I later wrote about controlling for the possibility that policy makers would manipulated their debt levels <i>in <a href="http://synthenomics.blogspot.com/2013/06/instrumental-tools-for-debt-and-growth.html">expectation</a></i> of future growth rates, and Miles had a post on the importance of taking enough lags of growth rates into <a href="http://blog.supplysideliberal.com/post/52121284524/for-sussing-out-whether-debt-affects-future-growth-the">account</a>. We pursued these ideas further in another <a href="http://qz.com/92855/economists-looked-even-closer-at-reinhart-and-rogoffs-data-and-the-results-might-surprise-you/">Quartz article</a> that featured (in my opinion) a very good looking scatterplot that lets you see the individual countries that contribute to the regression results.<br />
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Since part of this controversy was over data sharing practices, I made sure to make all the code available in the Data section of my blog.<br />
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Before presenting the original article, I want to add two more pictures to the debate. The first is a scatter plot that breaks down the relationships between future growth, past growth, and debt by both country and time -- something that <a href="http://esoltas.blogspot.com/2013/05/on-wang-kimball.html">Evan Soltas </a>asked for when the article was released. These diagrams show that even when the observations are grouped by decade, the general conclusion that debt does not slow future growth still holds. This plot also allows you to see which countries are the influential outliers. With any luck, this granularity can inspire some more posts about what the experiences of those individual countries can teach us about debt and growth.<br />
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To me, what is most stark about these plots is that the Solow growth model implies both panels should have downward sloping lines. Since debt levels usually rise as countries approach the technological frontier and start welfare states, we should expect debt to be negatively correlated with growth -- both past and future. Therefore the nearly flat slopes in the left panel really do suggest debt's effect on future growth is quite small.</div>
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As a second plot on this point, I want to present a version of the debt/gdp buckets plot because that nonparametric approach was a big part of the RR debt/growth message. It turns out that as soon as we look at future growth, the buckets no longer show much of a slowdown at all at moderate levels of growth. However, the buckets maintain the robust negative relationship between past growth and current debt. Even though this image might be provocative, I would recommend not reading too much into it. The standard errors should be quite large and are not included, and none of these bar charts adjust for past growth.<br />
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And now, the full text of the article. If you want to mirror the content of this post on another site, that is possible for a limited time if you read <a href="http://blog.supplysideliberal.com/post/28763082121/legal-notice-relating-to-reproduction-or-use-of-content">the legal notice at this link</a> and include both a link to the original Quartz column and the following copyright notice:<br />
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© May 29, 2013: Miles Kimball and Yichuan Wang, as first published on Quartz. Used by permission according to a temporary nonexclusive <a href="http://blog.supplysideliberal.com/post/28763082121/legal-notice-relating-to-reproduction-or-use-of-content">license</a> expiring June 30, 2014. All rights reserved.</blockquote>
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<a href="http://qz.com/88781/after-crunching-reinhart-and-rogoffs-data-weve-concluded-that-high-debt-does-not-cause-low-growth/"><span style="font-size: x-large;">After Crunching Reinhart and Rogoff’s Data, We Found No Evidence High Debt Slows Growth</span></a><br />
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Miles Kimball and Yichuan Wang</div>
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Leaving aside monetary policy, the textbook Keynesian remedy for recession is to increase government spending or cut taxes. The obvious problem with that is that higher government spending and lower taxes tend to put the government deeper in debt. So the <a href="http://www.peri.umass.edu/236/hash/31e2ff374b6377b2ddec04deaa6388b1/publication/566/">announcement on April 15, 2013 by University of Massachusetts at Amherst economists Thomas Herndon, Michael Ash and Robert Pollin</a> that Carmen Reinhart and Ken Rogoff had made a mistake in their analysis claiming that debt leads to lower economic growth has been big news. Remarkably for a story so wonkish, the tale of Reinhart and Rogoff’s errors even <a href="http://www.washingtonpost.com/blogs/wonkblog/wp/2013/04/24/even-stephen-colbert-is-piling-on-reinhart-rogoff/">made it onto the Colbert Report</a>. Six weeks later, discussions of Herndon, Ash and Pollin’s challenge to Reinhart and Rogoff continue in earnest <a href="http://delong.typepad.com/sdj/2013/05/martin-wolfs-point-about-the-british-industrial-revolution-debt-and-growth.html">in the economics blogosphere</a>, in the <a href="http://blogs.wsj.com/economics/2013/05/26/reinhart-and-rogoff-to-krugman-spectacularly-uncivil-behavior/?mod=rss_mobile_uber_feed_europe">Wall Street Journal</a>, and in the <a href="http://krugman.blogs.nytimes.com/2013/05/26/reinhart-and-rogoff-are-not-happy/">New York Times</a>.<br />
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In defending the main conclusions of their work, while conceding some errors, <a href="http://www.nytimes.com/2013/04/26/opinion/reinhart-and-rogoff-responding-to-our-critics.html?pagewanted=all&_r=0">Reinhart and Rogoff point out</a> that even after the errors are corrected, there is a substantial negative correlation between debt levels and economic growth. That is a fair description of what Herndon, Ash and Pollin find, as discussed in an earlier Quartz column, “<a href="http://qz.com/76447/an-economists-mea-culpa-i-relied-on-rogoff-and-reinhart/">An Economist’s Mea Culpa: I relied on Reinhardt and Rogoff</a>.” But, as mentioned there, and as Reinhart and Rogoff point out in <a href="http://www.nytimes.com/2013/04/26/opinion/reinhart-and-rogoff-responding-to-our-critics.html?pagewanted=all&_r=0">their response to Herndon, Ash and Pollin</a>, there is a key remaining issue of what causes what. It is well known among economists that low growth leads to extra debt because tax revenues go down and spending goes up in a recession. But does debt also cause low growth in a vicious cycle? That is the question.<br />
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We wanted to see for ourselves what Reinhart and Rogoff’s data could say about whether high national debt seems to cause low growth. In particular, we wanted to separate the effect of low growth in causing higher debt from any effect of higher debt in causing low growth. There is no way to do this perfectly. But we wanted to make the attempt. We had one key difference in our approach from many of the other analyses of Reinhart and Rogoff’s data: we decided to focus only on long-run effects. This is a way to avoid getting confused by the effects of business cycles such as the Great Recession that we are still recovering from. But one limitation of focusing on long-run effects is that it might leave out one of the more obvious problems with debt: the bond markets might at any time refuse to continue lending except at punitively high interest rates, causing debt crises like that have been faced by Greece, Ireland, and Cyprus, and to a lesser degree Spain and Italy. So far, debt crises like this have been rare for countries that have borrowed in their own currency, but are a serious danger for countries that borrow in a foreign currency or share a currency with many other countries in the euro zone.<br />
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Here is what we did to focus on long-run effects: to avoid being confused by business-cycle effects, we looked at the relationship between national debt and growth in the period of time from five to 10 years later. In their paper “<a href="http://www.nber.org/papers/w18015">Debt Overhangs, Past and Present</a>,” Carmen Reinhart and Ken Rogoff, along with Vincent Reinhart, emphasize that most episodes of high national debt last a long time. That means that if high debt really causes low growth in a slow, corrosive way, we should be able to see high debt now associated with low growth far into the future for the simple reason that high debt now tends to be associated with high debt for quite some time into the future.<br />
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Here is the bottom line. Based on economic theory, it would be surprising indeed if high levels of national debt didn’t have at least some slow, corrosive negative effect on economic growth. And we still worry about the effects of debt. But the two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth.<br />
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The graphs at the top show show our first take at analyzing the Reinhardt and Rogoff data. This first take seemed to indicate a large effect of low economic growth in the past in raising debt combined with a smaller, but still very important effect of high debt in lowering later economic growth. On the right panel of the graph above, you can see the strong downward slope that indicates a strong correlation between low growth rates in the period from ten years ago to five years ago with more debt, suggesting that low growth in the past causes high debt. On the left panel of the graph above, you can see the mild downward slope that indicates a weaker correlation between debt and lower growth in the period from five years later to ten years later, suggesting that debt might have some negative effect on growth in the long run. In order to avoid overstating the amount of data available, these graphs have only one dot for each five-year period in the data set. If our further analysis had confirmed these results, we were prepared to argue that the evidence suggested a serious worry about the effects of debt on growth. But the story the graphs above seem to tell dissolves on closer examination.<br />
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Given the strong effect past low growth seemed to have on debt, we felt that we needed to take into account the effect of past economic growth rates on debt more carefully when trying to tease out the effects in the other direction, of debt on later growth. Economists often use a technique called <a href="http://en.wikipedia.org/wiki/Regression_analysis">multiple regression analysis</a> (or “<a href="http://en.wikipedia.org/wiki/Ordinary_least_squares">ordinary least squares</a>”) to take into account the effect of one thing when looking at the effect of something else. Here we are doing something that is quite close both in spirit and the numbers it generates for our analysis, but allows us to use graphs to show what is going on a little better.<br />
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The effects of low economic growth in the past may not all come from business cycle effects. It is possible that there are political effects as well, in which a slowly growing pie to be divided makes it harder for different political factions to agree, resulting in deficits. Low growth in the past may also be a sign that a government is incompetent or dysfunctional in some other way that also causes high debt. So the way we took into account the effects of economic growth in the past on debt—and the effects on debt of the level of government competence that past growth may signify—was to look at what level of debt could be predicted by knowing the rates of economic growth from the past year, and in the three-year periods from 10 to 7 years ago, 7 to 4 years ago and 4 to 1 years ago. The graph below, labeled “Prediction of Debt Based on Past Growth” shows that knowing these various economic growth rates over the past 10 years helps a lot in predicting how high the ratio of national debt to GDP will be on a year by year basis. (Doing things on a year by year basis gives the best prediction, but means the graph has five times as many dots as the other scatter plots.) The “Prediction of Debt Based on Past Growth” graph shows that some countries, at some times, have debt above what one would expect based on past growth and some countries have debt below what one would expect based on past growth. If higher debt causes lower growth, then national debt beyond what could be predicted by past economic growth should be bad for future growth.</div>
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Our next graph below, labeled “Relationship Between Future Growth and Excess Debt to GDP” shows the relationship between a debt to GDP ratio beyond what would be predicted by past growth and economic growth 5 to 10 years later. Here there is no downward slope at all. In fact there is a small upward slope. This was surprising enough that we asked others we knew to see what they found when trying our basic approach. They bear no responsibility for our interpretation of the analysis here, but Owen Zidar, an economics graduate student at the University of California, Berkeley, and Daniel Weagley, graduate student in finance at the University of Michigan were generous enough to analyze the data from our angle to help alert us if they found we were dramatically off course and to suggest various ways to handle details. (In addition, Yu She, a student in the master’s of applied economics program at the University of Michigan proofread our computer code.) We have no doubt that someone could use a slightly different data set or tweak the analysis enough to make the small upward slope into a small downward slope. But the fact that we got a small upward slope so easily (on our first try with this approach of controlling for past growth more carefully) means that there is no robust evidence in the Reinhart and Rogoff data set for a negative long-run effect of debt on future growth once the effects of past growth on debt are taken into account. (We still get an upward slope when we do things on a year-by-year basis instead of looking at non-overlapping five-year growth periods.)</div>
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Daniel Weagley raised a very interesting issue that the very slight upward slope shown for the “Relationship Between Future Growth and Excess Debt to GDP” is composed of two different kinds of evidence. Times when countries in the data set, on average, have higher debt than would be predicted tend to be associated with higher growth in the period from five to 10 years later. But at any time, countries that have debt that is unexpectedly high not only compared to their own past growth, but also compared to the unexpected debt of other countries at that time, do indeed tend to have lower growth five to 10 years later. It is only speculating, but this is what one might expect if the main mechanism for long-run effects of debt on growth is more of the short-run effect we mentioned above: the danger that the “<a href="http://en.wikipedia.org/wiki/Bond_vigilante">bond market vigilantes</a>” will start demanding high interest rates. It is hard for the bond market vigilantes to take their money out of all government bonds everywhere in the world, so having debt that looks high compared to other countries at any given time might be what matters most.</div>
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Our view is that evidence from trends in the average level of debt around the world over time are just as instructive as evidence from the cross-national evidence from debt in one country being higher than in other countries at a given time. Our last graph (just above) shows what the evidence from trends in average levels over time looks like. High debt levels in the late 1940s and the 1950s were followed five to 10 years later with relatively high growth. Low debt levels in the 1960s and 1970s were followed five to 10 years later by relatively low growth. High debt levels in the 1980s and 1990s were followed five to 10 years later by relatively high growth. If anyone can come up with a good argument for why this evidence from trends in the average levels over time should be dismissed, then only the cross-national evidence about debt in one country compared to another would remain, which by itself makes debt look bad for growth. But we argue that there is not enough justification to say that special occurrences each year make the evidence from trends in the average levels over time worthless. (Technically, we don’t think it is appropriate to use “year fixed effects” to soak up and throw away evidence from those trends over time in the average level of debt around the world.)<br />
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We don’t want anyone to take away the message that high levels of national debt are a matter of no concern. As discussed in “<a href="http://qz.com/69302/austerity-is-bad-economic-policy/">Why Austerity Budgets Won’t Save Your Economy</a>,” the big problem with debt is that the only ways to avoid paying it back or paying interest on it forever are national bankruptcy or hyper-inflation. And unless the borrowed money is spent in ways that foster economic growth in a big way, paying it back or paying interest on it forever will mean future pain in the form of higher taxes or lower spending.<br />
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There is very little evidence that spending borrowed money on conventional Keynesian stimulus—spent in the ways dictated by what has become normal politics in the US, Europe and Japan—(or <a href="http://blog.supplysideliberal.com/post/25998407302/mark-thoma-laughing-at-the-laffer-curve">the kinds of tax cuts typically proposed</a>) can stimulate the economy enough to avoid having to raise taxes or cut spending in the future to pay the debt back. There are three main ways to use debt to increase growth enough to avoid having to raise taxes or cut spending later:<br />
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1. Spending on national investments that have a very high return, such as in scientific research, fixing roads or bridges that have been sorely neglected. </blockquote>
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2. Using government support to catalyze private borrowing by firms and households, such as government support for student loans, and temporary investment tax credits or <a href="http://blog.supplysideliberal.com/post/45262907432/quartz-1-more-muscle-than-qe-with-an-extra-2000-in">Federal Lines of Credit to households used as a stimulus measure.</a> </blockquote>
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3. Issuing debt to create a sovereign wealth fund—that is, putting the money into the corporate stock and bond markets instead of spending it, as discussed in “<a href="http://blog.supplysideliberal.com/post/47695540989/quartz-11-why-the-us-needs-its-own-sovereign-wealth">Why the US needs its own sovereign wealth fund</a>.” For anyone who thinks government debt is important as a form of collateral for private firms (see “<a href="http://blog.supplysideliberal.com/post/41436277287/how-a-us-sovereign-wealth-fund-can-alleviate-a-scarcity">How a US Sovereign Wealth Fund Can Alleviate a Scarcity of Safe Assets</a>”), this is the way to get those benefits of debt, while earning more interest and dividends for tax payers than the extra debt costs. And a sovereign wealth fund (like <a href="http://qz.com/21797/the-case-for-electric-money-the-end-of-inflation-and-recessions-as-we-know-it/">breaking through the zero lower bound with electronic money</a>) makes the tilt of governments toward short-term financing caused by <a href="http://qz.com/84448/martin-feldstein-doesnt-understand-how-qe-works/">current quantitative easing policies</a> unnecessary.</blockquote>
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But even if debt is used in ways that do require higher taxes or lower spending in the future, it may sometimes be worth it. If a country has its own currency, and borrows using appropriate long-term debt (so it only has to refinance a small fraction of the debt each year) the danger from bond market vigilantes can be kept to a minimum. And other than the danger from bond market vigilantes, we find no persuasive evidence from Reinhart and Rogoff’s data set to worry about anything but the higher future taxes or lower future spending needed to pay for that long-term debt. We look forward to further evidence and further thinking on the effects of debt. But our bottom line from this analysis, and the thinking we have been able to articulate above, is this: Done carefully, debt is not damning. Debt is just debt.</div>
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Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com0tag:blogger.com,1999:blog-6638187113544241481.post-49080147965593069252013-07-08T23:15:00.004-04:002013-07-09T21:16:47.239-04:00Where did the Reach for Yield Go?Friday’s strong data caused bond yields to <a href="http://online.wsj.com/article/SB10001424127887324260204578587902102488628.html">spike</a>. This has caused some consternation from economic <a href="http://economistsview.typepad.com/timduy/">commentators</a>, and Paul Krugman in particular has argued that the rise in interest rates will have severe economic <a href="http://krugman.blogs.nytimes.com/2013/07/07/that-terrible-taper/">impacts</a>. While I want to touch on these issues, I will approach them from a different debate -- that over the "reach for yield". My thesis? The recent rebalancing in the stock market shows that the reach for yield was overstated, and that, from this, we can conclude the taper will not have a severe negative effect on growth.<br />
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Let’s start by refreshing our memory of “reaching for yield”. In his February speech, Jeremy <a href="http://www.federalreserve.gov/newsevents/speech/stein20130207a.htm">Stein</a> argued that because many institutional investors need to meet nominal return requirements, these investors were reaching into riskier assets. Even though these assets may not offer high expected returns, their variance profiles offer better chances of hitting the nominal requirement. This game of distributions is illustrated below. Even though the safe red (i.e. low variance) asset has a higher expected return, the risky blue (high variance) asset has a better chance of getting the fund manager over the critical red required return line. As a result, a market wide reach for yield may result in a mispricing of risk, jeopardizing financial stability.</div>
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These arguments have been echoed by many other commentators. Here’s Martin Feldstein in the <a href="http://on.wsj.com/12AfOeH">WSJ</a> using the reach for yield as an argument to taper:<br />
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Although the economy is weak, experience shows that further bond-buying will have little effect on economic growth and employment. Meanwhile, <b>low interest rates are generating excessive risk-taking by banks and other financial investors. These risks could have serious adverse effects on bank capital and the value of pension funds</b>. In Fed Chairman Ben Bernanke's terms, the efficacy of quantitative easing is low and the costs and risks are substantial.</blockquote>
And here’s Rajan in a speech at the Bank of International Settlements</div>
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If effective, the combination of the <b>"low for long" policy for short term policy rates coupled with quantitative easing tends to depress yields</b> across the yield curve for fixed income securities. <b>Fixed income investors with minimum nominal return needs then migrate to riskier instruments such as junk bonds, emerging market bonds, or commodity ETFs</b>, with some of the capital outflow coming back into government securities via foreign central banks accumulating reserves. Other investors migrate to stocks. To some extent, this reach for yield is precisely one of the intended consequences of unconventional monetary policy. The hope is that as the price of risk is reduced, corporations faced with a lower cost of capital will have greater incentive to make real investments, thereby creating jobs and enhancing growth.</blockquote>
Indeed, Bernanke felt it was necessary to address these financial stability concerns at his <a href="http://www.federalreserve.gov/newsevents/testimony/bernanke20130226a.htm">February</a> and May <a href="http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm">testimonies</a>. He argued that even if low rates encourage a reach for yield, the only way to get sustainable rates in the long run is to keep rates low now. In the metaphor of Kochlerata, you need to keep the coat on until you are warm enough to take it off. <br />
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Bernanke can rest easy. Financial data since his testimonies has even further strengthened the arguments against a reach for yield. To see why, it is important to remember two stylized facts. First, "reach for yield" is a story about financial stability. Because people are going into riskier assets, this results in a systematic underpricing of risk. Second, it’s a story about increasing risk appetites. Excessively low interest rates trigger a flight *from* quality as fund managers look to hit their nominal return requirements.<br />
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But recent moves in equity prices contradict this story. The WSJ observes that defensive <a href="http://on.wsj.com/16SMkcd">sectors</a> are underperforming.<br />
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He said he still favors stocks over bonds, and has avoided "<b>bond proxies" such as utilities, real- estate investment trusts, and other sectors with high dividend payouts</b>. </blockquote>
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Those areas <b>are "really expensive, and they have little to no earnings growth</b>. They have benefited hugely from easing," he said. </blockquote>
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T<b>hose traditionally defensive sectors dragged on benchmarks</b>. The sole decliners in late trading were the utilities and consumer-staples sectors, which lost 0.9% and 0.3%, respectively. Those areas were among the biggest gainers in the beginning of the year, when yields on Treasury bonds remained low.</blockquote>
Whereas cyclicals are responding very <a href="http://on.wsj.com/13q7scV">well</a>:<br />
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Given the cross currents in the market, including the Fed's commitment to keeping overnight rates low at least until the unemployment rate falls through 6.5%, investors wouldn't want to overinterpret what's happened to the yield curve. But the stock market told a similar story of stronger growth expectations Friday. <b>Shares of economically sensitive companies, like banks, retailers and manufacturers, rallied, while defensive areas, like utility and telecom shares, did poorly.</b></blockquote>
In other words, the recent taper has caused people to pivot out of safe sectors into riskier ones -- the opposite of what a reach for yield story would suggest. In fact, there appears to have been a flight *to* quality that is only recently being reversed. These movements are also consistent with recent data showing the equity risk premium, or a measure of stock market performance relative to the bond market, is at extremely elevated <a href="http://libertystreeteconomics.newyorkfed.org/2013/05/are-stocks-cheap-a-review-of-the-evidence.html">levels</a>. With the taper we should expect this premium to fall as investors naturally increase their risk appetites.<br />
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Now, some may argue that there was a reach for yield in the fixed income market that is now being unwound. Indeed, mortgage rates and junk bond yields are <a href="http://on.wsj.com/13pndRk">rising</a>:<br />
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<b>Rates on a 30-year mortgage have climbed from 3.45% in April to more than 4% in June,</b> according to <a href="http://online.wsj.com/public/quotes/main.html?type=djn&symbol=FMCC">Freddie Mac</a> <a href="http://online.wsj.com/public/quotes/main.html?type=djn&symbol=FMCC?mod=inlineTicker">FMCC +1.97%</a> . <b>The 30-day average yield on new bonds sold by companies with "junk" credit ratings hit 7.72% in June</b>, up from 5.79% in April, according to S&P Capital IQ LCD.</blockquote>
The risk premium on high yield bonds has also risen slightly. But there are two reasons why we should discount this observation.</div>
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First, the bond spreads will have a minimal effect on<i> financial stability.</i> The concern shouldn't be whether individual funds will suffer, but rather whether there has been a massive mispricing in risk. But if the risk was underpriced in the debt market, then the equity prices should have been overpriced to match the artificially low cost of capital. However, since there did not appear to be a reach for equity yield, then any reach for yield in fixed income should also have negligible effects.<br />
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Second, the high yield spread is still not outside of its historical range. Even in the 1990’s, when the Fed was never criticized for promoting a reach for yield, the spread was still very low. Therefore we should be skeptical of arguments that there was a massive mispricing in the corporate debt market to begin with.<br />
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This perspective from the reach for yield debate leads to two insights.</div>
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First, Fed policy has not been distorting financial markets. If anything, people have been <i>too conservative</i> on equities. Monetary policy, by encouraging risk taking, has been doing the right thing to do to help reboot the market. Even if you don’t want firms reaching for yield, they should at least be encouraged to stretch. <br />
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Second, it’s not clear if the taper will be all that “<a href="http://krugman.blogs.nytimes.com/2013/07/07/that-terrible-taper/">terrible</a>” for equities. Of course, the human cost of tight monetary policy is <a href="http://t.co/gFPRIJFmjn">enormous</a>. I personally believe that the Fed should not taper in the face of such elevated levels of unemployment and depressed levels of nominal GDP. Nonetheless, the taper is likely to have only moderate impacts on the stock market, in spite of what short term <a href="http://esoltas.blogspot.com/2013/06/why-interest-rates-are-rising.html">correlations</a> may suggest.<br />
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The greatest irony is that only after the Fed tightens do we realize that the Fed didn’t need to tighten at all. But now that it has, it doesn’t look like the financial impacts will be that large after all.</div>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com3tag:blogger.com,1999:blog-6638187113544241481.post-30387445300642468002013-07-06T00:38:00.001-04:002013-07-06T00:38:32.471-04:00The Role of Financial InstitutionsThe real world of finance is not populated by the financial traders of model fame. Numerous studies in behavioral economics have identified what appear to be deviations from fully efficient markets with rational individuals. On the individual level, we know that overconfidence leads male traders to trade much more than female traders, and this has a negative effect on their <a href="http://qje.oxfordjournals.org/content/116/1/261.abstract">returns</a>. Therefore agents don’t seem to be optimizing -- rather they have their own idiosyncratic, but systematic, biases. On the market level, stock prices seem to exhibit strong short-run <a href="http://www.bauer.uh.edu/rsusmel/phd/jegadeesh-titman93.pdf">momentum</a> while also appear to have long-run mean reverting growth <a href="http://home.business.utah.edu/finmll/fin787/papers/debondtthaler1985.pdf">rates</a>. This suggests that there’s something going on with market participants that encourages overshooting in the short run but with corrections in the long run. <div class="separator" style="clear: both; text-align: center;">
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But what has gotten me curious over the past few months is the institutional aspect. In my view, because financial markets are actually populated by institutions that have their own quirks, financial markets can deviate from textbook models in very policy relevant ways.<br /><br />Most financial models that I have read about are populated by individual investors looking to maximize some expected future consumption stream subject to various constraints. Sometimes these constraints stick to describing feasible budget allocations,and sometimes they also include cognitive <a href="http://forum.johnson.cornell.edu/faculty/huang/prospect.pdf">biases</a>. But Wall Street doesn't look like this. Traders rarely trade by themselves -- they are usually a part of a large firm. These firms may also have different goals. Some, such as hedge funds, are just in the business of generating pure return whereas others, such as pension funds, are looking to maintain a steady stream of payments to pay out to their customers. Given that these firms have their own institutional demands, this suggests that their trading strategies could be quite different. These structural differences has implications for market efficiency.<br /><br />Past papers have of course addressed some of these issues. On a within-firm basis, work on the principal-agent <a href="http://dx.doi.org/10.2307/2331299">problem</a> has shown how compensation schemes can affect fund manager behavior. This would suggest that many financial managers maximize not the utility of the investor, but their payoff in the compensation scheme. Some past work has also indicated that institutional investors, in this case mostly pension funds, do not seem to exhibit the herding and destabilizing behavior that for which they are <a href="http://www.sciencedirect.com/science/article/pii/0304405X9290023Q">criticized</a>. However, some of these benign results are being challenged in the recent financial crisis, and this could have major implications for both financial research and monetary policy.<br /><br />As an example, there have been a set of recent popular articles from the <a href="http://www.economist.com/blogs/freeexchange/2013/01/putting-finance-macro">Economist</a> and FT <a href="http://ftalphaville.ft.com/2013/05/20/1507472/the-risk-of-a-japanese-var-shock/">Alphaville</a> on the notion of VAR shocks. VAR is a measure of financial risk that (theoretically) measures the worst case outcome for a firm. For example, a 5% weekly VaR of $5 million means that there should only be a 5% percent chance that the firm will lose more than $5 million over the course of a given week. This typically can be calculated by parameterizing a loss distribution with historical data on volatility and average yields. Even though this measure can mislead by ignoring the amount that would actually be <a href="http://synthenomics.blogspot.com/2012/05/var-she-blows.html">lost</a> in a worst-case outcome its simplicity makes it a natural candidate for institutions to use as a check against overly risky trading strategies. Therefore market moves that can impact the measurement of VAR are natural candidates for making the institutional investors jump.<br /><br /><br />Pioneering work by <a href="http://www.princeton.edu/~hsshin/">Hyun Song Shin</a>, an economist at Princeton, analyzes the role of VAR and argues that it contributes to market <a href="http://www.newyorkfed.org/research/staff_reports/sr338.pdf">procyclicality</a>. Because historical data is used to calculate the VAR that goes into risk weighting, banks may end up levering up their balance sheet just as the business cycle starts to rev up and deleveraging just as the entire cycle comes crashing down. The rising tide of the business cycle makes their VAR look much smaller, therefore allowing them to put smaller risk weights on their assets. Now that the size of risk weighted assets has fallen, banks can play the risk-weighting clause on capital requirements and fund themselves through more debt. This continues until the cycle breaks, at which point VAR measurements are shocked upward by the historical data, forcing a deleveraging in order to meet capital requirements, thereby amplifying negative effects on the business cycle. In particular, this story fits the recent financial crisis very well. Past decades of relative calm made the VAR models <a href="http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?pagewanted=1&_r=2">docile and ready</a> for the slaughter that was 2008.<br /><br />I see this as an institutional bug because there’s no efficiency reason why VAR should be used in such a way to risk-weight assets. It does not make for an omniscient <a href="http://en.wikipedia.org/wiki/Risk-neutral_measure">Q-measure</a> to identify risk. Rather, VAR is useful because it helps institutions streamline their risk analysis. By doing so, it quite possibly improves an individual firm’s performance by avoiding worse evaluation methods. But with the procyclicality argument made above, it should be clear that a group of banks all using VAR to risk weight their assets end up creating severe negative externalities on the business cycle.<br /><br />VAR shocks have also popped up in the <a href="http://ftalphaville.ft.com/2013/05/20/1507472/the-risk-of-a-japanese-var-shock/">Japanese case</a>. Back in the 2003 bond yield volatility spike, many Japanese banks ended up selling bonds as the volatility triggered their VAR limits. This intensified the cycle of bond selling until other investors, such as pension funds and insurance companies bought up the bonds and stabilized the market. This serves as another real world example of Shin’s theory that the use of VAR in institutional settings ends up intensifying market volatility.</div>
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<br /><a href="http://research.stlouisfed.org/fredgraph.png?g=kl3" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="384" src="http://research.stlouisfed.org/fredgraph.png?g=kl3" width="640" /></a><br /><br />It should also be clear that the institutional quirks can occur in financial markets with rational arbitrageurs. If the size of institutional flows are large enough, then it may be worthwhile for the smaller traders to just ride the flows to higher returns. There may just not be enough incentive to normalize prices. If the market can stay irrational longer than individuals can stay solvent, then an individual is likely better off to just play along with the market. Given thta we see this kind of serial correlation with hedge funds in the tech <a href="http://faculty-gsb.stanford.edu/nagel/pdfs/techbubble.pdf">bubble</a>, the risk of individuals riding along with the irrationalities of institutions should be taken seriously. In fact, I would go far enough as to argue that the burden of proof is on those who would like to defend their financial models with only individual investors. Given that we know the real world doesn’t work like that, and that this difference can result in dramatically different conclusions, the burden must on the traditionalists to show that models of individual investing can subsume those of institutions in most cases.<br /><br />To measure these effects and to calibrate new models, attention should be focused on the flow of funds in and out of these institutional investments. This way we could have a better notion of relative size and be able to measure if and how much institutional procyclicality affects markets.<br /><br />I see two main policy implications of this alternative approach. First, the VAR specific quirks create a further justification for strict capital requirements. Only this way can the risk weighting problem be robustly solved. In terms of monetary policy, a thorough understanding of these institutional quirks can help guide the direction of policy. As monetarism starts to integrate more markets as data points, it becomes more and more important for central bankers to know how to interpret the financial data that comes in. By knowing what’s signal and what’s noise, central banks can better conduct forward looking policy.</div>
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<br />In all these examples, we see how institutions -- not individual traders -- can end up driving markets. This marks a departure from traditional finance models in which everybody is just an individual playing the market. It is my hope that this kind of analysis will be useful for understanding causes of market inefficiencies and the optimal framework for financial data in monetary policy.</div>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com76tag:blogger.com,1999:blog-6638187113544241481.post-24609827865538734982013-07-04T23:16:00.002-04:002013-07-09T21:16:13.427-04:00Capital Requirements and Nominal GDP TargetingThe Federal Reserve has recently moved to tighten capital requirements for banks, and I see this as a long overdue move. While others have done a very good job summarizing the minutiae of the various <a href="http://www.bloomberg.com/news/2013-07-03/the-true-purpose-of-bank-capital.html">ratios</a>, I want to explore what capital requirements really mean and, more importantly, what implications these requirements have on monetary policy.<br />
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First, we should be clear on what capital really is. Despite phrases such as “capital cushion” or “holding capital”, capital holdings are not the same as reserves. Capital is meant to describe a type of funding structure, not an asset allocation -- a liability, not an asset. So what is truly at stake here with the capital requirements debate is how banks fund themselves: through equity or debt.<br />
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The argument for higher equity funding comes down to reducing the incentive to run on the banks. Because debt liabilities are fixed, creditors are likely to demand their money back at the first sign of trouble. On the other hand, if the funding comes from equity, there is no similar compulsion to run, thereby preventing the fire sale spirals that characterise financial distress.<br />
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To visualize this, consider the following bank balance sheet. On the left we have the funding sources -- debt and equity -- and on the right we have the assets. In this first diagram, we see a bank that relies heavily on debt funding (95%) and has very little equity (5%) -- a situation characteristic of many banks today.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhUIZm8Md_yWzjuFEoBZNedQFLSG4nvzJgyMX2XyW1rcfs3Izta0z9vo4pTI8WvbRHGFImHl38jhvQL2NU7mdB39bXOmRAKryBlyDbI3UZeKkKfeLIteALlYhF_AAJuytFtflgWD8P1IEee/s447/capOrig.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="331" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhUIZm8Md_yWzjuFEoBZNedQFLSG4nvzJgyMX2XyW1rcfs3Izta0z9vo4pTI8WvbRHGFImHl38jhvQL2NU7mdB39bXOmRAKryBlyDbI3UZeKkKfeLIteALlYhF_AAJuytFtflgWD8P1IEee/s400/capOrig.png" width="400" /></a></div>
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Figure 1: Highly Leveraged Bank</div>
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If the bank’s assets lose value and drop by a small amount, say 7%, because the debt quantities must stay constant, then all of the equity is wiped out and the bank is left insolvent. On the other hand, had the bank financed itself through mostly equity, then the bank would have stayed solvent and not all the equity would have been wiped out. There would have been less of an incentive to have a run on the debt and, in a time of financial stress, the bank would have avoided a fire sale. These examples illustrate why high levels of debt financing can be so problematic in a system of hard to <a href="http://synthenomics.blogspot.com/2012/08/inaccurate-estimation-in-gaussian-world.html">calculate risks</a>.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj4UFjfnnoKWxl1M6Kz7E5Xrv6ItAZB9HXg636p5O32y3rEC84s8Nr45pQR8rknpRGlL3By-G8VgqbjgUiqadPNTvtBkMu0jbfboLNUS-UBnJLySnzf3l1wJDRxcTwPS1aV3Zd9tk9ojBv4/s445/capInsolv.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="268" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj4UFjfnnoKWxl1M6Kz7E5Xrv6ItAZB9HXg636p5O32y3rEC84s8Nr45pQR8rknpRGlL3By-G8VgqbjgUiqadPNTvtBkMu0jbfboLNUS-UBnJLySnzf3l1wJDRxcTwPS1aV3Zd9tk9ojBv4/s320/capInsolv.png" width="320" /></a></div>
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Figure 2: Insolvent Bank</div>
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Equity funding prevents sudden runs and insolvency. That is the key justification for stricter capital requirements. With this in mind, I now turn my attention to the relationship between these new financial regulations and monetary policy.<br />
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The most important relationship between capital requirements and monetary policy is that capital requirements make the financial stability and “reaching for yield” arguments against monetary easing so much weaker. If institutions are well capitalized, what are we scared of? Equity bubbles, like the 2000’s dot com bust, do not leave lasting damage. However, debt bubbles, such as the 2008 financial crisis, can trigger an extended period of deleveraging and general economic malaise. Much as Scott Sumner has recommended, capital requirements can help keep the finance out of macro. While I personally believe insights from the financial literature may reveal more light on the mechanisms of monetary policy, I do agree that the task of monetary policy should stay very separate from that of financial regulation. Monetary policy makers can direct the guidance of interest rates towards maintaining a stable level of nominal output, whereas financial regulators focus on making sure the banks do not fall apart. If institutions are reaching for yield, leave it for regulators to cut the arms off. The monetary authorities need not pay any attention to it.<br />
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Even if these capital requirements are not implemented, the mere prospect of them greatly weakens the case for using monetary policy for financial stability purposes by exposing a contradiction: if monetary policy is surgical enough for financial markets, why aren’t capital requirements?<br />
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In Jeremy Stein’s February speech on monetary policy and <a href="http://www.federalreserve.gov/newsevents/speech/stein20130207a.htm">financial stability</a>, he argued that it may be appropriate for monetary policy to prevent bubbles. One of his key justifications was that monetary policy can “[get] in all of the cracks” of financial markets to stamp out bubbles. However, this neglects the bluntness of monetary policy.<br />
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In my view, to the extent that interest rates get in all the cracks, they do so by reducing the financial edifice into rubble. But if I am wrong and if monetary policy is indeed precise enough to stamp out bubbles without collateral damage, then aren't capital requirements even more surgical? Indeed, while monetary policy can affect the entire economy’s consumption and investment behavior, the Mogdiliani-Miller theorem suggests that changes in the capital structure would barely have an effect on those macroeconomic aggregates. The greatest irony is that the financial types who support tighter monetary policy to control financial risks are often the same ones who are against stricter capital requirements. But these views are inconsistent. Capital requirements are tailored for financial regulation, and to the extent one supports the blunt use of monetary policy, one should support the strengthening of capital requirements even more.<br />
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On the other hand, while capital requirements may make the task of monetary policy easier, some have argued that the reduction in credit from the stronger capital requirements goes against the goal of expansionary monetary <a href="http://www.cato.org/blog/federal-reserve-vs-small-business-0">policy</a>. First, I do not believe this is true on a purely finance theory basis. As has <a href="http://johnhcochrane.blogspot.com/2013/03/the-bankers-new-clothes-review.html">been</a> <a href="http://bankersnewclothes.com/wp-content/uploads/2013/06/parade-continues-June-3.pdf">discussed</a> <a href="http://johnhcochrane.blogspot.com/2013/06/stopping-bank-crises-before-they-start.html">elsewhere</a>, higher capital requirements are unlikely to increase funding costs. To the extent that they do raise funding costs, this reflects an efficient reduction in the government’s implicit subsidies for bank debt. Second, even if this were the case, we should remember that monetary policy is not credit policy. If there is a reduction in credit, the question for the monetary authorities is whether this reduces nominal GDP. Depending on that, the Fed should ease or tighten. Therefore, a well functioning monetary policy should fully offset the potential impact of credit shocks. The level of credit in an economy is a matter of financial organization, something far outside the domain of monetary policy. The Fed should adjust the path of interest rates depending on where they want to see nominal GDP go.<br />
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While the above discussions focus on how capital requirements make monetary policy easier, I also believe better monetary policy, especially through a nominal GDP target, can help make capital requirements simpler. It’s useful to remember that debt is an extremely important channel through which nominal shocks have real effects. Rarely are these bonds written with inflation indexing, so stabilizing nominal aggregates can help make satisfying capital requirements easier. Under a nominal GDP target, the size of the debt chunk of the balance sheet can stay roughly around the same level as the size of the equity chunk, reducing the amount of scrambling that can occur in financial markets as bank struggle to reach their regulatory goals.<br />
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To conclude, I should note that there is an elegance in the combination of nominal GDP targeting, a robust monetary policy regime, and high capital requirements, a robust financial regulatory regime. As Plosser recently <a href="http://www.philadelphiafed.org/publications/speeches/plosser/2013/06-06-13_reducing-financial-fragility-by-ending-too-big-to-fail.cfm">noted</a>:<br />
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In the context of monetary policy, <b>I have long advocated simple, robust rules and transparent communications</b>.<a href="http://www.philadelphiafed.org/publications/speeches/plosser/2013/06-06-13_reducing-financial-fragility-by-ending-too-big-to-fail.cfm#footnotes">2</a> Robust rules are important because they are intended to work well in a variety of environments. This reflects our limited knowledge about the true determinants of economic outcomes. Economists have also come to understand that using policies that are optimal in one specific economic model can often deliver very poor outcomes if that model proves incorrect. So a policy rule that operates well under a wide range of models is a better and more robust approach.</blockquote>
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The same approach applies to the design of regulatory frameworks as well. Because the financial world is very complex, there is merit in simple, transparent regulatory solutions designed to work reasonably well in a wide range of situations. We want rules that regulators can enforce without having superhuman knowledge or foresight. However, we can predict with virtual certainty that private actors will seek to evade regulatory restrictions and taxes. This is often called "regulatory arbitrage." We also know that enforcement costs rise as firms' incentives to evade regulations increase.</blockquote>
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In my view, simple mechanisms that are harder to evade — and even better, mechanisms that utilize market forces to discipline firm behavior — are superior to an elaborate list of rules that seeks to cover every possible outcome. <b>Simple and transparent regulatory mechanisms make it easier for market participants to predict how regulators are likely to behave. This, in turn, makes it easier for regulators to credibly commit to implementing the regulations in a consistent manner.</b></blockquote>
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Reading Plosser’s second and third paragraphs really shines light on some common issues such as commitment, credibility, and transparency that relate financial and monetary policy. For monetary policy, these qualities can help guide the expectations that give monetary policy its oomph. For financial regulation, these qualities limit the hidden fault lines that can make crises so severe. One can only hope that policy can combine these all these qualities to make a more enlightened monetary and regulatory framework.</div>
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Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com5tag:blogger.com,1999:blog-6638187113544241481.post-1848829023498050682013-07-04T00:11:00.000-04:002013-07-04T00:11:18.462-04:00Man of Steel: Morality as an Evolutionary Advantage<img height="442" src="http://images.hitfix.com/photos/3259045/Antje-Traue-in-Man-of-Steel.jpg" width="640" /><br />
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<i>"Your sense of morality is an evolutionary disadvantage...and evolution always wins"</i><br />
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This post will not be about monetary policy -- it will barely be about economics. But nonetheless, after seeing <i>Man of Steel</i>, I thought a fun essay connecting some core concepts from game theory and our notions of morality are in order. While none of the insights are particularly new, the specific application to <i>Man of Steel </i>should be, and I hope you enjoy.<div>
<br />The core proposition was the one uttered by the evil Kryptonian woman pictured above. Between high paced punches and knocking helicopters out of the sky, Faora-Ul uttered to Superman: “Your sense of morality is an evolutionary disadvantage...and evolution always wins.” Whether evolution always wins is an issue that I will attend to perhaps on a different occasion, but I want to address the first claim. Is a sense of morality antithetical to the survival of the fittest?<br /><br />With what we know about animal behavior, the answer seems to be a resounding “no”. While it is difficult, if not impossible, to impose a natural system of morality for animals, I think a natural interpretation could be the presence of behaviors that may not be beneficial to oneself. While morality surely goes beyond self-flagellation, it does serve as a useful residual for explaining altruistic actions.<br /><br />One of the most commonly evoked examples of such behavior in the animal kingdom comes from <a href="http://www1.umn.edu/ships/evolutionofmorality/images/11c.htm">ground squirrels</a>. These squirrels make sure to loudly alarm their kin mates of the presence of dangerous predators. On the squirrel level, this is very costly behavior because it increases the risk that a predator finds and eats the squirrel. Yet if all squirrels do this, everybody is better off. This is a classic example of the difficulty of providing public goods, as every squirrel has the incentive to free-ride off of the alarm calls of others. But if nobody makes the alarm call, then they are all at a higher risk of being eaten by an eagle. Somehow, the squirrels manage to overcome this public goods problem. There’s no Coase theorem contract, no government enforcement, yet squirrels provide the public alarm nonetheless.</div>
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<br />Why? In this case it’s simple: kin selection. Because these ground squirrels usually spend most of their lives around family, it’s in their incentive to protect their peers in order to pass on the most amount of genes to the next generation. Under the framing of Richard Dawkin, the selflessness of the individual squirrels comes from the selfishness of a gene that may encourage the alarm calls. To see this logic, suppose there exists a squirrel with a gene that induces the alarm calls. Then his offspring are also likely to have the same gene. Because the alarm behavior serves to preserve his offspring, then this alarm gene will propagate its way through the population. Therefore, this gene selfishly works to propagate itself, even at the cost of its host squirrel. Such is the power of family.<br /><br />The above explanation has an interesting analogue from public economics, in particular the analysis of firm mergers in the presence of positive externalities. For example, consider the case of two stores that need to decide on their advertising budgets. Because of their proximity, the stores are complementary in the sense that more traffic in one store means more traffic in the other. Therefore in equilibrium, if there is no cooperation, these firms will choose an inefficiently low level of advertisements because they fail to take into account the positive benefits their own ads have on the other firm. But if they merge, the merged firm can capture this positive externality. While this may seem contrived, you can think of family structure as a merger between individual squirrels. By the same logic, this genetic merger allows the family to capture the positive externality from the alarm.<br /><br />One of the greatest appeals of this kin selection theory is that it yields many good out of sample predictions. The original evidence was just the basic anomaly that the squirrels would take any kind of altruistic behavior. But by extending the gene logic, then it should be the case that the probability of any given squirrel to sound the alarm is positively related to the extent of familial relations between the squirrel and the group. Indeed this is the case, as the females, who tend to spend their lives around the same family, are much more likely to sound the alarm than the males, who go off to live with other squirrel groups in adulthood. These females are also more likely to sound the alarm when they are around close relatives -- further corroborating the kin selection hypothesis.<br /><br />From this relatively scientific evolutionary analysis of animals I now pivot to the much more speculative and unscientific theorizing about human systems of morality. Here, I will push the claim that systems of human morality were also driven by similar evolutionary principles, and that this framing of morality helps explain some of the universality in basic morality across societies.<br /><br />Again, let’s consider a concrete example. Consider the commandment “Thou shalt not covet thy neighbor’s wife”, and consider the most literal interpretation of it. Indeed, I do believe such a rejection of wife-stealing is fairly universal. Even in polygamous societies, I do not believe relations with a woman who is somebody else’s wife are encouraged. What could be a game theoretic interpretation of this? Well, suppose men indeed were encouraged to chase after the wives of others. What would the equilibrium be? If the “cheating” status of partners in a relationship were to be private information, then there could be an adverse selection spiral in which men do not believe their wives are faithful, and then wives, because they are not being treated as well, end up being open to extra-marital affairs. Therefore, society as a whole converges on the norm that a neighbor’s wife should not be coveted in order to avoid the bad adverse selection equilibrium.<br /><br />I snuck in a few tricks into the past paragraph. First, what I described was more characteristic of group selection, and not kin selection as with the squirrels. Group selection is much more controversial due to its tenuous connection with the empirics and its use as a justification for genocide. Nonetheless, I do believe it provides a parsimonious framework for some of these game theoretic justifications for moral norms. Second, it should not surprise us that many observed societies do have these kinds of norms. Since societies that do not have this norm end up spiralling into some bad equilibrium, they end up erased from the historical record. As a result, we only see the societies that succeeded and, surprise, they tend to exhibit these norms that avoid bad equilibria.<br /><br />Those familiar with philosophy will be able to identify my above analysis with the Kantian notion of a <a href="http://en.wikipedia.org/wiki/Categorical_imperative">categorical imperative</a>, or that ethics should be based on rules that everyone can apply. Indeed, a game theoretic interpretation of a stable equilibrium captures this notion. The stable equilibrium is the one where everyone can play the same strategy of not violating a moral code. This is why potential alternative moral rules, such as “do not covet thy neighbor’s wife except if she is very fertile and attractive” cannot hold. They cannot be held symmetrically, and therefore fail to propagate themselves through a group.<br /><br />While the above analysis does not qualify as scientific (it’s quite hard to falsify), I do believe it’s a nice economic interpretation for why moral structures can be so similar across societies. Most historical codes -- I am thinking all the way back to Hammurabi’s -- have similar core ideas: don’t steal, don’t kill, etc. One would think that through the thousands of years of history, there must have existed at least one society that had very loose rules regarding murder and theft. Yet I would claim that we do not hear of these societies because the loose rules caused the society to collapse before we could find evidence for them.<br /><br />As a final example, consider again the Kryptonians mentioned in Man of Steel. If the moral structure of the old Kryptonian society was governed by Faora’s preference for no regard for organisms of other species, it seems highly unlikely that they would have been able to persist for so many thousands of years. First, on a planet-level basis, would it have taken that long before military coups pulled the Kryptonian people apart? Given how easy it is for our Congress to disagree, there must have existed at least one disagreement about how to treat organisms of different species in the hundred thousand years of glorious expansion. Moreover, such a cold moral system against other organisms would have cut the Kryptonians off from the most important driver of prosperity: trade. With these weakness, it seems more likely that they would have been conquered or merged into another society that exhibited more robust morals against mass exterminations of other races.<br /><br />These economic interpretations add a new spin on the design of moral structures. By grounding the development of morality in a game theoretic framework, I can derive a very natural reason why certain moral rules are so universal. So rest assured, humanity . In spite of what the villains from Man of Steel may have us think morality is an evolutionary advantage, and more evolved humans will not be forced to leave it behind.</div>
Yichuan Wanghttp://www.blogger.com/profile/15398092824604478764noreply@blogger.com5