Author Archive for Cullen Roche

Scott Sumner Says Silly Things

Scott Sumner is out with a new post making some rather bold assertions about last night’s BOJ announcement which sent the Nikkei Index surging 4.8%.  Specifically, he says this action discredits Keynesian economics, RBC theory, and the theory of beggar-thy-neighbor policies.  He says:

“Yes, these theories have been totally discredited dozens of times before over the past few years (or decades if you wish), but piling on is fun!”

Sigh.  Let’s touch on that first one specifically since it is beyond comical.

First, we should note that the only reason Sumner’s new theory (Market Monetarism) even exists is because old school Monetarism was proven substantially flawed over the last 20 years.  No serious economist adheres to the original beliefs of Milton Friedman and after many of Friedman’s ideas were debunked these “Monetarist” economists had to rebrand themselves around some new unifying set of ideas.  The result of this rebranding is what is now known as “Market Monetarism”.  It’s based on a lot of the same old defunct Friedman ideas, but with a new target (NGDP Targeting).  So it’s rather comical to declare that a certain set of theories have been “totally discredited” when your new theory only exists because your original underlying set of theories was totally discredited to the point where Monetarists had to distance themselves from the original moniker.

But here’s the more interesting point he makes in reference to the idea that the BOJ’s announcement and the subsequent 4.8% rally in stocks proves something:

“Of course Keynesian economics predicts the QE announcement would have no effect on stock prices, as the new money would just sit there as excess reserves.  You are just swapping one low interest government asset for another low interest government asset.  (In fairness, I don’t know what the BOJ is buying in this case, but we also see big market effects when central banks just buy government bonds.)”

Sumner is saying that, just because the Nikkei rose 4.5%, then that means Keynesian economics has been wrong and Market Monetarism is right.  How in the world can such a naive conclusion be made by such a seemingly intelligent person?  Of course a Central Bank with legal authority to purchase assets on a secondary market (as the BOJ has) can cause the stock market to rise.  If the Federal Reserve had the legal authority to buy out every S&P 500 firm that’s listed at a 100% premium then they certainly could.  Does this mean that those firms are actually worth twice what they were before the Fed intervened?  Does it mean the economy is twice as strong as before?  Of course not.  It just means that the Central Bank had the legal authority to buy stocks.  The fact that Central Banks and markets often respond to events in silly ways does not prove or disprove anything.  Scott is a big fan of looking at short-term stock market moves and then declaring a certain position to have been “proven”.  It’s amateurish and silly – the sort of stuff you expect to hear from a day trading monkey with no real investment experience, not a macroeconomist….

More importantly, how does this “disprove” Keynesian economics?  His reference to the Liquidity Trap is obviously a reference to “New Keynesian” economics.  But New Keynesian economics ins’t even real Keynesian economics.  New Keynesians could easily be called “New Monetarists” as Greg Mankiw explained long ago.  New “Keynesian” economics is just tidbits of what Keynes believed in mixed with a heavy serving of Milton Friedman.  So you get the Chicago School’s microfoundations, rational expectations, the natural rate of interest and lots of other essential pieces of Monetarism.  This is not Keynesian.  It is Monetarism!

Of course, this isn’t the first time that a Chicago School economist has declared the death of “Keynesian” economics.  Robert Lucas famously did the same thing in the early 80’s right before the intellectual collapse of his own school….


I Wish That I Knew What I Know Now, When I was Younger

I loved this question from the most recent Q&A:

“What do you wish you knew, that you know now, when you were first starting out after college?”

I am hardly qualified to answer this, but I do have some thoughts.

First, where do I begin?  My whole life has been one big evolving learning experience.  There is so much I wish I’d known when I was graduating college.  But mistakes are part of the experience.  That’s how people grow.  Regulars know that I totally embrace being wrong.  I think it’s such an important part of life and learning to grow as a person.  We’re all flawed, irrational at times and learning as we go.  That’s part of what makes it all worth doing.

Anyhow, here are three of the more important lessons I’ve learned:

1)  Know the difference between money and wealth.  When you’re young you’ll be inclined to pursue a career simply because you think there are great financial gains to be made.  In essence, you’re thinking that money will solve all your problems.  But this mentality can lead to all sorts of other problems because the pursuit of money could lead to an imbalance in your pursuit of other things that matter in life.  The pursuit of wealth can consume people to the point where they lose sight of other things that matter.  Of course, this also doesn’t mean you should follow the generic “do what you love” advice.  Doing what you love is often the extreme opposite view which could lead you down a path where you end up generating a sub-par income which creates its own obvious problems.  The key, in my opinion, is finding some balance.  You don’t need to be totally in love with what you do for a living.  But it has to interest you enough that you’re totally engaged in doing it well.  Additionally, you can never lose sight of the necessity for balance here.  Balance is the holy grail of wealth.  When you can find a decent income doing something your’re totally engaged in while also being able to embrace the things in life that really matter, you’ve achieved a very special thing.  And a big part of that has to do with understanding that money isn’t the path to true wealth.

2)  Know what it means to invest in your future production.   Generating an income doesn’t mean punching a ticket that anyone else can punch.  If you want to generate an income you should prove to other people that you have a unique and irreplaceable talent.  Investing in yourself is the pursuit of developing a differentiating skill set.  When you have a unique skill that other people see the value in then it doesn’t matter if you’re self employed or you work at the biggest company in the world.  Your customers and your co-workers will see the value in your abilities and you will be irreplaceable.  The only way to achieve this is to develop that skill set by knowing the importance of investing in yourself.  We too often think that “investing” is something that’s done in other people, but it’s primarily something we do in ourselves in the pursuit of proving to others that we have something valuable to contribute to their well-being.

3)  Be a measured optimist.   I got into finance obsessed with “risk management”.  That is, I was obsessed with finding the bad in the good.  This is a valuable tool to develop in all facets of your life, but it can also be a dangerous one if you let it consume you.  It can turn you into an irrational pessimist.  We see this all too often following the financial crisis.  I think it’s so important to approach the world in an optimistic manner.  This doesn’t mean you allow yourself to turn into the irrational optimist, but you again have to find the right balance here.  You can be an optimist, but also a risk manager.  It is valuable to find the bad in the good, but you also have to be able to find the good in the bad.  Being a measured optimist gives you the ability to know when to take risks, but not become consumed by the fear of not taking risks.  Ironically, a good risk manager knows when to take risks.  Not just when to avoid them.  This is what being a measured optimist is all about.

Q&A…Have at it

With the end of QE I figured it might be time for another Q&A.  Feel free to use the comments to ask me whatever is on your mind.  I am proficient in misunderstanding the effects QE, the monetary system, the financial world, relationships, love, sports as well as most other things.  So please let me know how I can further muddy your understanding of the world.  You’re welcome in advance.

More Thoughts on “Fad Investing”

In a recent post I called factor investing “fad investing” (see here) because it is, at its core, an ex-post view of the world that implies that the markets will perform a certain way in the future because they’ve performed a certain way in the past. That is, many of the investors who rely on “factors” are utilizing a rear view mirror look at the markets based on extrapolative expectations that the future will look like the past (though not all do this and many quant firms use forward looking models).  In a sort of humorous irony, the “passive indexers” who apply these “factors” to their portfolio are the ultimate performance chasers.  This annoyed a lot of people and I got a number of emails and forum comments from unhappy readers.  This is not surprising given that I am stomping on hallowed ground here (passive indexing, active factor pickers, Efficient Market Hypothesis, etc – is there anyone I haven’t annoyed yet on this blog because I assure you I will find you!).  Let me see if I can explain this a bit better.

First, when we look at the markets in the aggregate we should all acknowledge that there is only one truly “passive” portfolio of all outstanding financial assets.  If you were truly passive you would try to replicate the global market cap weighting of these outstanding financial assets.  At present, that portfolio is roughly a 45/55 stock/bond portfolio (with lots of other financial assets obviously, but those are the two dominant asset classes).   When you deviate from this market cap weighted global portfolio you are making an active decision about your asset allocation.  You are essentially an “asset picker” whether you have a home bias (US stocks are your “stock allocation”) or whether you overweight stocks relative to bonds.  As Cliff Asness has stated, you don’t get to deviate from global cap weighting and then go on to disparage what you perceive to be “active” investing from your not so “passive” perch.

Second, the market return of the global market cap weighted portfolio is the market return.  After taxes and fees no one beats this portfolio in the aggregate.   Saying that most people won’t beat the market is not some Earth shattering discovery in finance.  It should be an obvious fact.  Of course, this doesn’t mean that some investors won’t “beat the market” as the relative risks and returns of different asset classes vary.  But when we look at the aggregate market cap portfolio and its inevitably mid-single digit returns it is not even remotely shocking that an asset manager who charges 2 & 20 will have a very difficult time beating the aggregate index over long periods of time.  Again, we don’t need strawman studies on stock pickers to realize this.  We just need to look at the world for what it is and understand some basic math.

Now, when we try to discover why certain investors are able to “beat the market” we often look at various “factors” that account for this.  This thinking is derived from Eugene Fama’s factor modeling in an attempt to explain the Efficient Market Hypothesis.  But we should note that the Efficient Market Hypothesis is really just a political theory to try to argue why the “market” is smarter than everyone else.  It is, in essence, an argument against government intervention based on laissez-faire Chicago School economics, rational expectations and the idea that the market knows better than any interventionist could ever predict.  This is little more than a beautifully packaged marketing campaign.  Of course the market generates the “market return”.  The fact that this return is difficult to beat doesn’t mean the market is “smarter” than everyone.  It’s just an obvious fact that the market generates the market return and the more fees and frictions you incur the more difficult it is to beat that hurdle over time.  This mathematical reality doesn’t mean markets are “rational”, “efficient” or that intervention is never wise.   It is just an obvious statement of fact that the market generates the market return and high fees erode that return.

More importantly, I would argue that this underlying model of the world distorts our reality.  Andrea Malagoli had a nice comment in the forum that summarized how some of this theoretical thinking is flawed:

“Factors are nothing more than the coefficient of a linear regression applied to the returns of an asset. In doing so, all the information about the ‘sequencing’ of the returns is lost – i.e. there is no concept of cycles because it is assumed that the markets are more or less the same at all times (no bubbles, no business cycles, etc ..).

More troubling, it is wrongly assumed that factors ‘explain’ the ‘returns’ of an investment, while all they to is to ‘explain’ the variability. This means that an investment could be highly exposed to a factor (w.g. growth), while most of the returns come from somewhere else entirely.”

Bingo.  When you apply a linear model of the financial system to what is, in reality, a dynamic system, you come up with results that require a good deal of further explanation because there are inevitable issues that don’t account for this natural cyclicality of the financial system.  But this is the underpinning of the thinking here – the assumption that, in the long-run, the markets are linear, highly efficient and the natural conclusion is that you can apply a static explanation for why the market operates in a certain way.  Even worse, you might assume that a static asset allocation is appropriate….

Eugene Fama didn’t care about presenting this reality when he constructed his factor model of the financial system.  He was simply trying to data mine his research well enough that he could convince people that he was really on to something that would rationalize a set of underlying political assumptions.  He had to make his linear model of the world look accurate.  But his model was incomplete because it didn’t account for the natural dynamism of the world and the very real inefficiencies that arise in the short-run due to cyclicality and irrational thinking.  So there were anomalies that “beta”, the market return, couldn’t explain.  In other words, there was evidence that the market was not rational and this left the door open for an excuse to intervene.  Fama promptly shut that door by adding other various “factors” to his model.  So we got the 3 factor model and then the 5 factor model and today we seem to have an endless number of factors that explain market moves.

Of course, “beta” is just another way of explaining the aggregate market return, but since Fama wasn’t looking at “the markets” in terms of the global aggregate he got bogged down in micro explanations for why stocks did certain things.  Had he bothered to focus on the global market cap weighted aggregate of financial assets he wouldn’t have had to bother with all these “factor” explanations.  Of course, he couldn’t do that because, as Paul Samuelson noted, the markets are “micro efficient” and “macro inefficient” so you run into other problems when you look at things in aggregate terms, which is an unfathomably silly irony considering that EMH and factor investing are cornerstones of the same indexing approaches which advocate buying the aggregate market.

But what are these “factors” really?  They are ex-post explanations for why the market performs a certain way.  But they don’t apply to all asset classes of course.  This is mostly just a stock market obsession even though stocks are not even the majority holding in a truly passive portfolio.   Now, these factor explanations could be perfectly relevant and they might even help someone identify some inefficiency in the market, but there is no iron clad law that says these factors will explain future performance.   They are little more than an ex-post view of what caused stocks to perform a certain way during a certain period of time.

Does this mean that factor investing is useless?  Not necessarily.  Looking at why the market has done certain things in the past can be a very useful exercise in understanding why it might do certain things in the future.  In this sense, some of these “fads” could be quite useful.  In fact, understanding the basic math of the beta factor is beyond important.  But I think it’s important to understand certain “factors” and apply a forward looking model of some type in the process of portfolio construction.  There are no iron clad “factors” that will always account for future performance and if you believe there are then you’re likely just extrapolating past performance into future expectations, which is probably a bit of a naive approach.  But more importantly, these “factors” don’t mean that markets are “efficient”, “rational” or smarter than everyone.

QE: Until We Meet Again….

The Federal Reserve is expected to officially announce the end of Quantitative Easing.  I’ve spilled an unhealthy amount of ink here over the years on the topic and I doubt that my “QE Pen” is going to be tucked away for all that long.  That is, as I’ve stated in the past, I think QE is the new monetary policy tool of choice.  So this is good bye, for now….

Anyhow, after all this time can we finally make any conclusions about QE?   Honestly, not really.  It’s almost impossible to quantify the impact of QE because there is no reasonable counterfactual to judge the program against.  We just don’t know how the US economy would have done without it.  But we can, in my opinion, make some reasonably simple and common sense conclusions based on understanding the accounting and transmission mechanisms of QE.

First, as I’ve long stated, QE is really just a simple asset swap at its most basic level.  The Fed buys bonds from the private sector by creating new money thereby printing reserves/deposits into the private sector in exchange for T-bonds or MBS.  While there’s obviously more “money” in the economy after this transaction there are also fewer bonds.  What most people don’t account for in the transaction is the fact that the Fed’s balance sheet is like a big black hole.  In theory, there’s gazillions of dollars sitting there, but since the Fed doesn’t shop at WalMart their balance sheet doesn’t have a discernible impact on the actual economy (aside from the interest income channel that the Fed remits to Treasury every year). So, when QE is implemented the private sector’s balance sheet has the same net worth, but a different composition.   All the Fed has done is altered the composition of balance sheets.  It has not “printed money” in any meaningful sense because it has also “unrpinted” the bonds.  You don’t spend more when your savings account gets swapped for a checking account so why would QE make much of a difference either?  That’s the basic and vastly oversimplified view.  You can read my paper on how this works in more detail in case you’re looking for something to put you to sleep tonight.

In theory, QE works through lots of different channels.  There’s the interest rate channel, the financial crisis channel , the asset price effects (wealth effects & housing & equity price channels), expectations channel, credit channel and the exchange rate channel.  There’s considerable debate about the efficacy of each of these.  For instance, there’s been substantial research done arguing that QE lowered long-term interest rates.  But there’s also the counterfactual perspective that interest rates would likely be low whether QE was initiated or not because inflation has been so low.  Global interest rates have been falling even in countries without QE and many are at record lows so there’s actually no reason to think that interest rates would be a lot higher today if QE had never been implemented.

The financial crisis channel was, in my opinion, the most impactful, but it had diminishing rates of return.  That is, QE1 was important in that it helped put a floor under the markets at a time when there was a great deal of uncertainty.  This bolstered asset prices, improved balance sheets and helped the economy stabilize.  On the other hand, the impact of this declined as confidence was restored.  Monetary policy works wonders in a crisis much like a good doctor works wonders calming down a hypochondriac.

The most popular view about QE is that it is just a way to manipulate asset prices via the asset price channel.  While QE has clearly had an enormous psychological impact on the economy’s participants it’s almost impossible to quantify this impact.  But we know that QE isn’t the only reason for rising asset prices.  After all, with corporate profits near all-time highs it’s totally reasonable to assume that stocks have had a very solid fundamental underpinning over the last 5 years.  You can see my more thorough explanation here.  So again, a basic understanding and a little perspective goes a long way to debunking the idea that QE falsely bolsters asset prices.

The expectations channel is the most widely touted in academic circles, but again, there’s no evidence that this has a substantial impact on the economy.  After all, the most popular view following QE1 was that high inflation and hyperinflation would ensue as a result of all that “money printing”, but we never saw a sustained pick-up in inflation.  We saw a brief blip in commodity prices and reports of farmers hoarding commodities waiting for the inflation to come, but didn’t last and the high inflation view has been soundly debunked by now.  QE clearly doesn’t create high inflation and many academics are now wondering if the program isn’t actually deflationary.

The credit channel is often cited as one powerful way for the Central Bank to expand the broad money supply.  It’s been widely believed that more bank reserve balances would lead to more bank lending in some money multiplier fashion.  I still read, on a near daily basis, how banks aren’t “lending out” their reserves.  Paul Krugman said it just the other day  and we’ve seen this view expressed by some of the most prominent economists in the world over the years.  Of course, banks don’t lend reserves.  The money multiplier is a myth.  And banking is primarily a demand side business.  Well capitalized banks don’t run out of the ability to type new loans into their computers.  But they do run out of creditworthy borrowers in an economic environment where consumers are excessively indebted. This is why negative interest rates are failing in Europe and also why QE never led to a huge lending boom.  Demand for debt has been weak.  End of story.

The exchange rate channel has varying degrees of efficacy.  For instance, in Japan where the country is a significant exporter the exchange rate can make a meaningful impact on the economy.  And I believe that much of the recent success of QE in Japan (if we can still call it successful) has been due to the exchange rate channel.  The US Central Bank, on the other hand, has not been targeting the exchange rate so there’s been no meaningful impact from currency devaluation.

When you connect all of these dots it’s hard to see what the big fuss has been all about.  QE just doesn’t have a direct or powerful transmission mechanism  to bolster the economy once the uncertainty of a crisis has stabilized.  That doesn’t mean it’s had no impact at all, but I think its impacts on the economy have been vastly overstated for the most part.  But since the Fed is the only game in town thanks to an incompetent Congress which won’t cut taxes or invest in infrastructure because they buy the false narrative about the USA’s impending bankruptcy then we’re stuck here hoping the Central Bank can work miracles by continually waving their hands in the air.

Of course, QE isn’t really ending.  The Fed is still reinvesting principal proceeds and it’s my opinion that we’ll meet QE in the not so distant future since inflation is likely to remain low, interest rates are likely to remain low and QE becomes the obvious policy variable of choice.  So it’s so long…for now.

Some related work:


My “Most Important Chart in the World”

Business Insider has put together another excellent set of the world’s “most important charts in the world”.  The list is from “Wall Street’s brightest minds” and also me.  My contribution was Europe related:

“The divergence between the USA and the EMU remains the most important point of contention in the global economy.  While both monetary systems are similar in many ways (users of a single currency, no FX rebalancing, etc) the EMU has proven unworkable as there is no mechanism by which inherent trade imbalances can rebalance over time without massively deflationary and depressionary dynamics.
A restructuring of the EMU from its present state remains the greatest near-term threat to global stability, but also the greatest long-term potential benefit as few things are more important to global growth than a healthy functioning Europe.”

Bond Market Narrative Fails

The irritating thing about the failure of the “bond bubble” calls in recent years has little to do with bad market predictions.  Anyone who’s been in the markets for more than a few years knows that bad predictions happen.  But what’s really frustrating about the failure of the “bond bubble” calls is that many of these calls were based on failed narratives.

Over the last 5 years we’ve repeatedly heard some version of one of the following:

  • Interest rates will rise because the US government is bankrupt!
  • Interest rates will rise because the bond vigilantes are coming!
  • High inflation is coming to ruin all of our lives!
  • The USA is just like Greece!
  • The US government has printed so much money that high inflation must eventually come!

These were all scary narratives that were repeated time and time again by the same people.  And these narratives were trotted out often coupled with scary stories about the bond markets.  The problem is that these narratives weren’t really sound macro views.  They were mostly just political nonsense:

  • Someone whose ideology is centered around an anti-Fed agenda saw QE and thought up a narrative about how the “money printing” would ruin the economy.
  • Someone with an anti-government agenda saw the budget deficit and said it would cause interest rates to rise.
  • Someone who thinks the bond markets control US government bond yields would result in bond vigilantes moving the Fed off its target rate.
  • Someone who thinks “inflation is always and everywhere a monetary phenomenon” saw QE and said inflation was coming.
  • Someone who misunderstood the difference between the EMU and the US monetary system saw the Greek crisis and predicted a similar outcome for the USA.

These weren’t just bad predictions.  They were often political narratives or incorrect understandings that were pushed by people with a certain agenda.  And even though the narratives have failed these same people have refused to alter their thinking.  And that’s a real shame because we’re all worse off for it as this flawed thinking continues to influence people’s portfolios and the world’s policy decisions.


Fad, I mean, Factor Investing

When Eugene Fama couldn’t explain why beta didn’t cover all of the stock market’s various twists and turns he started to explain the market’s “efficiencies” by adding various “factors” to his model.  He expanded it to the 3 Factor model and then a 5 Factor model and today we seem to have an endlessly growing list of “factors” that explain the market’s moves.

What’s really going on here is a series of backtested studies that have been extrapolated into the future to try to explain why the market might move in a certain way.  And the inevitable result is a series of research reports trying to explain why and how the market moves using a rear view mirror approach.  And then investors take these “factors” as if they are the rule of law, apply them to their portfolios and expect the future to look like the past.  And then when these “factors” fall out of favor for long periods, as we’ve seen with value and growth for instance, then the fad shifts and investors come up with some new reasoning for why the market might perform in a certain way.

It’s all a great irony in that Fama’s work has been used to promote the idea of “passive indexing” which supposedly doesn’t require forecasting the future and is very critical of people who chase performance.  But what we find with all of the research that’s used to justify “passive indexing” is that it’s all based on extrapolative expectations where researchers study the past and then expect the future to look like the past.  And then when they can’t explain the future moves (because their original research was wrong) then they add in different factors (which also will end up being wrong at points).

The result of all of this is that you end up with is a bunch of investors who don’t think they’re predicting the future, don’t think they’re investing in fads and don’t realize that they’ve been sold a great big pile of academic mumbo jumbo.

Everyone Hates Bonds….

Just a brief follow-up on the bond bubble post….

A key aspect of any bubble is excessive euphoria.  In fact, one of the key aspects of a bubble is that the market appears totally rational and the majority of investors agree that the asset price trends appear sustainable.  This is, to  a large degree, what drives the irrational pricing.  Extrapolative expectations lead to unreasonably priced assets.  But while many people continue to think that T-bonds are in a bubble we continue to see terribly bearish outlooks for bonds.

Here’s the latest big money poll results from Barrons.   The line that really jumps out is that 91% negativity about US Treasuries.  In fact, most bonds are viewed pretty negatively.  And stocks are viewed positively.  I’m not sure why that just about always seems to be the case, but 91% looks more than a bit unusual.  And it certainly isn’t consistent with an excessive euphoria.


(Source: Barrons)

If we look at the latest Merrill Lynch Fund Manager Survey we find similar bearishness with a 53% underweight in global bonds.


 (Source: Merrill Lynch)

The world’s biggest fund managers just don’t like bonds right now….Of course, this doesn’t mean bonds are some no-brainer bullish bet here.  In fact, bonds are a lot less attractive today than they were even just 12 months ago.  But the idea that bonds (especially US T-Bonds) are currently susceptible to some sort of Nasdaq circa 2002 style crash strikes me as a bit an extreme position.

Thinking About Bond Bubbles….

A little over four years ago it was very popular to declare that the US Treasury Bond market was a “bubble”.  A number of high profile people made that prediction including Jeremy Seigel, Nassim Taleb and many others.  Even Warren Buffett was hinting at a bubble.  There were also many of us who said, quite loudly, that this was erroneous thinking.  From memory, Brad Delong, Paul Krugman and myself were among the more vocal here.   T-bonds have generated a 50%+ return since then and while some people will likely double down on their “bubble” call I don’t think today’s environment looks all that much more bubbly than the non-bubble of 2010.  I don’t have nearly the necessary time nor the space to hash this out completely, but here’s my general thinking on the matter.

First, I define a “bubble” as:

“A bubble is an environment in which the market price of an asset has deviated from its underlying fundamentals to the point that its current market price has become unstable relative to the asset’s ability to deliver the expected result.”

So, in order to believe that the T-bond market is unable to generate the type of returns that investors presently expect you basically have to believe that the US government will become unable to make the payments on its debt.  Or, you likely believe the real rate of return will be far less than what investors expect.  Ie, inflation will soar in the coming years.

There are a lot of moving parts here, but the first part of this discussion should be relatively easy to resolve.  As I’ve explained many times in the past, the US government is virtually guaranteed to make the necessary payments on its debt.   That is, the US government is a contingent currency issuer with a Central Bank that can always finance its debt and a Treasury that is likely to always find ways to make the necessary payments.  There’s some element of political risk there, but a default is highly unlikely given that it would be nothing more than a self-inflicted decapitation.   The USA is not Greece where the country cannot print its own currency and is at a very real solvency risk if the ECB or Germany were to impose such an outcome on Greece.  The same goes for many of the peripheral countries in Europe and so I would be much more inclined to call some peripheral countries “bubbly” than a country like the USA.  So the issue of solvency risk is largely misguided to begin with.

The inflation story is much trickier.  If you believe interest rates are going to surge due to high inflation then you believe the economy is on the verge of a boom (interest rates would surge in a booming economic environment).  Or you believe the 70’s are about to come and we’re entering an era of stagflation.  I don’t have the time to cover this thoroughly, but as I’ve outlined in the past, I think the boom outcome is unlikely given the private sector debt overhang and the weak global economy (Europe in particular thanks to an unworkable monetary union).  This environment, in my opinion, also does not resemble the 1970’s.  The key reasons are a lack of labor class negotiating power, the differing oil price dynamics and the fact that there is no credit boom (yes, there was a credit boom in the 70s).

All of this, in my opinion, means that there is likely no bubble in US T-bonds.  That doesn’t necessarily mean they’re as attractive today as they were a year ago or 4 years ago, but the implication of a crashing market (which is what the “bubble” fear mongering implies) is a vastly overstated risk.  This also doesn’t mean there are no bubbles in bonds or higher risk bond markets (pockets of European debt and high yield do worry me at present), but we should be very clear about US government bonds.


The Profits-Investment Disconnect? (Pretty Nerdy)

I always talk about how important it is to understand accounting when doing economics.  While most economists want to build rigorous mathematical models of the world I would much prefer rigorous stock-flow consistent models of the world by understanding the relationship between income statements, cash flow statements and balance sheets.  In my opinion, this is a much more useful framework for understanding the cause and effect of certain economic policies and environments.

As an example of this we might look at how Dr. Krugman is analyzing what he calls the “profits-investment disconnect”.  Now, he concludes that there’s something nefarious going on here that reflects “monopoly power rather than returns on capital.”  But he wouldn’t say this if he looked at the full picture from the perspective of an accounting based model.

First, Dr. K is right that there appears to be a “profits-investment disconnect”.  But this isn’t due to greedy monopolists hoarding more than they should.  It’s mostly just that corporations are giving back much more of their profits in the form of dividends and households are saving less.

Here’s the basic accounting behind corporate profits:

Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends

Now, if you read my recent post on dividends as the “secret sauce in corporate profits” you know that dividends contribute to corporate profits.  It’s a bit counter-intuitive, but as I’ve explained:

“Corporations don’t count dividends as a business expense because they’re distributed profits.  And if households spend all of this dividend income (ie, don’t increase their saving) then this contributes to corporate profits.  So, if the household saving rate remains the same then that means that increased dividends are actually ADDING to corporate profits over time (as has been the case in recent decades).”

So, if you look at business spending as purely “investment” then you’ll be inclined to come up with the same conclusion that Dr. Krugman comes up with which looks like this one where businesses aren’t spending:


If you understand the accounting behind corporate profits then this doesn’t tell the full picture.  You have to include dividends in the picture considering that dividends have become 5% of the share of GDP as of Q1 2014.  When you add dividends back into the mix you get this far less greedy looking picture:


Now, that’s a pretty different image than the first one above.  There’s still some “disconnect”, but it’s not nearly as horrible looking as it is in the original Krugman chart.  But if one were so inclined, they might just use the first chart to claim that corporations are big bad evil greedy monsters who aren’t spending enough.  But if you add the dividends back in then you see that business spending that includes dividends is actually at pretty healthy levels.  There’s really nothing all that unusual going on there.

Of course, the question isn’t about whether corporations are evil monopolists.  Any good capitalist entity is an inherent monopolist that tries to maximize its share of profits – is that somehow news to some people?  But that’s not really what matters here.   The problem isn’t that these corporations aren’t spending enough – they clearly are spending when you look at the full picture.  The problem is that they’re not INVESTING enough.  So Krugman is right, but he’s right for the wrong reasons because this has less to do with monopolies and more to do with a crummy economic environment where corporations are choosing not to reinvest because they think it’s better to return capital to shareholders in other manners.

The mess of it all is that if economists and politicians were to understand some of this accounting a bit better they’d know that the easiest lever to pull for an improvement in both aggregate demand and profits would be a larger deficit (tax cuts or government investment would be my preferred policies) since this would add to private sector net worth (deficit spending adds a private sector asset without a private sector liability) which would improve private sector balance sheets resulting in income and more demand which would add to corporate revenues which would incentivize businesses to invest more.  But since our politicians and our leading economists don’t understand these points then they politicize everything, demonize corporations unnecessarily and the other side fights back with their own non-sensical rhetoric because they’re defending a certain ideological narrative.  And we end up right where we started because we’re defending against constant attacks.

And this, to a large degree, is why we’re in the mess we’re in.  Economists and politicians would rather politicize all of this instead of looking at the world from an operational level where we might actually resolve problems in a reasonable and bipartisan manner….Instead, we just sling mud at each other and point fingers.  Pretty cool, huh?




Global Inflation Update – Continued Disinflation

Global disinflation has picked up pace in recent months and several regions of the global economy are now on the verge of a full blown deflation.

The latest readings on inflation are just about unanimous – there’s widespread disinflation, or a slowing rate of positive inflation. The latest reading out of the USA showed a stagnant, but well below historical average rate of 1.7%.  China’s rate of inflation has slowed from 2% to 1.6%.  The UK slowed sharply to 1.2% from 1.5%.  And the EMU is on the verge of deflation at 0.3%.  The one outlier of the major economic regions is Japan where the rate of inflation spiked following the currency devaluation due to Abenomics.


Rail Traffic Just Keeps on Chugging

The latest trends in rail traffic showed more of the same that we’ve been seeing for the last few months.  Interestingly, despite the Ebola scare and the brief Europe shock, there was no substantive change in rail trends.

The latest weekly reading came in at 3% which is just below the 12 week moving average of 4.3%.  That’s down marginally over the last few months, but still a strong reading in the grand scheme of things.  Via AAR:

“WASHINGTON, D.C. – Oct. 23, 2014 – The Association of American Railroads (AAR) today reported increased U.S. rail traffic for the week ending Oct. 18, 2014 with 297,130 total carloads, up 2.7 percent compared with the same week last year. Total U.S. weekly intermodal volume was 272,554 units, up 3 percent compared with the same week last year. Total combined U.S. weekly rail traffic was 569,684 carloads and intermodal units, up 2.9 percent compared with the same week last year.”



Negative Interest Rates – How’s That Working Out?

Back in June the ECB initiated a small negative interest rate on deposits held at the ECB.  Over the last 5 years we’ve repeatedly heard economists and other pundits say that Central Banks just need to reduce the demand for Excess Reserves by charging a negative interest rate and that this would surely cause inflation to increase as banks would lend out their reserves or “stop sitting” on their money (as Scott Sumner likes to say).

So, we’re almost 6 months into this policy change and what can we conclude thus far?  Well, as I stated back in June, this policy wasn’t likely to have much of an impact and in fact, the Eurozone has deteriorated since then.   Chart 1 shows the level of bank lending since the beginning of the year.  Clearly, the ECB’s negative rate policy isn’t forcing banks to “stop sitting on their money”:


Sumner also claimed that “If they did [charge a penalty] it would be easy to get inflation expectations up to 2%.”  But the rate of inflation has continued to decline since then:


Of course, the misguided thinking on this stems from the myth that banks lend their reserves in some money multiplier style fashion or that the Central Bank can control the rate of inflation directly by steering the banks to act in precise ways.  But bank lending is primarily a demand side function so supply side economics doesn’t apply to the degree that some economists seem to think.   This isn’t rocket science, but very smart people, even after all this time, continue to misunderstand the importance of bank lending and endogenous money….

Thus far, it’s pretty clear that this policy is having no discernible positive impact on either lending or the broader economy.


What This Nerd is Reading: X-CAPM – An Extrapolative Capital Asset Pricing Model

Just passing this paper along which I missed.  Noah Smith mentioned it yesterday on Twitter and it looks pretty interesting.  If any fellow nerds have thoughts feel free to use the comments…

X-CAPM: An Extrapolative Capital Asset Pricing Model

Nicholas Barberis, Robin Greenwood,
Lawrence Jin, and Andrei Shleifer

Yale University and Harvard University


Survey evidence suggests that many investors form beliefs about future stock market returns by extrapolating past returns: they expect the stock market to
perform well (poorly) in the near future if it performed well (poorly) in the recent past. Such beliefs are hard to reconcile with existing models of the aggregate stock market. We study a consumption-based asset pricing model in which some investors form beliefs about future price changes in the stock market by
extrapolating past price changes, while other investors hold fully rational beliefs. We find that the model captures many features of actual prices and returns, but is also consistent with the survey evidence on investor expectations. This suggests that the survey evidence does not need to be seen as an inconvenient obstacle to understanding the stock market; on the contrary, it is consistent with the facts about prices and returns, and may be the key to understanding them.

Read it here.