Economics.....from a penguin

My thoughts on economics, ranging from books to ideas to current events.

[econpenguin-blog]

Secular Stagnation and Inequality

I just thought of an interesting explanation for secular stagnation, especially in the U.S. This may be completely wrong, but bear with me.

Since the financial crisis, the U.S. has been faced with rapidly rising inequality. The median income has dropped, even as productivity continues to increase. The gains from the recovery have been given mostly to the richest. In fact, over 90% of the gains from the recovery were taken by the top 1%. The top 10% now takes around 50% of total income. 

These people are incredibly rich: it would be difficult to spend a high proportion of their income. As such, relative to lower income groups, their saving rate is extremely high. They are also far more likely to actively invest their money. They have more investment opportunities open to them (hedge funds for example, are restricted to accredited investors). They are also more likely to have money that they can put in an investment for several years and not need it. 

Whether they invest it themselves or throw it at Goldman Sachs, it seems likely that this money will find it's way overseas. With quantitative easing, domestic investment yields have fallen quite far. There is widespread evidence of money flowing from advanced economies to emerging markets in search of higher yields. In the past, this money would have been used for domestic investment. Without it, we may see shortfalls in investment, leading to a stagnating economy.

In my previous post, I argued that secular stagnation did not seem realistic in relationship to the many investment opportunities domestically. However, I didn't think about the possibility that foreign investment would offer more than investing domestically. Accounting for this, it does lend more credence to the theory of secular stagnation. 

If my theory is correct, then that could mean that stagnation is a good thing. It allows the rest of the undeveloped world some time to catch up. As time passes, investment opportunities in emerging markets will saturate. Money will then return to the U.S., and (hopefully) be used in domestic investment. If that is achieved, secular stagnation is solved!

Of course, this is all just a theory, I haven't researched any numbers or anything on whether or not this is correct. I would love to hear your opinion though! :)

[econpenguin-blog]

Secular Stagnation

There has been this idea of secular stagnation floating around recently. For those unfamiliar with the theory, it is the idea that there is long-term stagnation in an economy due to inadequate investment. It is a Keynesian idea, essentially arguing that savings is outrunning investment consistently over a long period of time. Larry Summers says that the average prospective return on new investment is too low to encourage new investment. 

However, I'm slightly skeptical of the lack of investment opportunities. Nominal interest rates are near zero, and real rates are negative. I would find it extremely surprising if entrepreneurs really couldn't find opportunities that would have a return above these rates. As Robert Skidelsky points out here, the shale gas boom is a good example of opportunities for investment. 

So I don't think our current economic situation can be explained by secular stagnation. Sadly, I haven't found any other convincing explanations either.

[econpenguin-blog]

Money Illusion

What is money illusion?

The idea that people tend to think of money in nominal terms, instead of real (adjusted for inflation) terms.

The term was coined by Irving Fisher (one of my favorite economists), who wrote a book about it in 1928. 

Why is it important?

It is a very strong criticism against one of the central assumptions of modern economics: that people think of money in real terms. 

As such, it is a resounding argument against many classical and monetarist ideas, such as the permanent income hypothesis, or natural rate theories.

It explains “sticky wages”, which is the difficulty of adjusting wages downwards in nominal terms).  

It hints at more government intervention in creating inflation indexed wages, contracts, and even laws. Employees and employers are unlikely to do it themselves, employers because they don’t want to pay more, and employees because they don’t realize they are losing out. As for laws, a fine of one dollar might have been a lot in the 1950‘s, but it  is unlikely to faze anyone now. 

Can you prove it?

Well firstly, can you tell me the current inflation rate? If you can, can you tell me your current real wage? If you can recite both these things of the top of your head I would be very surprised. However, it is relatively easy to remember how much money you have in your bank account (nominal wealth) and what your current (nominal) wage is. It goes to show that people don’t generally think of wealth in real terms.

Furthermore, think of the last time you had a pay rise. You undoubtedly would have been  very happy with yourself, and assumed that it was due to your good work. This again shows money illusion: a large part of your pay rise would have been more to do with inflation than improved job performance.

There have also been studies showing this phenomenon.

If you genuinely do think of your wealth in real terms, you are rare (and slightly odd :P). However, the majority of the population do not. Economists should rid themselves of the illusion that people think in real terms. They should then work on developing new theories and models that incorporate money illusion.

[econpenguin-blog]

Asset Bubbles for the Layman

How is an asset bubble formed? Let us use the analogy of a really big party.

So, let's say that people going to the party is like them buying into a stock/commodity/house/etc, and leaving it is selling their stake. Also, the only way to leave the party happens to be a taxi.

Step One:

Someone starts a party. At first it might be boring, but then people start to come. The party gets better, and people start telling their friends (network effects) and then everyone rushes to join in. People start coming just because other people are going (herding behaviour).

Some people start buying a stock. The price might rise slightly, but as more rush to buy it, the price rises even more. If animal spirits are high, and there is enough credit, the bubble will inflate. People are no longer assessing the fundamentals of the stock, but are buying it because everyone else is.

Step Two:

For some reason or another, some people might start leaving. Let's say that there aren't very many taxis in the area, leaving early means they can get one before the crowds rush out. However, there are still people coming to the party.

Some people are clever, they sell the stock at the top of the bubble and make a profit. However, there aren't enough of them to make an impact, people will still be buying into the bubble.

Step Three:

People are leaving, but there are more to take their place. But, at one point, people will start to think that the party can only go downhill

(Minsky moment) 

There will be more people leaving than joining and then all of a sudden, the party will stop being fun.

Everyone will then rush for the exit.

More money is being put into the stock, but at some point, the money will run out. People think the asset has reached it's peak and will start selling. So the price stops increasing and people start selling. If everyone starts selling at once, the price will fall dramatically. And thus the bubble pops.

Step Four:

Now, everyone is trying to leave, but there are only so many taxis. So a few lucky people get away, but a large number are stuck at what is now a pretty lame party. 

Some are lucky enough to sell their stock before the price bottoms out. The rest are holding a stock that is now worth far less than what they paid. Those who borrowed money to try profit from the bubble are now poor. 

Of course, there are tons of flaws with this analogy. However, it does mirror to a certain extent what happens in an actual bubble.

[econpenguin-blog]

Ever closer

Ugh. Why?!? Did they not see how bad the Euro crisis was? In terms of optimum currency areas, it isn't much better than the Eurozone either. The business cycles vary greatly across the countries, and they don't share a common language. *sigh*

[econpenguin-blog]

The monolith and the markets

This is a really interesting article on BlackRock, an investment firm. Two interesting facts:

"...it has $4.1 trillion in assets under management, making it bigger than any bank, insurance company, government fund or rival asset-management firm."

If BlackRock were a country, and it's assets were GDP, BlackRock would have the fourth biggest GDP in the world. 

Aladdin keeps its eyes on almost 7% of the world’s $225 trillion of financial assets.

Aladdin is BlackRock's risk management platform, which is used by other firms as well. It allows companies to see how portfolios might do under different circumstances in the future. It gives BlackRock a ridiculous amount of power: firms are, to a certain extent, seeing the future through it's eyes. Also, if Aladdin assesses portfolio risk incorrectly, that would have a massive influence throughout the financial world. 

At the time of the Lehman's Brothers collapse, it had 600 million dollars of asset under management. The Lehman collapse sparked the worst recession since the Great Depression. BlackRock has over 4100 million under management. Imagine what would happen if BlackRock collapsed.

[econpenguin-blog]

Dead Aid

"Dead Aid" by Dambisa Moyo 

This book is slightly depressing. Essentially, it argues that development aid to Africa, over a trillion dollars of it, has done nothing to help development in Africa. In fact, she argues that this “aid” is detrimental to growth in Africa.

Aid can drive local firms out of business. Moyo uses the example of an African mosquito-net maker that employs ten people. They churn out nets but there are never enough. So some Hollywood big-shots donate a million dollars worth of nets, doing what they think is a great deed. However, this “great deed” also has the effect of putting the net-maker, along with its ten employees, out of business. 

There is the problem of corruption: not only does aid lead to corruption, it also sustains it. Foreign aid is easily taken for other purposes, and encourages rent-seeking (using power to make money without creating wealth). Moyo also mentions “positive” corruption, where stolen funds are reinvested in the country, as opposed to “negative corruption, where the wealth is taken out of the country. This explains (to an extent), why some Asian countries with high levels of corruption still have such high levels of growth (e.g. China, Indonesia, Thailand).

One point I found very interesting was that “In the early stages of development it matters little to a starving African family whether they can vote or not.” Moyo says that a democracy can actually harm a developing country in these times. It’s harder to get legislation passed with so many people/parties wanting different things, and as a result, the economy might be left without crucial legislation, such as property rights or a functioning legal system. She says that growth is a prerequisite to democracy, not the other way around. 

One of the many solution she suggests is issuing bonds instead of recieving aid payments interesting. Does it really matter where the money comes from? Supposedly, bonds are better than aid because you only get one shot. If you steal the money from a bond issue and buy a private jet, you won’t be able to get any more money. If you use aid money and buy a private jet, you most likely will continue to receive aid. 

Moyo envisions Africa no longer needing aid in the future, calling for it’s gradual reduction over time. She feels that if all the donor countries all told African countries that they would stop receiving aid, they would have more of an incentive to sort things out inside the country (a very free market view). She outlines several things African countries must do to get there: issuing bonds, attracting foreign direct investment, increasing trade, and opening up the financial markets, especially to small to medium sized enterprises.

“Dead Aid” is a very good book about aid to Africa, and presents one view of how to address the problems of aid. It is quite well researched, and Moyo obviously knows her stuff. However, I felt that it was rather brief; it did not go into much detail and I felt like she was skimming over some of the issues a little bit. Furthermore, it doesn't offer alternate solutions to the aid problem, but only to abandon aid altogether. As such, this book is an excellent briefing into the topic, but perhaps not enough for someone who wants to get an in-depth understanding of the problems facing Africa.

[econpenguin-blog]

Relations between China and Japan

Sino-Japanese tensions are are at their highest in years. If you haven’t heard, China recently claimed the airspace over the Diaoyu/Senkaku islands. In response, the U.S. flew two B-52s in. Dangerous stuff. In Japan, people have raised the idea of Japanese re-armament. Perhaps they have found a solution to their economic woes. 

[econpenguin-blog]

Alleged Silk Road Founder Wanted Austrian Economics in Video Games - Digits - WSJ

More than three years before the U.S. government arrested Ross Ulbricht, the alleged ringleader of the Internet drug market the Silk Road, he wanted squash inflation inside video game economies, according to documents obtained by The Wall Street Journal.

I just read this. I just realized, some video games are excellent simulations of economies. In fact, I’m pretty sure there have been studies on virtual economies, such as World of Warcraft. Ulbricht’s idea is really interesting, you could make a new game, embark on Keynesian stimulus, change the money supply, etc etc, and see what effects they have on the economy. That should definitely be an economic study.

[econpenguin-blog]

Economics: Ancient Greece Edition

"The materials to be used were stone, bronze, ivory, gold, ebony, and cypress-wood; the arts which should elaborate and work up these materials were those of carpenter, moulder, bronze-smith, stone-cutter, dyer, worker in gold and ivory, painter, embroiderer, embosser, to say nothing of the forwarders and furnishers of the material, such as factors, sailors and pilots by sea, and, by land, wagon-makers, trainers of yoked beasts, and drivers. There were also rope-makers, weavers, leather-workers, road-builders, and miners. And since each particular art, like a general with the army under his separate command, kept its own throng of unskilled and untrained labourers in compact array, to be as instrument unto player and as body unto soul in subordinate service, it came to pass that for every age, almost, and every capacity the city's great abundance was distributed and scattered abroad by such demands."             (Plutarch, “Pericles” 12.6)

In 448 B.C., Pericles proposed a new building program, which included the rebuilding of the Parthenon on the Acropolis. Good little account of the far-reaching effects that Keynesian stimulus has on an economy.

[econpenguin-blog]

Bankers and Behavioral Economics

A month or so ago, I went to a talk by Jim Rogers, a former hedge fund manager. He co-founded the Quantum Fund with George Soros. Anyway, he discusses the idea of being a “contrarian”. Throughout his speech he talked about how he would always avoid buying into markets when they were rising. He implicitly referred to the whole herd idea, where people just jump on the bandwagon when the price of something is rising, leading it to become overvalued. His example of this was the Chinese property market, since everyone was talking about it and buying into it, he himself steers clear. The point is, Rogers seems to very clearly understand the idea of markets being driven by psychological forces.

Today, I went to a talk by Bunt Ghosh, who was formerly the Credit Suisse Vice Chairman of Fixed Income in the Asia Pacific region. One of the points was yet again the herd effect, although he didn’t explicitly state it. His example was when something was undervalued, some people would notice this, and thus buy it. This would lead to an increase in price, and the people buying it subsequently would be buying it not because of any fundamentals, but purely because it was rising in price. This process would then later reverse in exactly the same fashion. Again, there was  an inherent understanding of behavioral forces in the market. 

Its not just these two who advocate behavioral effects. Keynes, who was an investor in the stock market saw these effects first hand. In fact, he lost his fortune several times doing so. I often read stories of bankers or traders who understand these forces, some of them even using them to their advantage.

So to my main point: lots of people in the financial industry seems to believe in psychological forces driving the market. Why do economists still insist on markets being rational (and get Prizes for it?!).

[econpenguin-blog]

A Non-Monetary Explanation for Inflation

Very technical, but also very interesting article. Lots of econometrics, but to be honest, you just need to understand regression and correlation. They   picked some variables from supply, demand, and policy and then did used regression analysis to find any links. Their main aim seems to be to prove  Friedman's idea of inflation ("always and everywhere a monetary phenomenon") wrong, or at least slightly wrong. They found that inflation isand is mostly driven by supply and demand factors and policy seems to have comparatively little effect on future inflation (although I am a bit skeptical).

Most interesting points:

"the price level increase preceded the money supply increase — that is, money supply rose to match the increased price level. " 

Their regression analyses gave this:

The most interesting bits are the capital stock per capita and the population growth, which are shown to be very strongly correlated with inflation. The 10 year M2 growth is shown to be correlated (with similar correlation over different time frames), but is not that strongly correlated. So this article shows a supply and demand relationship for inflation, similar to Keynesian theory. So there are some interesting conclusions.

If this article is correct, central banks might be better off using "accumulate capital stock", or population control (the horror!) as a policy. However, I'm slightly skeptical of this study (and econometrics in general). Why did they analyse so few variables? What data did they use? Were they selective in choosing data? Plus, there have been other studies which would show that inflation is indeed always a monetary phenomenon. So on so forth. Regardless, it's a good article, I'll leave you to form your own conclusions.

[econpenguin-blog]

Efficient Markets

Following on my previous post, I wanted to elaborate on my opinion of efficient market theory.

What is the efficient market theory/hypothesis?

Developed by Eugene Fama (this year’s Nobel Prize winner)

It’s main tenet is that market prices incorporate information, with several “forms” of to what extent they do it

Weak-form: Prices reflect all past information, and one can’t earn more than the market by analyzing past data

Semi-strong form: Prices adjust instantly to any new information, so no one can earn excess returns by 

Strong form: Prices adjust to public and private (insider) information.

The main point is that one cannot consistently beat the market, and that market prices are good indicators of current, and to a certain extent, future prices. 

It is based on rational expectations in the sense that on average, everyone who invests into the market will have an accurate view of future. 

My arguments against efficient markets

Firstly, I have some surface level criticism:

If markets are efficient, and no one can earn excess profits, why do so many banks have proprietary trading divisions, why are there so many hedge funds? Why do they generate such massive profits? The argument against this is that there are thousands of money managers, but only a few are profitable. However, many fund managers are consistently profitable, which shows that they are consistently beating the market, which the efficient market hypothesis would say is impossible.

The various bubbles we have had seem to be a pretty strong indicator that efficient markets don’t hold in real life. However, Fama doesn’t actually believe in bubbles. *eye roll*

Some people are stupid. There’s no other way to put it. Read this article. That doesn’t even fit in weak-form efficiency. 

Back to the Twitter theme, if Twitter were weak-form efficient, that would mean it’s $30 billion valuation correctly reflects all past information, including the fact that it hasn’t made a profit yet. Either something is wrong with the theory, or perhaps other loss-making companies are undervalued on the stock markets. But if markets were efficient, they couldn’t be undervalued. So yeah, efficient markets don’t make sense. 

Some stronger criticisms:

Human psychology and behaviour:

Herd behaviour, where people do what everyone else is doing. If everyone else is selling, it takes a lot of guts to be the one buying. Think of it as peer pressure. There are accounts of traders who, when asked why they are buying or selling a stock, their answer is along the lines of “everyone else is doing it”.

There is the whole idea of “irrational exuberance”, where buyers barely even look at the fundamentals of what they are buying. Some might just buy because the price is going up. Linked to this are network effects. A large number of people buying will lead to even more people buying, exacerbating a price increase.

There many well-documented psychological phenomenon that affect a person’s decisions too. Some of the main ones are things like intuition, loss-aversion, or even reasoning errors (like TWTRQ). There are far too many for me to go into here, but there are many books on the subject.

Information asymmetries

There are time lags for people getting information, which makes it difficult for the price to reflect all publicly available information. High-frequency traders use this to make millions: they use computers which can react to news far before anyone else can, and make profits off subsequent movements. 

Even if information is public, it doesn’t mean everyone has seen it. 

Institutions

Institutions have immense power in markets, they can put out a large order to buy or sell, and the sheep market will move with it.

Information has different effects on the price depending on who has it. If it is a single person, the effect of this person buying or selling the stock would be negligible, even if it were something like the company was going bankrupt. (Edit: even if the person used leverage, it is unlikely that they would be able to access the amount of leverage needed to move the price, especially for highly traded goods/stocks. We would probably be talking millions) If an institution had it, the price is more likely to change. So strong-form and semi-strong form efficient markets depend on either enough people getting the information, or a large institution getting it. This makes it very difficult for me to believe that insider information can possibly be reflected in the price instantaneously (in strong-form).

Thats all I’ve got for now. If you have any criticisms of what I’ve said, feel free to drop me a message.

[econpenguin-blog]

Rational Expectations

Rational expectations are quite often criticised and ridiculed, at least in many of the books I've read. For those who don't know what it is, it is an assumption in economics that essentially, humans can predict pretty much with certainty, what the future holds. 

It sounds ridiculous I know, and I've thought it was stupid for a long time. However I just read this blog post by Simon Wren-Lewis, which gives a very good argument for rational expectations, and why they use them.

Rational expectations replaced adaptive expectations, which is when people would base their expectations of the future solely on the past. This is quite obviously flawed, as it means that people ignore what is going on in the media, the current state of the economy, etc. Wren-Lewis says that modelling this way is to pretty much to assume that agents are stupid. So, rational expectations are more logical than adaptive expectations (but it's pretty difficult to define something in between the two). It is also extremely useful in economic modelling: you can give agents in the model a certain measure of "intelligence", which makes predictions in the model more realistic. 

So theres a very good reason for rational expectations to be around. So now I don't think rational expectations are stupid. However, I think it should be used purely as a modelling assumption. Things like efficient market theory that are based on it are just plain silly. 

[econpenguin-blog]

I just saw this very interesting graph. It's from Paul Krugman's lecture at a a recent IMF conference. Krugman argues that the debt to GDP ratio has little to no effect on a countries interest rates (which this graph shows very well). Thought I might post this, since there seem to be  people worrying about sovereign debt and it's relationship to growth, or what would happen if China stopped buying American debt (nothing).

[econpenguin-blog]

Fudge and diminishing utility

I just thought of something: diminishing marginal utility of fudge. First piece of fudge: fantastic. Second piece of fudge: I never want to eat fudge ever again. Which seems to show that marginal utility goes negative at some point.

More seriously, does money have diminishing marginal utility? If it did, wouldn't that mean that the marginal utility of money will at some point be negative? However, we don't see billionaires throwing money out of their mansions. So it seems unlikely that the marginal utility will go negative. The x axis might be an asymptote though. 

Just an interesting thought. I'm definitely a believer in diminishing marginal utility of money. I just find it odd that it doesn't obey the same rules of marginal utility as say, fudge. 

[appliedtechnotopia-consulting]

An infographic look at the future of money (via Envisioning)

[econpenguin-blog]

This is quite interesting, although it seems rather far-fetched. The idea of peer-to-peer economies is very intriguing.