Saturday, March 31, 2012

Points of Public Interest

This week’s best and most intriguing for your weekend reading:

  1. Krugman on (or maybe off) Keen
  1. Why Some Multinationals Pay Such Low Taxes
Insight into Google’s use of a “Double Irish Dutch Sandwich” and many other clever practices being used by GE, Microsoft, Apple, etc.
  1. WHY MINSKY MATTERS: Part One
A former student of Minsky’s elegantly outlines the important aspects for understanding the reality of our financial and economic system. More on Minsky: Was 'Post-Keynesian' Hyman Minsky an Austrian in Disguise?
  1. The worst anti-regulatory travesties in the financial sphere have had broad, bipartisan support
Without much fanfare, the “fraud-friendly JOBS Act” passed Congress this week with overwhelming support. William Black, a professor of law and economics, offers a history of anti-regulatory bills over the past several decades. If history is any guide, the JOBS Act will be front and center as having aided and abetted massive frauds during a financial crisis in the not too distant future. More on the JOBS Act: Bill Black: “The only winning move is not to play”—the insanity of the regulatory race to the bottom
  1. Liberating The Hunger Games and What Happened to Liberty in the The Hunger Games Movie?
What can I say...talk of The Hunger Games is everywhere these days!
  1. The Real Leadership Lessons of Steve Jobs

The bottom 99% fall further behind:

Source: NYT

Thursday, March 29, 2012

The Economy Needs a Bubble, but Treasuries are NOT it!

Yesterday, using the help of Nick Rowe and Michael Sankowski, I described why The Economy Needs a Bubble! The basic premise was that when the interest rate, r, is below growth, g, there is a larger than normal demand for money to spend and invest. Fulfilling this excess demand often results in an expansion of money-like instruments, which feeds on itself and ultimately forms a bubble. Although this relationship is broadly understood, most economists assume that this situation rarely occurs.

Proving this point, in a recent post titled Shadow Banking, Bubbles and Government Debt, Karl Smith writes (my emphasis in bold):

“While its possible that the interest rate on T-Bills averages only 3.3% over the next 30 years this is – hopefully – extremely unlikely. It implies that nominal GDP growth will average 3.3% over the next 30 years, as the Fed must ultimately align interest rates with nominal growth rates or the economy will persistently overheat or stagnate.”
Smith clearly recognizes the effect of holding interest rates below growth, but assumes this is will not happen over a 30-year period. If the belief that T-bill rates (and nominal GDP growth) average more than 3.3% for the next 30 years comes true, than long-term Treasury bonds are certainly overpriced (yield is too low). Stemming from this view, Smith claims:
“US Government debt is in a bubble.I am coming to believe that bubbles are a persistent feature of  the modern global economy and extend from the fact that the world is aging.”
Summing up Smith’s view, our economy experiences frequent bubbles but since interest rates and nominal growth are ultimately aligned, an aging economy is the likely reason. But here’s the trouble, why should we assume interest rates and nominal growth align over time? Using Bloomberg I pulled up the following charts displaying quarterly data of the Federal Funds Effective Rate (FEDL01) and US Nominal GDP growth, year-over-year and seasonally adjusted (GDP CURY), for the past 50 years.    


The top chart shows the actual levels for both data series while the bottom chart depicts the spread between nominal GDP growth and interest rates. Within the bottom chart, green areas represent periods where the interest rate was less than the nominal growth rate (r < g). What may be a surprise to many, apart from a period between 1979 and 1991, interest rates are almost always below the nominal growth rate. In fact, over the last 50 years, interest rates on average were more than 1% below the rate of nominal growth.

A simple look at empirical data clearly shows the assumption that interest rates and nominal growth align over time to be false (at least within a 50-year time frame). Combining this data and  Smith’s own analysis, our “economy will persistently overheat or stagnate.” Interestingly, only looking at the past 20 years of data, interest rates were on average 1.4% below the nominal growth rate, which happened to be 4.7%. Current 30-year Treasury rates of 3.3% are therefore exactly what investors should expect, if the next 20 years actually resemble the previous 20. While one should not expect a replica of the past 20 years, one thing is certain, Treasuries are NOT in a bubble!

Wednesday, March 28, 2012

The Economy Needs a Bubble!

Nick Rowe, in Do we need a bubble?, states that economics generally assumes that “in a normal world, the equilibrium rate of interest [r] is above the growth rate [g] of the economy.” However, by this definition, our world is often and currently not in a normal state. With US inflation currently near 2% (core CPI) and the 10-year treasury bond yielding 2.2% (as of this writing), the real interest rate (risk free rate minus inflation) is just slightly positive. Meanwhile, nominal GDP in the 4th quarter of 2011 was 3.8%, meaning the real growth rate (nominal GDP minus inflation) is closer to 2%. (Note: Reported US data typically uses different rates of inflation for real GDP, but I used the same statistic here to simplify). When growth outpaces interest rates, the environment is ripe for borrowing money to invest and consume.

During these supposedly abnormal periods the demand for money is high. If this demand is not met with supply(e.g. through government deficits) or reduced (e.g. increased taxes), than people will seek out money-like instruments. Michael Sankowski notes that money-like instruments can be as simple as “stocks being used to purchase real world goods, or using the paper value of real estate as collateral to purchase real world goods. Increasing demand for these instruments drives prices higher, which in turn, boosts their value as money-like instruments. This creates a self-fulfilling upward cycle in both demand and price. Therefore, “as long as the real growth rate is higher than the real interest rate, the economy will demand bubbles.” (Graph below from The supply and demand for bubbles (in pictures))

Americans experience during the past 20 years should bear out this fact since the economy has seemingly moved from one bubble to the next (e.g. dot-com, real estate, commodities). As we speak, stocks and commodities may once again be providing the bubble our economy desires. In contrast to the US experience, Japan’s economy has resembled a ‘normal’ world for much of the past 20 years. Deflation has largely kept the real interest rate (using 10-year JGB yields) in the 1-2% range, while real growth rates were frequently between 0-1%. This environment encourages reduced borrowing and, by extension, less desire for money-like instruments. The result has been real estate and equity markets that dropped over the entire period. (Graph from Dr. Housing Bubble)


While the economy may frequently desire bubbles, these are a sign of private sector waste (inefficiency) that always results in wealth destroying busts. Within Post-Keynesian schools of economic thought, both the interest rate and inflation can be controlled, to a degree, by the combination of fiscal and monetary policy. Accepting that our economy is often in an abnormal state is the first step to alleviating the economy’s need for a bubble.  

Sunday, March 25, 2012

Quote of the Week


...is from p.96 of Vitaliy Katsenelson’s The Little Book of Sideways Markets: How to Make Money in Markets that Go Nowhere:
“Stock buybacks can create shareholder value if the stock is purchased cheaply, but they often destroy value when management overpays for the stock.”

This past week Apple announced plans to buy back up to $10 billion in stock as the company’s shares continue their meteoric rise past $600 from only $80 three years ago. Apple, however, is not alone in ramping up funds to buy back stock at markets repeatedly move higher. The graph below displays total buybacks for US companies over the past 20+ years (from Musings on Markets):
There are two distinct, significant run ups in buybacks: during the late 1990’s and in the middle of the 2000’s. The first peak, in 2000, coincided with the top of the dot-com bubble and the beginning of a lost decade in stock returns. The second peak, in 2007, is also apparent in this next chart depicting the past ten years of stock repurchases with the broad S&P 500 index overlaid on top (from ALPHA NOW):
Once again the peak in stock buybacks (and all-time high) occurred just as the stock market was reaching its all time high. Interestingly, stock buybacks were at their lowest levels in 2002 and 2009, precisely the same time stocks were bottoming.

Since the market’s lows in March 2009, buybacks and the stock market have largely been rising together once again. Analysts and investors frequently celebrate new announcements for buying back stock, seemingly unaware of companies poor historical record of timing the market. Will Apple, among others, choose their timing right this time around? Or will current purchases at new all-time highs destroy value and mark another peak in stocks? History is not on their side.

Saturday, March 24, 2012

Points of Public Interest

Ugly day in DC after a beautiful week, but more good NCAA basketball on TV. Good luck to those whose brackets still have a chance of winning!

  1. “The Current Models Have Nothing to Say”
Should we be surprised? Policy makers continue to employ models of an economy with no financial system.
  1. Economics without a blind-spot on debt
The aggregate level of debt, especially private, matters in
forecasting economic growth.
  1. Consumer Credit Growing at Highest Rate in Past Decade: Unhealthy and Unsustainable?
Stopping addictive habits is not easy, but extending those actions will only make the eventual adjustment more difficult and painful.
  1. The Japan debt disaster and China’s (non)rebalancing
Chinese consumers continue to increase savings in lieu of domestic consumption. Japan is attempting to rebuild its trade surplus, but which countries will allow their surplus to decline or deficit to increase? Global (and domestic) imbalances not addressed remain significant risks to the global economic outlook.
  1. A step in the right direction
Scientific exploration incorporating complex systems and networks continues to move our understanding of reality forward.
  1. It's not structural unemployment, it's the corporate saving glut
Businesses save instead of investing in labor when consumer demand is weak. Until policy focuses on improving the consumer balance sheet (e.g. debt write-downs), unemployment will remain high.
  1. Wrong vs Early – Contrarians Bet on Natural Gas
The best investors are often early and patient.
  1. The Real Problem with Microfoundations
Microeconomics is not especially sound in predicting all outcomes
either.
  1. Principal writedowns of the day, mortgage edition
Positive for households but will Bank of America (and others) really accept the associated losses?
  1. Why Using P/E Ratios Can Be Misleading
In early 2009, at the market bottom, the P/E jumped to over 100 as profits plummeted. Using E/P corrects for this issue and shows the market is slightly overvalued currently.
 

Wednesday, March 21, 2012

The Forthcoming Profit Recession

During the past few years many individuals, including myself, have been surprised by how strong the rebound in corporate profits has been amidst a weak recovery in GDP and unemployment. New all-time highs in corporate profits have seemingly been the main driver behind the more than 100% rise in the S&P 500 since its lows in March 2009.
Richard Bernstein supports this view in The First Sign of Weakness in Corporate America:

Our research over the past twenty-five years has consistently suggested that profit cycles, rather than economic cycles, drive equity markets.”
Bernstein’s research note comments on the recent rise in companies reporting negative earnings surprises and negative earnings growth (year/year). Although corporate balance sheets are much improved over a few years ago, these factors are warning signs that profit growth is slowing and may turn negative.

Another highly regarded investor/analyst, James Montier of GMO, is also now expressing concern over a profit recession in his recent commentary What Goes Up Must Come Down. Montier is part of a relatively small group of individuals/investors that foresaw the large rise in corporate profits based on its relationship with government deficits. A common trait among this cohort is a view of economics consistent with Post-Keynesian macro, including its different branches e.g. MMT and MMR.

Montier breaks down the components of corporate profit margins in a flow of funds framework:

Proļ¬ts = Investment – Household Savings – Government Savings – Foreign Savings + Dividends

This arrangement is an expanded derivation of (Michal) Kalecki’s profit equation, which says

Retained Earnings = Investment + Government Deficit - Household 
Savings

The insightful blogger, Ramanan, recently provided a more detailed background of Kalecki’s Profit Equation. Looking at corporate profits in this manner displays that government deficits have been the primary driver during this recovery.

For the current fiscal year (2012), the budget deficit (Gov’t Savings) is still expected to be more than 8% of GDP (over $1 trillion). However, with tons of tax breaks potentially expiring at the end of this year, next year’s budget deficit could be significantly lower (~5% of GDP). If this occurs then corporate profits are likely to decline in 2013. Regarding the murkiness of next year’s budget outlook, Cullen Roche also chimed in on WHERE ARE CORPORATE PROFITS HEADED? He comments, and I agree, that regardless of upcoming elections the budget deficit next year may very well end up being higher than current CBO projections. The following chart depicts possible outcomes for profits based on his assumptions:

Looking ahead I doubt much, if any, of the decisions on future tax rates get decided before the November elections. If recent debates in Congress offer any insight, decisions on the budget will remain on hold until the last possible minute. Fearing the potential outcome in red above, investors may seek safety in advance...  

Tuesday, March 20, 2012

"Stress" Tests Succeed as Bank Marketing Tool

Last Tuesday, JP Morgan announced plans to increase its dividend and buy back stock after passing the Federal Reserve’s stress tests, which were set to be reported two days later. Since the announcement, JP Morgan’s stock has rallied over 10%. Other banks followed suit, forcing the Fed’s hand in announcing all their results early. In total, 15 of the 19 banks analyzed officially passed the test. Bank of America’s stock has risen nearly 25% since passing and is up over 75% so far this year, leading a more than 20% year-to-date rise in the broader financial sector.

From the perspective of improving sentiment, the stress tests are clearly a roaring success. However, investors should remember that the purpose of the stress tests was to inspire confidence and NOT to test the liquidity or solvency of banks in a crisis. As Bloomberg’s Jonathan Weil highlights in Class Dunce Passes Fed’s Stress Test Without a Sweat:

“Citigroup Inc. (C) was deemed well capitalized under the government’s methodology when it got bailed out in 2008. So was CIT Group Inc. when it filed for bankruptcy in 2009.”
The stress tests then and now continue to use Tier 1 Capital ratios, which is simply the amount of Tier 1 capital divided by a firm’s risk-weighted assets. Risk-weightings are often decided by the regulator based on credit ratings. Many AAA-rated securities are assigned 0% risk and removed from the calculation. As various assets are downgraded during a crisis, total risk-weighted assets rise and the Tier 1 Capital ratio declines. Rating changes, which played a major role in both the financial and European debt crisis, depict one of many flaws in using Tier 1 Capital Ratios to assess a bank’s health.

Although the Fed continues to use this poor indicator, Weil notes that:
“Tangible common equity became the capital benchmark of choice for many investors during the last U.S. banking crisis, because the government’s main capital measures lost credibility.”
Expanding his investigation into the current realistic health of banks, Weil found that:
“if it weren’t for the inflated loan values, [Regions Financial’s] tangible common equity would have been less than zero, with liabilities exceeding hard assets.”
Despite still not having paid back TARP funds and potentially being insolvent, Regions passed the stress tests.

Apart from testing somewhat irrelevant capital measures, the stress tests also provided an estimate of bank losses during the projection period (Q3 2011-Q4 2013). During that year and a half the Fed projects these 19 banks will, on net, lose nearly $250 billion. These estimates are almost surely optimistic and don’t account for future losses on these assets, among other things. Daniel Alpert of Westwood Capital, LLC has great, detailed report on the expected losses over time,  Deconstructing the Federal Reserve’s 2012 Comprehensive Capital Analysis and Review: What Does the CCAR Really Tell Us About the Big 4 Commercial Banks? As the title suggests, the Big 4 banks may be significantly more vulnerable than many expect.

One final point of interest regarding the stress tests relates to the underlying assumptions made by the Fed. The following graphs outline the assumptions made (courtesy of Zero Hedge):
Reflecting similarities to the most recent crisis, GDP and the stock market move sharply upward after the initial decline, while unemployment and housing prices languish. The aspect I’ve yet to see mentioned with these assumptions is that the bailouts (Fed and TARP) along with stimulus measures are supposedly the reason behind the rebound. One might then infer that the Fed’s stress tests assume future bailouts and stimulus measures, of similar proportions, to achieve comparable results.

Overall the Fed’s stress tests have been wildly successful as a promotional tool for the largest banks. Many of these banks are now increasing the return of capital to shareholders that will prove critical in the next crisis. Maybe after the next round of bailouts regulators will be forced to change their approach.

Sunday, March 18, 2012

Quote of the Week

...is from legendary investor Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor:

“In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and “sure things” can fail. However, there are two concepts we can hold to with confidence:
• Rule number one: most things will prove to be cyclical.
• Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”

This week stock markets continued their persistent rise with the S&P 500 crossing 1400 and the Nasdaq topping 3000. Since bottoming in October, stock markets across the globe are up 30-40 percent. Most market participants now seem confident that Europe has turned the corner, China has avoided a hard landing and the US housing market has finally bottomed. With fear subsiding (the VIX dropped under 15), analysts and investors are becoming increasingly confident that the current bull market is here to stay.

Lurking beneath the largely positive economic headlines, actual global economic growth has been slowing. First quarter US growth is once again trending below 2 percent and the full-year outlook is not much different. Europe has entered a recession, with several periphery countries either in or approaching depressions. Spain, not Italy, is struggling mightily and will truly test the resolve of European politicians in the months ahead. China recently lowered their growth target for the next 5 years to 7.5 percent, but current data suggests actual growth is even lower.

Aside from lower growth, corporate earnings estimates for the current quarter and year have been adjusted lower over the past few months. Profit margins also appear to have peaked as input prices continue to rise and productivity growth slows. Lastly, oil prices continue to rise with gas at the pump in many metropolitan areas already over $4 per gallon.

None of this data implies that the stock market is going to stop rising or roll over anytime soon. However, Marks’ cautions us to remember that periods of consistently positive headlines and investor sentiment are fleeting. Soon a time may come when most others have forgotten this rule. Be mindful of protecting your capital in advance of that moment.  
 


Saturday, March 17, 2012

Points of Public Interest

Happy St. Patrick’s Day! Enjoy the weekend by reading some great articles from this past week (if you're not watching the NCAA tournament)...


  1. Ray Dalio: Man and machine - One of the best investors ever shares thoughts on two types of credit cycles present in his economic model.
  2. Why ECRI’s Recession Call Stands - Lakshman Achuthan continues to defend his recession call from last year. I think current budget deficits are large enough to maintain 1.5-2% growth for most of the year. However, further deterioration in Europe and China’s economies may lead to the onset of recession in the 4th quarter.
  3. Philip Pilkington: Falling for Behaviourism – The Neoclassicals Join a New Cult
  4. Speculators might be in for a crude awakening - Marshall Auerback speculates on potentially forthcoming government actions that could send the price of oil down sharply.
  5. Good and Bad Deficits - Robert Skidelsky argues that “Government deficits incurred on current spending for services or transfers are bad, because they produce no revenue and add to the national debt. Deficits resulting from capital spending, by contrast, are – or can be – good.” If only governments on both sides of the Atlantic could accept this view...
  6. The Forgetting Pill Erases Painful Memories Forever - Fascinating article by Jonah Lehrer on how memories are re-created in our mind and potential cures for PTSD that disassociate the emotional response from the act of remembering.
  7. The Myth Of Cash On The Sidelines – An Update - Don’t be fooled into buying stocks based on this myth.
  8. The Bounds on what we are Likely to Learn from Models with Boundedly Rational Learning - Robert expresses skepticism over the current ability of any science to fully predict the expectations formed by individuals.

Sunday, March 11, 2012

Quote of the Week

...is from p.98 of Carmen Reinhart and Kenneth Rogoff’s outstanding book, This Time Is Different: Eight Centuries of Financial Folly (2011)
“Greece, as noted, has spent more than half the years since 1800 in default.”
Over the past three years, countless officials from the EU, ECB and IMF have proclaimed that no country within the Eurozone would be allowed to default. Given the history of many European countries, especially Greece, trying to prevent default seemed absurd yet authorities initially appeared willing to provide endless sums through bailouts to avoid a single default. Although Greece has been loaned funds in excess of the initial amount of debt outstanding, the countries economic deterioration and continually lax collection of taxes proved to much for the authorities. As of Friday, Greece has once again defaulted on its sovereign debt.

Although Greece’s default will create losses for the private sector of around 100 billion euros, Greece’s debt outstanding still remains more than 160% of GDP. With the economic contraction picking up speed (last quarter GDP was down 7.5% on an annual basis), any hopes of that percentage decreasing in the near future are ridiculously optimistic, if not impossible. By practically any standard, Greece is currently living through a Depression that appears to have no end in sight.

The majority of Greece’s outstanding debt will now be held by the EU, ECB and IMF. These holdings are senior to all other claims, making future defaults more difficult and complicated. Regardless of these hurdles, Greece can not and will not repay the current debt outstanding. Another default/restructuring is a practical certainty and will likely occur in the next couple years. Hopefully by that time the Greek people will have an elected leader that places the interests of the people first and finally takes Greece off the Euro.

European authorities tried to ensure this time was different by preventing sovereign defaults from ever occurring again. History was not on their side and ultimately won out, as it has for many centuries. In the end, this time was not different and Greece will likely spend more than half of the next decade in default as well.

Saturday, March 10, 2012

Points of Public Interest


  1. The Complexity of Hayek - Greg Fisher comments on similarities and differences between Hayek’s work and complex systems. Complexity theory is a fascinating subject I hope to study in the future.
  2. Social Security, the Financial Crisis & Modern Monetary Theory - John Carney continues to display how MMT, in focusing on the monetary system, forgets the many ways in which government can harm real economic growth and wealth.
  3. US Credit and Economic Views: It’s the Housing Market Stupid - Constance Hunter wisely notes the deflationary pressure of over $1 trillion in underwater mortgage debt. This remains a key aspect of my view that inflation will remain muted for several years.
  4. Tuning In to Dropping Out - Alex Tabarrok draws attention to the lack of college graduates in STEM fields and the disappointing level of dropouts both in high school and college. Focusing subsidies on STEM majors and offering “vocational” programs are a couple potential solutions for improving education within the US.
  5. GAO: Almost Half of Bailed Banks Repaid the Government With Money “From Other Federal Programs” - Matt Stoller examines the truth behind Treasury’s claims that “TARP made money.”
  6. For Profit Education, Pigs at the Trough - Russ Winter looks at how For Profit Education programs are abusing the government system to earn massive profits, while loading students with debt and only graduating around 33%.
  7. Josh’s Twenty Common Sense Investing Rules - Joshua Brown provides a great outline for individual investors, not traders.

Thursday, March 8, 2012

Operation Twist Doubles as Sterilized QE

Yesterday Jon Hilsenrath of the Wall Street Journal, who doubles as spokesman for the Federal Reserve, published an article titled 'Sterilized' Bond Buying an Option in Fed Arsenal. Upon word of another possible round of quantitative easing (QE), stocks and commodities rallied as the dollar fell against most other currencies. In the article, Hilsenrath comments that:
Under the new approach, the Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates.”
The first comment that jumped out was this notion of the Fed ‘printing money’. QE is nothing more than the Fed merely exchanging one financial asset (Federal Reserve notes) for another financial asset (Treasury bonds). Following the exchange, the private sector still holds the same exact amount of net financial assets. Asset durations in the private sector change, but QE alone will not cause inflation. Mike Norman expands on this issue and more in The Fed's "new and improved" QE.

Apart from this misconception of ‘printing money’, the specific durations that the Fed might buy and sell piqued my interest. Just last September Operation Twist was enacted, whereby the Fed purchased long-term Treasury bonds in exchange for short-term Treasury bonds. Read the description of Sterilized QE again. Under this program, the Fed plans to buy long-duration bonds and sell short-duration bonds. The size of the Fed’s balance sheet remains the same. Aside from the possible inclusion of long-term mortgages, Operation Twist and Sterilized QE are, in practice, exactly the same.

The Fed appears to have recognized the ineffectiveness of QE on the real economy, resolving to adjust perceptions by changing the name of its programs. While this may encourage greater speculation in stocks, commodities and MBS once again, one has to wonder how many versions of QE the Fed can perform before investors realize the truth behind these actions.

Wednesday, March 7, 2012

Saving is NOT Enough for Consumer Led Recovery

Over the past few years, public policy has relentlessly attempted to ensure the solvency and profitability of the financial sector, namely the largest financial institutions. Lost in these efforts is any recognition that the Great Recession was primarily due to a highly indebted household sector being pressured to reduce leverage. As shown in the graph below (from Fisher Dynamics in Household Debt: The Case of the United States, 1929-2011), household debt as a percentage of GDP increased from approximately 10% in 1945 to nearly 100% by 2007.
As an avid follower of new economic work being done in Post-Keynesianism, Modern Monetary Theory (MMT) and Modern Monetary Realism (MMR), I’ve often been perplexed by apparent inconsistencies in discussions regarding saving and leverage. My confusion stemmed, in part, from the notion that households are capable of saving and increasing leverage (debt as a share of GDP) at the same time. If you’re a bit confused at this point, don’t worry, I’ll explain the situation more simply in a moment.

Before moving on, it’s important to recognize that economic terminology often does not fit with typical usage of every day words. Here are some important economic terms to understand going forward:
Saving -  The difference between disposable income and consumption.
Disposable Income - Income minus taxes.
Consumption - The amount spent on non-durable goods (e.g. food, clothing) plus the amount spent on durable goods (e.g. autos) spread over the item’s life span. (Note: Purchasing a home is an investment, for which an imputed rent is counted as consumption.)

Using this definition of saving, it becomes clear that households can maintain a positive savings rate yet still be net borrowers, as long as that borrowing goes towards investments. Ramanan, a horizontalist, recently explained this concept in a wonderful post on Saving Net Of Investment [Updated]. From this perspective, the frequent comment that households must increase saving to reduce leverage is clearly false. The rise in household debt during the post-WWII period is apparently based on net borrowings, not the private savings rate.

This new found understanding has proved short-lived after reading the following Guest Post by JW Mason: The Dynamics of Household Debt over at Rortybomb. A new working paper finds

that changes in borrowing behavior has played a smaller role in the growth of household leverage than is widely believed. Rather, most of the increase can be explained in terms of “Fisher dynamics” — the mechanical result of higher interest rates and lower inflation after 1980.”
Put in simpler terms, interest rates on household debt since 1980 have been consistently higher than income growth. Under these conditions, even without increasing borrowing, household leverage will increase.

Over the past few years, household leverage has been decreasing largely due to debt write-downs. With this process slowing, the scenario mentioned above is likely to return. Even though interest rates remain at or near historical lows, income growth has been practically stagnant. Without a drastic change in these variables, the large burden of household debt is likely to continue suppressing consumer demand well in to the future. Attempts by households to increase saving may inadvertently decrease income, exaggerating the problem. Simply put, significant debt write-downs (a modern day debt-jubilee) may be necessary to restore the household sector to a stronger, more stable, financial position.    

Sunday, March 4, 2012

Points of Public Interest


  1. In America, the shale gas revolution is creating jobs and growth. It can here too - Matt Ridley explains the importance of cheap energy in creating jobs.
  2. Free Trade Ad Nauseam - Jagdish Bhagwati makes the case against increasing protectionism.
  3. Why bother with microfoundations? - Noah Smith reasons that micro-founded models may only occasionally be better than aggregate-only models. This offers some good background on the potential misuse of current models for determining public policy.
  4. Corruption and Politics - The motivation behind crony capitalism stemming from a highly centralized government.
  5. JKH On Saving And Sector Balances (WONKISH) - MMR continues to illuminate flaws within the prescriptive portion of MMT, based on slight adjustments in meaning. Read the comments on the site to see much of the new insights being hashed out.
  6. Warren Buffett: Baptist and Bootlegger - One of the all-time great investors has been as savvy in political calculation/courtship as he has been in picking stocks.
  7. He Had Moves Like Jagger - Steve Horwitz praises the economic rhetoric of Frederic Bastiat.

Saturday, March 3, 2012

Quote of the Week

...is from Emanuel Derman’s insightful book, Models.Behaving.Badly. (2011):

”Physicists, brought up on a diet of astounding theories and successful models, have the ability to distinguish a theory from a model and a good model from a bad one. Economists for the most part have never seen a genuine theory, and so discrimination is harder. The simple models they work with fail to reflect the complex reality of the world around them. That lack of success is not the fault of economists, for people have proved difficult to theorize about, and we still await an understanding of Spinoza’s adequate causes for their behavior. But it is the economists’ fault that they take their simple models so seriously. Finding the truth about nature takes cunning and intuition. The invisible worm of financial economics is its dark secret love of mathematical elegance regardless of its efficacy, and its belief that rigor can replace fact and intuition.”
A former theoretical physicist and Wall Street Quant, Derman offers a unique perspective on the difference between physics and economics through a distinction between theories and models. Stemming from the Great Recession, countless articles have been written about the state of economics today and potential directions for the future. As Derman wisely points out, the incorporation of human action significantly hinders the ability of economics to create genuine theories, those that prove true for all instances across time.

This view is not to suggest that mathematical elegance should be disregarded, but rather that its limitations in predicting human behavior be understood and acknowledged. Advances within physics, such as chaos theory and quantum electrodynamics (QED), are currently being employed by economists (ie. Steve Keen) to formulate new models of the economy. However, it remains unlikely that these advances will ever fully predict the future actions of individuals and therefore some level of uncertainty will always remain present within economical models.