The Next Great Depression

The financial markets are in turmoil. We are dangerously close to the next financial crisis.  The FTSE in the UK is down by 13% from its April peak. The Dow in the United States is off by 10%

and the Hong Kong Hang Seng index, the market that  is closest to the epicenter of the crisis, is down by a whopping 21%.

Why worry? Surely this is just a market correction. Traders in the financial markets are, after all, simply making the trades that are in all of our best interests. I don't think so!

Are the financial markets efficient? In one sense yes. In another sense no.

The financial markets are informationally efficient. It is difficult or impossible to make money trading in the markets unless you have inside information. There is no free lunch. That's what Gene Fama meant when he defined the term “efficient markets hypothesis”.

The financial markets are not Pareto efficient. They do not allocate capital across time in a socially optimal way. They are not Pareto efficient because almost all of the people who are affected by the trades we make today are not yet born. That is what explains Bob Shiller’s finding that long-run returns are predictable.

Real interest rates, and their close cousin, price earnings ratios, are incredibly persistent. They are persistent because the mistakes that our parents and our grandparents made in the past are carried into the present through the generational wealth distribution.

For the past hundred  years, we have managed the economy with a single tool; monetary policy.  Central banks raised the interest rate when inflation was high or when unemployment was low. They lowered the interest rate when inflation was low or when unemployment was high. For the past thirty-five years, there was no conflict between those objectives. Times have changed.

The stock market crash is screaming out for the Fed to lower interest rates. That option is closed as the interest rate has reached its lower bound. Some economists are calling for a huge fiscal stimulus. That is not the answer. Although I have stated publicly that I don't believe in fairies: Unlike Paul, I DO believe in the confidence fairy. Pessimistic beliefs about the value of private wealth are as destructive to the economy as a hurricane.

For monetary policy to work effectively as a lever to control inflation, the interest rate must be positive. We must raise the interest rate. And we must do it now.

If we raise interest rates now, the stock market will fall further. The U.S. market correction will turn into a full scale rout. Unemployment will soar. Unless.

Unless we use the deep pockets of the Treasury to step in on behalf of unborn generations and prevent that from happening.

For the economy to function at a high level of activity, the value of paper assets must be high. When we feel wealthy we spend. When we spend, firms create jobs. When firms create jobs, earnings and dividends increase and the high value of paper assets is validated.

What can we do? What should we do?

First: Give the Fed the power to buy a value weighted Exchange Traded Fund that contains every publicly traded stock.  Commit to support the ETF by buying stocks. Pay for the shares by  borrowing, or by trading Social Security Trust Fund.

Second: Raise the money interest rate to bring us back to normality and restore normal functioning of monetary policy.

When? Now! 

If we do not act, and act soon, we are headed for another Great Depression.

Animal Spirits and the Two Natural Rates

In my last post I pointed out that it is not enough for monetary policy to guide the economy back to the natural rate of interest. Central banks and national treasuries must use financial policy to guide us back to the natural rate of unemployment.

Imagine two economies in parallel universes. I will call them economy A and economy B. Both economies are populated by identical copies of the same people. They have the same endowments of land labor and capital. And each economy has access to identical technologies for producing goods. In economic jargon: they have the same fundamentals.

But although these economies have identical fundamentals, the people in economy A are naturally optimistic. They believe that shares in their stock market are worth PA. And PA is a large number. The people in economy B are pessimists. They believe that their stock market is worth PB. And PB is a small number. Importantly, PB < PA.

In economy A, as a consequence of the optimism of the population, households have a high demand for goods and services. To meet that demand, firms require a high labor force. The unemployment rate in economy A is 2%.

In economy B, as a consequence of the pessimism of the population, households have a low demand for goods and service. To meet that demand, firms require a low labor force. The unemployment rate in economy B is 10%.

In each economy, the households and firms believe, correctly, that the value of a share is equal to the discounted present value of a claim to the dividends that will be paid by the firm. And in each economy people discount the future at rate 1/R*, where R* is Wicksell’s ‘natural rate of interest’.

Dividends, in each economy, are a fraction of GDP. Because employment is higher in economy A than economy B, GDP is also higher. And so are dividends. The valuations placed on the stock market in both economies are rational. PA is equal to the present value of the dividends paid in economy A, discounted at rate 1/R*. PB is equal to the present value of the dividends paid in economy B, also discounted at rate 1/R*. Optimism or pessimism is a self-fulfilling prophecy.

How can this be? Surely the unemployment rate is determined by fundamentals. Not so. I explain in my published academic work, how there can be many unemployment rates, all of which are consistent with the conditions I described in this example. In a labor market where people must search for jobs, there are not enough price signals, to lead market participants to the optimal unemployment rate.

A Tale of Two Natural Rates

Narayana Kocherlakota makes the case for more public debt. Paul Krugman and Steve Williamson agree. (I have to keep rereading that sentence before I believe it). What is this argument all about and how does it relate to the soul of Keynesian economics?

Let's start with a key premise in the Kocherlakota speech. There is a theoretical concept called the ‘neutral real interest rate’ and one of the jobs of a central bank is to get us back to that rate of interest as quickly as possible. The ‘neutral rate’ is what Wicksell called the ‘natural rate of interest’ and I'm going to stick with Wicksell’s terminology here.

Wicksell’s natural rate of interest inspired Milton Friedman to coin the term ‘natural rate of unemployment’. In classical economics and in the brand of New Keynesian economics that inspires central bankers, there is a one-to-one correspondence between these concepts. If we could only ensure that we were at the natural rate of interest, it would simultaneously be true that we were at the natural rate of unemployment. That is, to use a technical term, poppycock.

Let's consider two possible definitions of ‘the’ gross real interest rate.

Definition 1: R1

R1 is the number of apples you could buy one year from today if you sell one apple today, invest the proceeds in one year treasury bonds, and convert the interest and principal, one year from now, back into apples.

Definition 2: R2

R2 is the number of apples you could buy, one year from today, if you sell one apple today, invest the proceeds in the stock market, and reinvest the quarterly dividends. One year from now, you sell your shares and convert the proceeds back into apples.

These two real interest rate concepts will always be different because the stock market return is far riskier. But economic theory says that they should be connected by the equation,

R2 = R1 + RP

where RP is a positive number that represents the extra return you require to compensate you for risk.

So far so good.

Now let's look at the connection between R2 and the stock market price. Imagine that we repeat the experiment of selling an apple many times and that we compute the average return. That's a bit of an artificial experiment because technically, I am thinking of the return earned in a billon parallel universes, all with the same initial conditions. That's a technicality that lets me abstract from uncertainty.

How would R2 be related to the price dividend ratio?

Here’s the answer.

R2 = 1 + D/P = 1 + (1/pd)

where pd is the price dividend ratio, P is the price of the stock and D is the dividend averaged over all of these parallel universes.

Now let's get back to original question. Let R2* represent the natural rate of interest earned in the stock market. Let U be the unemployment rate, let U* be the natural rate of unemployment and let pd* be the price dividend ratio when we are at the natural interest rate.

QUESTION

Here is my question to Narayana, Paul, Steve and anyone out there who wants to throw in their two cents. 

If: R2 = R* is it necessarily true that U = U*?

My answer is a resounding no. And that is what distinguishes my work from new Keynesian economics. The reason is that for every U there will be a P(U) and a D(U) where D(U) is the dividends you would earn on the stock market, and P(U) is the price you would pay for a share if the unemployment rate was U. In my world, there are multiple equilibrium unemployment rates. That is, after all, the essence of Keynesian economics. And that premise implies that there are multiple values of U such that

pd* = P(U)/D(U)

The answer to this question matters. And it matters a lot. During the Great Moderation, unemployment and inflation came down together. There was no apparent conflict between the goal of 2% inflation and full employment. That divine coincidencecannot be expected to continue. We need two tools for two targets. As I have argued here; we must use financial policy to target the unemployment rate and monetary policy to target inflation. 

So my question to wannabe Keynesians is: Are you a Neo-paleo Keynesian? Or are you a watered-down-Samuelsonian-MIT-Hicks-Hansen-1950s-IS-LM kind of guy?

Somebody at the PBC blinked

In a recent post I made this comment about China’s decision to intervene in its own stock market.

China is holding more than $1.2 trillion dollars of U.S. government debt. If the Bank were to tap those funds to stabilize the Chinese stock market it could not simultaneously maintain an exchange rate peg. If China goes that route, look out for upheaval in the foreign exchange markets.

Chinese policy makers are now learning that lesson. The Peoples Bank of China (PBC) has allowed the Renminbi to tumble by more than 3% in the last few days. The ride may not yet be over.

What’s happening and why? It's my guess that there are investors on the margin who are pulling money out of the Chinese market and moving it into the world capital markets. Those investors are betting against the valuation that the PBC is putting on domestic assets. The outflow of funds  puts downward pressure on the RMB and if the PBC were to maintain its previous parity they would be obliged to sell their holdings of dollar denominated assets to support the currency.

The PBC blinked! But that's a good thing. They’ve chosen a domestic target over an exchange rate target and to make that work, the world needs to keep buying Chinese goods.

I have advocated a policy of Treasury and Central Bank intervention to stabilize domestic asset markets. What we are seeing in the Chinese case is that this policy is inconsistent with a fixed exchange rate.

Playing Chess with the Devil

I love this quote (with my amendments for economists)  from the NY Times article about Terrence Tao. 

The true work of the mathematician economist is not experienced until the later parts of graduate school, when the student is challenged to create knowledge in the form of a novel proof piece of research. It is common to fill page after page with an attempt, the seasons turning, only to arrive precisely where you began, empty-handed — or to realize that a subtle flaw of logic doomed the whole enterprise from its outset. The steady state of mathematical economic research is to be completely stuck.

It is a process that Charles Fefferman of Princeton, himself a onetime math prodigy turned Fields medalist, likens to ‘‘playing chess with the devil.’’ The rules of the devil’s game are special, though: The devil is vastly superior at chess, but, Fefferman explained, you may take back as many moves as you like, and the devil may not. You play a first game, and, of course, ‘‘he crushes you.’’ So you take back moves and try something different, and he crushes you again, ‘‘in much the same way.’’ If you are sufficiently wily, you will eventually discover a move that forces the devil to shift strategy; you still lose, but — aha! — you have your first clue.

That's pretty much how I feel about research. Another analogy is that research is like solving a Rubik's Cube: You're about to put the last piece in place and you find you have to go back 25 moves and start over.