Monday, August 24, 2015

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.





41 comments:

  1. This is all a bit ridiculous, as Dean Baker notes ( http://www.cepr.net/blogs/beat-the-press/quick-thoughts-on-the-stock-market-and-the-economy ), the stock market is not strongly associated with the health of the economy.

    If GDP tanks and unemployment starts souring, maybe such radical policies may be necessary; but in response to stock market fluctuations? That's just silly.

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  2. "If GDP tanks and unemployment starts souring, [soaring?] maybe such radical policies may be necessary;"

    "silly" is a bit derogatory. But you are right to point out that, IF this turns out to be a temporary dip then we are all ok. Would you bet your house on that?

    If it doesn't: look out for big increase in unemployment in three months time. Here's why Dean Baker is wrong.

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    1. Still think it's premature, Granger causality is not true causality. Shouldn't we wait and see if it's actually feeding into the real economy first?

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    2. I'll wait a week or two. Lets see if the market stabilizes. Or if it drops off a cliff.

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  3. Thought this was a joke at first, unfortunately it is not, lol

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    1. I got that same comment for this post this post. But then again, that one appeared on April 1st. No - its not a joke.

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  4. When consumer demand increases, firms create jobs, earnings and dividends increase and the high value of paper assets is validated

    Buying paper does not validate paper, earnings validate paper, this just increase the wealth of at best top 20%, 30 years of supply side economic solutions have run there course, we need consumer demand now from the 80%

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    1. This is not supply side economics. Its a different kind of demand side stimulus based on the fact that there has historically been a close causal relationship from the value of paper wealth to unemployment.

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  5. I'm a bit confused by your policy prescriptions. Will the Treasury buy the stock market assets or will the Fed? Don't you think the asset purchases should be managed by a separate institution tasked with maintaining a SWF, rather than the Fed or the Treasury?

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    1. Financial policy should be coordinated with monetary policy. A newly constituted analogue of the FOMC with overlapping membership is the natural body

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  6. Well...the US stock market tanked by 20+% in one day back in October 1987...the 1990s were robust...

    However, I totally support aholiday on FICA payroll taxes, offset by the Fed buying Treasuries and putting them into the FICA trust funds...this should continue until we see inflation comfortably in the 4% range for a few years....

    that should also raise interest rates, but through growth and inflation, not just by raising them....

    The Fed cannot simply raise rates...that will only result in tighter money and lower rates....you cannot tighten your way to higher rates, at least not for long....

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    1. In 1987 the Fed had the room to lower rates.

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  7. If the monetary contraction continues at the rate it is at present there will certainly be a crash. See http://www.philipji.com/item/2015-05-15/the-monetary-contraction-continues-at-a-slower-clip

    But monetary growth YoY won't go below 0% until much into next year. So it is unlikely a serious crash will happen until then.

    Nothing can prevent the crash except a moderate QE to ensure that monetary growth does not far below zero. Yet it must not be so large that it continues inflating the bubble as it has since 2009.

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    1. I read your linked blog Philip. I didn't see an argument. Simply an assertion. I wish you luck in your debunking crusade.

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  8. https://research.stlouisfed.org/fred2/graph/fredgraph.png?g=1FwP

    See the cut, from $1.4 trillion in 2009 to $484 billion the first quarter of this year?

    Sure you do. The deficit still is higher than it was just before the “Great Recession” and before Obama became President in 2009.

    https://research.stlouisfed.org/fred2/graph/fredgraph.png?g=1FDs

    However...the second graph shows annual percentage changes in the federal “debt” (i.e. the net number of dollars the government has sent into the economy) relative to the size of the economy. (Or the net number of dollars “Uncle Sam" has given you).

    Look at the graph and decide: When do we have recessions? What is the PRELUDE to our recessions?

    PAPER WEALTH (as the cause of unemployment) is a fiction.

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    1. Steve
      This is way too cryptic for me, and I'm sure for everyone else reading these comments. If you have a point to make: make it in plain English

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  9. "The financial markets are informationally efficient. It is difficult or impossible to make money trading in the markets unless you have inside information."

    I think this is misleading. It should be made clear that it's difficult (extremely rare) to make money without risk, instantly, in a classic arbitrage way. But there's still lots of inefficiency. For example some investments are much better in expected return even adjusting for risk, and yet they don't get bidded down; many many people continue to invest in other assets that have much worse risk-adjusted expected returns. The risk-adjusted expected return on the stock market has been very dependent on the P-E ratio, and so on.

    Fama's absolutely wrong about the great efficiency of the stock market. Just because the most blatant form of inefficiency is extremely rare – classic riskless, no upfront money required, arbitrage – does not mean that there's not still tons of inefficiency – mean reversion, a non-random walk, persistently underpriced and overpriced assets given their risk-adjusted expected returns, and so on.

    It's just misleading to give in to Fama, even though there is a lot of incentive to do so. It's really a form of what Krugman calls Seriousness, honestly, with all the respect which is certainly due.

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    1. And I know you have a generational reason for some of this, but certainly part of the reason has to be massive and widespread inexpertise and ignorance in an ultra-complex modern world. That 65% of people answered incorrectly when asked how many reindeer would remain if Santa had to lay off 25% of his eight reindeer might, just maybe, just maybe, call me crazy, have a little something to do with it. See:

      http://richardhserlin.blogspot.com/2015/07/the-intuition-behind-wallace-neutrality.html

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    2. A long discussion, but I don't think the evidence and logic is with Gene.

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  10. "They are not Pareto efficient because almost all of the people who are affected by the trades we make today are not yet born."

    Also, there's the big issue of non-rival idea goods. For example, if we invest heavily in the stocks of biotech research firms, there will be more biotech discovery, and that discovery will be a benefit today, but that knowledge will also be free to all future generations – not fully considered in the investment decisions. If we invest in solar companies, or buy solar panels for our homes, this will contribute to knowledge on solar, and its advancement, which will be free to all future generations (let alone lowering their risk of catastrophic global warming). Again, not fully factored in.

    Plus, uggh, the libertarians force us to only consider their ideology's version of efficiency, as opposed to maximizing total societal utils efficiency. As if there are only two possible options that society has to choose from, the status quo and Pareto.

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    1. There are lots of reasons why markets MIGHT be inefficient. Absence of prenatal finial markets is my favorite because it is hard to refute.

      And why are you opposed to Pareto efficiency as a minimalist criterion. There's nothing stopping you from adding a distributional criterion in addition.

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    2. I don't think there's anything wrong with saying what the Pareto optimum is, but it should be just one optimum calculated for readers and policy makers to consider. The problem is that there's a lot of pressure to make it the *only* one you're allowed to let readers know about and consider. There's a lot of pressure not to publish if the total societal utils optimum is included. There's a lot of pressure to not calculate that, to not think about, and analyze, and spend time on that, if you want to publish and advance.

      Yet, you can say what the total societal utils optimum is, and analyze why certain things lead to its optimization, and still be positive, still not endorse it, just let readers at least know what it is and how it works so they can know and decide what they favor.

      And certainly this is something very much of interest to the public and policy makers, so they shouldn't be kept in the dark about it because powerful gatekeepers have an agenda of silencing it and only letting their preferred optimum, for ideological and/or career reasons, be known, discussed, analyzed and researched.

      It should be noted too that the policy that maximizes total societal utils is not at all necessarily found by just first going Pareto and then redistributing wealth or income in dollars. It will be something more complex than that, and multi-faceted. For example, you could do all of your Pareto changes first. But then optimization of total societal utils (say over the next few generations) would involve, among much else, a great deal of Heckman-style early human development investment. This is a redistribution, but not of pure money, of goods and services, or money with strings attached. This Heckman, step and future steps, would be done in a Pareto way, so you'd stay Pareto. But the main point is what optimizes total societal utils is complicated, not just first Pareto, and then shift some dollars.

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    3. Ok, my writing needs editing (but not possible). The Heckman investments are obviously not Pareto; some tax payers lose. But you would do them in such a way that after they were done, there would be no Pareto move you could make starting from that new status quo.

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  11. "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."

    The first is a, perhaps giant, quantitative easing. If you did the first really strongly, then you probably could safely do the second. But the first will not happen, so do you agree then that the second will be very harmful because it will be without the first?

    I mean if you did a gigantic quantitative easing you might increase the inflation rate substantially, and so an increase in the nominal interest rate might not even be a real increase.

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    1. Yes of course. Raising rates without committing to support asset prices would be an unmitigated disaster.

      And the proposal is not for Quantitative Easing. It's for Qualitative Aeasing.

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    2. Ok:

      "This paper is about the effectiveness of qualitative easing; a government policy that is designed to mitigate risk through central bank purchases of privately held risky assets and their replacement by government debt, with a return that is guaranteed by the taxpayer"

      At: https://research.stlouisfed.org/conferences/annual/Farmer-QuaE-R2.pdf

      I'll have to read that eventually. Thanks.

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  12. Why do you want to Increase Ag demand thorugh such an inderect way as increasing Securities/Stocks instead of helicotper money?

    You cant put stocks up indefinitly so corrections will be mandatory.

    Besides most stocks are held by fonds/banks not by the average joe. So an increase in stocks will foremost produce increased profits for fonds/banks which would only increase AG Demand marginally imo.

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    1. The proposal follows from my empirical work that finds a stable low frequency link from asset prices to unemployment.

      No, you can't increase PE ratios forever. Correction should be managed once U rate is normalized

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  13. Why buy stocks that already exist? instead, use the money to build new infrastructure the US needs. Puts money directly into the economy and increases productivity of capital.

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    1. Yes. Build infrastructure. I agree we need new bridges. That decision should be independent of demand management. I would prefer to let the private sector find best uses for new investments.

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  14. Roger: have you tested other measures of employment slack (the prime age labor force participation rate, the employment rate, etc) to see if they are also granger-caused by the stock market? Maybe more importantly: what is the causal mechanism that connects the stock market valuation to changes in unemployment? Do high share prices induce entrepreneurs to invest and hire in the hope of selling off in a future IPO? Does a high share price make it easier for an existing company to buy new capital goods? Is there a wealth effect on consumption? I suppose I'm asking a Lucas critique question here, but it seems important to have some reasons to believe that a very public intervention in the stock market would have the same affect on whatever subsequent behavior matters for future unemployment as would a "spontaneous" upsurge in optimism, before the Fed embarks on such a maneuver.

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    1. My guess is it's a wealth effect. It's important in the data at low frequency: not high frequency. As for participation. See my BofE paper..

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  15. How correct was Keynes about stock markets? Here is what Bhargava finds:
    http://www.sciencedirect.com/science/article/pii/S0304407614001171

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    1. Thanks for the link. I will take a look at it.

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  17. I can't believe in the MEH. Just think that all participants move in the same direction, quite a lot longer than the value of the firms quoted. I'm only intuitive, but an efficient market should not be one where movement were only related to firm values? I agree with the Keynes' description. The only reason not to close it is liquidity.

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    1. Ok. But it is worth identifying the reasons for market inefficiency. I don't think it has to do with irrationality. Fama is right to point out that it is difficult or impossible to beat the market without a significant informational advantage. Markets are Pareto inefficient: Not informationally inefficient.

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  18. Since 2009, the fed has expanded its balance sheet by about $3 trillion, while US corporations have bought back their own stock in an almost equivalent amount (about $3.5T). These repurchases have been financed either through new debt or through existing cash balances held by corporations, each of which has been be less expensive as a result of the Fed's accommodating policies, including is own asset purchases. So, how different has the result been compared to the policy you describe? If the actual practice of the Fed has been effectively equivalent to the policy you're recommending, have the results been consistent with your expectations? In so far as many observers consider the US recovery to be "sluggish", do you agree and does this suggest that your proposed policy is inadequate to the task of getting the economy to full employment? In so far as the fed's actual policy differs from your proposal, how much do those differences matter, and should we expect a policy closer to your proposal to have a larger labor market impact?

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    1. There is a lot to answer here.

      1) Investors are afraid of future market movements. The policy I advocate is designed to alleviate that fear.
      2) The Fed has lost control of inflation. We need to get interest rates into positive territory to regain control.

      I'm finishing up a book right now that will explain these ideas and put them into context. Stay tuned.

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  19. Could you identify other economists or articles with similar opinions to yours? I would like to explore this idea but need more academic support.

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