Monday, June 13, 2016

Paul Simon - Wristband (Static Image Video)

Paul Simon's still got it!

Beth Orton - "1973" (Full Album Stream)

Beth Orton - "Snow" (Full Album Stream)

Tuesday, August 11, 2015

Macroprudential Policies: A Primer

This post is a simplified summary of The Promise and Peril of Macroprudential Policy By Barry Eichengreen, Project Syndicate, August 7, 2015. It may be a helpful article about macroprudential policy.

Monetary policy is mainly about keeping unemployment and inflation low. But it would be nice if it could also be used to restrain asset price bubbles (because such bubbles invariably burst, causing severe financial crises and recessions). Given that during asset price bubbles people tend to feverishly buy assets with borrowed money, the central bank could simply slow its lending of newly printed money to banks and thereby cut off the bank lending fueling bubbles.

And yet, until the financial crisis of 2008, central bankers had been unwilling to take on the task of fighting asset price bubbles. Why? When asset prices start to rise, it is hard to know whether the rise in prices is sustainable or a bubble that is about to burst; by the time it is clear that a rise in asset prices is a bubble, it is usually too late. So, given that bubbles are hard to detect quickly, it was thought that instead of trying to stop bubbles from forming central banks should let them form, but move in quickly after they burst to make the inevitable recession as painless as possible (by implementing expansionary monetary policy to reduce interest rates and thereby stimulate the economy).

Unfortunately, the crisis of 2008 has shown that while detecting an asset price bubble in a timely manner may be hard, letting a bubble develop and cleaning up the mess after it bursts may be even harder.

So, should central banks set aside their hesitation about fighting bubbles, and restrict the money supply in order to raise interest rates whenever they see what looks like the beginnings of an asset price bubble? Not so fast; it is a hard trick to pull off. The Swedish central bank tried to do just that in 2010 but ended up creating a recession. "Before long, Sweden had succumbed to deflation, from which it is still struggling to recover."

The best approach may be to use the central bank's control over the interest rate for the traditional purpose of keeping unemployment and inflation low, and to develop separate tools to tackle asset price bubbles. The use of these separate tools is called macroprudential policy.

The two main tools of macroprudential policy are (procyclical) capital requirements and (countercyclical) loan-to-value ratios.

Capital Requirements: The money that a bank lends comes from its depositors (deposits), its lenders (debt), and its owners (capital). If the monetary authorities require banks to rely more on their owners' capital for the money they lend, the banks would tend to be more cautious about lending. Therefore, raising capital requirements during the initial stages of an asset price bubble may squelch bank lending to the crazed buyers driving up asset prices, and thereby stop a bubble from forming.

Loan-to-Value Ratios: Suppose you wish to buy a house and a bank lends you 95 percent of the value of the house, leaving you to pay only the remaining 5 percent. That would make buying a house easy. On the other hand, if the monetary authorities impose a loan-to-value ratio of 75 percent, the demand for houses would shrink. In this way a bubble in home prices can be avoided if the loan-to-value ratio is reduced when house prices start to rise in a bubble-like manner.

Unfortunately, although these macroprudential tools are fine in theory, they have problems of their own: "The Bank of Spain’s attempt to implement adjustable capital requirements for banks, ... did little to deter aggressive lending during the country’s property boom. Once a mania gets underway, the temptation to join is simply too strong." Also, discouraging banks from lending to home buyers by reducing loan-to-value ratios may simply encourage other unregulated lenders to step in and fill the gap.

So, where does all this leave us? Although the new macroprudential tools are imperfect, it is probably better to have more tools than less. The central bank can use its control over interest rates for the traditional purpose of keeping inflation and unemployment low, and it can use macroprudential policies to stop asset price bubbles from destabilizing the economy.

Tuesday, February 03, 2015

Medical Education in India

Just read a fascinating article on the dysfunctional nature of India's medical education system: India’s private medical colleges and capitation fees by Jeetha D’Silva, British Medical Journal, January 21, 2015.

Many of the horrors of the system -- such as the huge capitation fees collected in defiance of the law -- could, in hindsight, have been predicted by an average sentient being. Why then was such a system put in place to begin with? What was the nature of the debate that led to the current system? I wish I knew the history of the system.

On the issue of reform, I agree with the opinion expressed in the final paragraph by Dr. Samiran Nundy, chairman of the department of surgical gastroenterology and organ transplantation at Sir Ganga Ram Hospital, Delhi: There should be a common entrance exam and a common exit examination for all who wish to be recognized as doctors in India.

The government should lift all restrictions on fees; price control is not working. And the system of government medical colleges has been a disaster. In 2014, "616,982 [candidates] took the All India Pre Medical Test to qualify for 2503 “open” places". And this is in a country of more than a billion people!

After eliminating all restrictions on fees, the government should then regularly publish data for every medical college -- government and private -- on the fees it charges, the profile of its admitted students' scores in the common entrance exam, the number of admitted students who took the common exit exam, and the profile of their scores in the common exit exam. This information will help prospective students to do some comparison shopping.

The other problem is how to help students from poor families pay the steep fees without helping the rich or those who would eventually leave for lucrative careers in other countries. Here's my proposal: After a student from a poor family is admitted to a medical college (government or private), for every fee her family pays, the government will deposit an equal amount into a special bank account in the student's name. The student's family will be able to decide how the money is invested (in stocks, bonds, whatever). After the student's education at the college ends -- successfully or not -- the family will be able to withdraw the money in the special account, not all at once, but in staggered annual amounts over the period equal to a typical Indian's professional life, with the proviso that each such fixed withdrawal would be allowed only if the student was an Indian resident during the year or no longer alive.

I am aware that my proposal has glaring weaknesses. Please feel free to criticize; I promise my feelings will not be hurt.

Saturday, January 24, 2015

Here's a mystifying NPR report on a community in upstate New York where women are pressured to not drive, apparently on religious grounds. Some questions: Why do religious people so often feel the need to impose their preferences on others? And why do they feel the need to segregate themselves into communities in which public morality can be imposed? Why are they so unwilling to consider religion to be a private matter? Why is it that the more punctiliously religious some people are, the more likely they are to be doing things that seem totally incomprehensible to me?

The Libertarian Utopia of Hazaribagh

This is an informative -- and transfixing, frankly -- report on the environmental impact of the tanning industry in the Hazaribagh area of Dhaka, Bangladesh, by Tania Rashid, a talented young Bangladeshi-American reporter for Vice News. Libertarian utopians in the West who decry environmental regulations -- and regulations in general -- should take note.

A Report on Rape in Bangladesh

The occurrence of rapes and gang-rapes in India have received a great deal of global attention. But if this report by Tania Rashid of Vice News is to be believed, the situation in neighboring Bangladesh may not be a whole lot better: "A recent UN report revealed that one in eight men in rural Bangladesh admit to having committed rape." (This Vice News report is revealing on multiple levels and bears repeated viewing. I was stunned by how astonishingly riverine and verdantly green Bangladesh looks in the video. Also priceless was the utter contempt Rashid expresses as she leaves a meeting with the head of a mosque.)

What Charlize Theron's Good Fortune Tells Us About Wages

I don't know whether the higher remuneration that Charlize Theron was able to obtain using information revealed by the Sony hack corrects an unfair outcome or makes a fair outcome unfair. But it does show how wages depend on bargaining power and the availability of information -- two factors that are generally ignored in undergraduate courses that discuss wages. (In the utopia described in those courses, the contribution of each worker is easily measured and known to all. And each worker gets paid what they contribute. I teach that material, but -- in my defense -- I do feel guilty about it afterwords.)

Sunday, February 23, 2014

Today's Reading

  • Robert H. Frank, the Cornell economist, asks: Which economic metaphor best describes our future: the winner-take-all economy or the long-tail economy?
  • The number of Indian farmers who have committed suicide since 1995 under the pressures of loans they cannot repay is approaching 300,000. They are borrowing money from loan sharks because (a) government subsidies are being cut, (b) competition from imports is surging, and (c) agriculture now requires large investments in costly genetically-modified seeds. The lenders charge interest rates as high as 24 percent. Even suicide brings no relief: the loan falls on the widows and the children. Unlike in rich countries, there is no bankruptcy protection, and no bans on usurious interest rates: rural India is now a haven for pitiless pure capitalism! And government officials are shockingly unsympathetic, blaming the suicide victims for spending too much money on -- wait for it! -- their children's education. Here is one family's story.
  • Gregory Clarke, an economist at UC Davis, presents a fascinating summary of his new book on how impervious social mobility is to social engineering.
  • This editorial in today's New York Times effectively demolishes the idea that the Obama stimulus (formally, the American Recovery and Reinvestment Act, enacted five years ago) was a waste of money.
  • This is a fine summary of recent research that poverty leads to irrational choices, and not just the other way around. I have been following this literature every since the publication of "Scarcity: Why Having Too Little Means So Much" by Sendhil Mullainathan and Eldar Shafir, and I discussed the book with my students last semester. Although the study on Indian sugarcane farmers was known to me, I was unaware of the Great Smoky Mountains study described in this piece.
  • Here's another blog post on the same theme.

Friday, December 06, 2013

The Origins of Bangladesh's Garments Industry

Please listen to this terrific radio report on the origins of Bangladesh's internationally pre-eminent garments industry.

Two thoughts: First, I have often wondered why the neighboring Indian state of West Bengal -- where I grew up -- never managed to spark its own industrial revival -- in garments or something else -- despite its obvious similarities with Bangladesh (which, incidentally, is where my parents were born, at a time the region was still part of British India). The report shows the role that plain old chance plays in things as momentous as the development of an entire national industry.

Second, the report also shows that a private profit-seeking company may unwittingly generate huge wealth that it does not get to enjoy, but others do. Daewoo, the South Korean conglomerate, trained a contingent of Bangladeshis to produce textiles, hoping to profit from its Bangladeshi venture; Richard Nixon had put a limit on textile exports from Korea to the US. But Daewoo did not get the profits it hoped for. Instead, the Bangladeshis trained by Daewoo ended up spawning a huge industry that all of Bangladesh is now benefiting from.

One final point: This report -- by Zoe Chace and Caitlin Kenny of the Planet Money team of National Public Radio -- also shows how good American radio journalism can be.

Friday, November 08, 2013

The Paradox of Inflexibility

In my previous blog post, I mentioned a forthcoming paper by a co-author and I. It is a simple paper that shows how one can explain to undergraduates the macroeconomic behavior of an economy that is stuck in a so-called 'liquidity trap.' At the liquidity trap, interest rates are at the 'zero lower bound;' interest rates have been reduced as far as they can be reduced and cannot be reduced any further.

At the zero lower bound, a whole raft of paradoxical results -- with names like "paradox of thrift," "paradox of flexibility," and "paradox of toil" -- appear. A new NBER working paper by David Cook and Michael B. Devereux ("The Optimal Currency Area in a Liquidity Trap," NBER Working Paper No. 19588, derives yet another paradoxical result.

Cook and Devereux argue that -- contrary to the received wisdom that a monetary union (such as the European Monetary Union) makes its member economies more vulnerable to economic shocks -- in a liquidity trap a monetary union may makes its member economies less vulnerable!

Countries that form a monetary union agree to give up their national currencies and adopt a common currency. And, as Greece, Portugal, and Ireland have discovered the hard way, not having a national currency can drastically reduce a country's ability to fight its way out of a recession.

Normally, when a country finds itself in a recession, its central bank prints a lot of money and spends it on financial assets (bonds, typically). Buying a bond from somebody and paying him cash for it is really just the same as lending him money: you pay him money now and he promises to pay you money later. Consequently, the new money printed (and spent) by the central bank essentially turns into a gusher of loans. Borrowing becomes cheap and interest rates fall. Lower interest rates lead to increased spending by households and businesses. The rise in spending leads to an economic recovery. Everybody breathes a sigh of relief.

Unfortunately, a country without its own currency would not be able to take any of the recession-fighting measures just mentioned. If the members of a monetary union are similar enough that their business cycles are perfectly aligned, then when one member is in a recession all other members would also be in a recession. In such a case, tons and tons of the common currency could be printed and used in the usual way to pull all member economies out of the recession. But when the member economies of a monetary union are vulnerable to "asymmetric shocks," a member economy that falls into a recession does so alone. And it would have no independent monetary policy to help it escape the recession. This is why, monetary unions have been frowned upon by economists, except for countries that belong to an "optimal currency area" where their economies are always in sync and economic shocks are symmetric.

Cook and Devereux argue that the above argument against monetary unions is turned upside down when interest rates reach zero and, therefore, cannot be reduced any further.

First, when interest rates reach zero and cannot be reduced any further, the lack of a national currency is no handicap; after all, monetary policy would be ineffective even in a country that does have its own currency.

Second, a country with its own currency might see the exchange value of its currency rise and thereby cripple its economy by reducing its exports and raising its imports. A country that is in a monetary union and, therefore, has no currency of its would not face such a danger.

Consider a country that has its own currency, and happens to be at the zero lower bound. Now, suppose there is a fall in demand that brings about a deeper recession. Falling demand would lead to falling inflation. With the nominal interest rate stuck at zero, falling inflation would cause the real (or, inflation-adjusted) interest rates to rise. The rising real interest rates would attract foreign lenders. All this borrowing from foreigners would -- by the balance of payments identity -- lead to a yawning trade deficit. To see this in another way, note that when foreigners, eager to earn the rising real interest rate in a country, buy the local currency in order to lend to the local residents, the country's currency would rise in value. A more expensive currency would reduce exports and increase imports.

Obviously, if a country that is already in trouble from falling demand now faces falling exports and rising imports, it would only be digging a deeper grave for itself.

Cook and Devereux explain that a country that is a member of a monetary union would not have to face the above predicament. Not having a currency of its own, it runs no danger of its currency appreciating in value and thereby crippling foreigners' demand for its products.

Cook and Devereux make an argument that is persuasive, surprising, and simple.

Thursday, November 07, 2013

Inflation Puzzles

Inflation in the United States -- as measured by the annualized increase in the consumer price index -- was a paltry 0.2 percent in September. This is significantly below the 2 percent informal inflation target of the Federal Reserve, the central bank of the United States. Such low inflation came as a surprise to many. No less a figure than Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, speaking in Philadelphia last Friday (November 1), admitted to being surprised by how low and stable inflation had lately been despite the Fed's vigorous program of asset purchases (paid for with mountains of newly printed cash). For Lacker, the idea that money printing by central banks inevitably leads to rampant inflation was an article of faith, not significantly less worthy of trust than the idea that the sun rises in the east.

But the Great Recession has been a stern teacher. It has taught us that the connection between the rate at which the Fed prints (and spends) money and the rate at which prices rise breaks down when unemployment is above the rate consistent with full employment. Lacker should have relied on an alternative theory: the expectations-augmented Phillips curve.

This theory says that inflation in the short run consists of three parts: expectations-driven inflation, demand-pull inflation, and cost-push inflation. First, when firms expect rapid inflation, they expect the prices they'd have to pay for raw materials and labor to rise rapidly, and consequently they raise their own prices rapidly in order to remain profitable. Second, when -- as a consequence of the heavy pull of demand -- the economy's production is close to its potential, and unemployment is close to the rate consistent with full employment, incipient labor scarcity raises wages rapidly, which in turn leads to rapidly rising prices. And third, if droughts, other productivity failures, and/or rising prices of imported oil lead to rising production costs, prices would again have to rise rapidly in order to ensure profitability. [See this.]

The Phillips curve theory does not say that money printing and asset purchases by a central bank cannot cause inflation. It only says that if money printing is to cause inflation, it would first have to instigate either expectations-driven inflation, or demand-pull inflation, or cost-push inflation. Therefore, the theory says, there is no point in watching the rate at which the Fed is printing money in the hope of predicting inflation. One should instead watch data on inflation expectations, the rate of economic growth, unemployment, oil prices, and so on.

A new NBER working paper ("Is the Phillips Curve Alive and Well After All? Inflation Expectations and the Missing Disinflation", NBER Working Paper No. 19598, by Olivier Coibion and Yuriy Gorodnichenko argues that with a tweak or two the Phillips curve can explain inflation during the Great Recession quite well. Unlike Lacker who relied on the money-printing-causes-inflation theory and was surprised that inflation during the Great Recession was so much lower than he had expected, Coibion and Gorodnichenko had relied on the Phillips curve and were surprised that inflation was higher than they had expected.

But all was not lost for the Phillips curve. Coibion and Gorodnichenko found that when traditional measures of inflation expectations (such as the "TIPS spread" obtained from financial markets or surveys of professional forecasters) are replaced by the measure of inflation expectations in the Michigan Survey of Consumers, the Phillips curve does well in explaining inflation. During the Great Recession, households surveyed by the Michigan Survey consistently expected higher inflation than the financial markets and the professional forecasters.

Coibion and Gorodnichenko also propose an interesting explanation of why households consistently expected higher inflation than bond traders and forecasters. They argue that households tend to be keenly aware of oil prices, which had risen sharply since 2009. And this sensitivity to prices at the gas pump influences households' expectations of inflation. (As a fan of behavioral economics, I see here the presence of the concept of 'salience.')

More provocatively, Coibion and Gorodnichenko argue that it was actually a stroke of luck that rising oil prices kept inflation expectations -- and, therefore, inflation itself -- above dangerously low levels that could have pulled the US economy into deflation. (In a tangential remark in a soon-to-be-published paper, Sebastien Buttet and I briefly pointed out the other side of this very coin: falling oil prices -- normally a reason for rejoicing -- can push a sluggish economy into a deflationary spiral and cause a lot of mayhem.)

Finally, Coibion and Gorodnichenko made me wonder about the wisdom of the Fed's reliance on the so-called core inflation measure that strips out food and energy prices as a guide to policy making. The Fed's argument is that it needs to predict inflation nine months or so down the road because any policy measure adopted today would take nine months or so to take effect, and, as food and energy prices are extremely volatile, a consumer price index that excludes them would be better at predicting inflation nine months ahead. The Fed's argument makes sense. But Coibion and Gorodnichenko's paper makes me worry a bit. Food and energy prices are highly salient for households. As a result, food and energy prices are likely to have a huge impact on inflation expectations. Therefore, today's food and energy inflation is likely to drive future inflation through the expectations-driven inflation in the Phillips curve. Maybe the Fed should take another look at its position on the usefulness of paying attention to food and energy prices.

To wrap up, the expectations-augmented Phillips curve is a pretty good guide to short-run inflation. Mr. Lacker should take note.

Friday, November 01, 2013

Ants, Grasshoppers, and Food Stamps

This evening's PBS Newshour had a report followed by right-v-left debate on the expansion of the food stamps program during the recession -- and the slow recovery -- of recent years. (The video is available below.)

The food stamps program (formally, SNAP or Supplemental Nutrition Assistance Program) was expanded four years ago. However, the expansion was intended by the U.S. Congress to be temporary. In fact, it was today that the expansion came to an end, thereby occasioning the Newshour's program.

The debate, moderated by Jeffrey Brown of the Newshour, was between Ellen Teller of the Food Research and Action Center, an anti-hunger nonprofit, and Robert Rector of the Heritage Foundation.

At one point in the debate, Rector denounces the food stamps program as follows:

Another thing that they have done is get rid of the asset limits which were traditionally part of this program. You can have a million dollars in the bank. You're unemployed, you can get into food stamps. Now, that's an outrage.

Jeffrey Brown, seemingly impressed by Rector's thrust, turned to Teller and asked, "Is that true about the million dollars, first?"

Teller totally avoided Rector's specific complaint and instead argued -- quite accurately -- that the reason for the recent increase in the number of people getting food stamps was not fraud but the worsening economy. Rector picked up on Teller's evasion and came right back:

She just ignored the fact that they have removed the asset test. ... There's no meaningful asset test. One of the things that the Republicans are doing is restoring the asset test.

Even the mild-mannered Jeffrey Brown would not let Teller go: "All right, answer that," he said, turning to Teller. All that Teller could manage in reply was that Congress's decision to not insist on an assets test had been bipartisan, and that the current Republican objections were a reversal of their previous position.

The whole issue of whether people with little or no income should be showered with food stamps if they happen to have a million dollars in the bank needs to be dealt with directly, not evaded. Sure, it looks terrible if a millionaire who happens to have a meager current income is given money by the government to buy food. Nevertheless, appearances aside, there actually is a good reason why there should be no assets test for food stamps.

There once were two people: Mr. Ant and Ms. Grasshopper. They earned the same income in the years before the economic crisis. However, Mr. Ant led a frugal life and managed to accumulate a million dollars in savings, whereas the prodigal Ms. Grasshopper flagrantly spent most of her income on travel, entertainment, etc., and accumulated no wealth at all. Then came an economic crisis, and both Mr. Ant and Ms. Grasshopper lost their jobs.

Would it be a good idea to assist Ms. Grasshopper with food stamps and deny them to Mr. Ant? Ms. Grasshopper deserves help because she has lost her job and has no savings to fall back on. But Mr. Ant deserves not to be denied assistance simply because he lived a frugal life. They should both be helped, irrespective of their wealth. The food stamps law should not have the assets test that the Republicans of today and Mr. Rector have demanded. An assets test would provide a perverse incentive to be profligate: why save, if, when you are in trouble, your savings will be held against you?

Finally, I should mention that the argument I am using to oppose the right wing demand for an assets test in the allocation of food stamps (and other government assistance), is also the argument that people on the right use to argue against taxes on capital income, such as interest income, dividends, and capital gains. To see why, assume as before that Mr. Ant and Ms. Grasshopper earned the same income for the same number of years, and that, while Mr. Ant saved a lot of money, Ms. Grasshopper did not. Consequently, Mr. Ant will be earning a substantial amount of income in interest, dividends, and capital gains, whereas Ms. Grasshopper will not. Therefore, under current income tax systems, which tax interest, dividends, and capital gains, Mr. Ant will be paying taxes on both current income from work and current income from his wealth, whereas Ms. Grasshopper will be paying taxes only on current labor income. They both earned the same income from work every year, and yet Mr. Ant ends up paying more in income taxes simply because he was frugal. Therefore, say people on the right, taxes on income from wealth punish frugal behavior and should be done away with.

I actually enjoy this irony. The fact that the same argument can be used to make both the left and the right uncomfortable tells me that it is the real deal; it's not sophistry.

Robert Rector probably knows the argument inside out. He has probably used it once or twice to argue against taxes on capital income. But he will turn a blind eye to it when it implies that food stamps should be given liberally, without some stupid assets test.

Monday, October 14, 2013

Economics Nobel 2013

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2013 has been given to Eugene Fama, Lars Peter Hansen, and Robert Shiller -- all Americans -- for some statistical findings on asset prices, and for the development of a statistical technique called generalized method of moments that has helped economists understand the behavior of asset prices.

Although I have a PhD in economics, I have never taken a course in finance. (Finance courses were simply unavailable when I was a student, first at Presidency College, Calcutta, and then at Stony Brook University.) Nevertheless, I will try to describe my understanding of the work recognized by the awards.

We'd all like to be able to predict asset prices. If we knew which asset would rise in price, we could buy it now, and sell it later at a profit. If we knew which asset would fall in price, we could "short" it -- that is, borrow the asset (from someone who currently has it), sell it right away for, say, $100, buy it later for the lower price of, say, $80, return the asset (to whoever we borrowed it from), and keep the $20 profit (less a small interest payment to the lender, perhaps).

Unfortunately, a theory called the efficient markets hypothesis -- with a long pedigree that stretches back a hundred years to the doctoral dissertation of French math student named Louis Bachelier -- says that if people are rational and if asset markets function well, asset prices would be unpredictable.

Here's how I teach the theory to my (undergrad) students: I say to them, "Imagine you are listening to your car radio on the way to class and you hear that McDonald's shares are rising sharply. What could be the reason for this?" After some prodding, the students provide explanations such as "McDonald's just announced a new burger or salad", "McDonald's just announced unexpectedly high profits in the previous quarter," "There's been an E-coli or salmonella outbreak in Burger King restaurants," etc. I then point out to the students that all the explanations they had offered were news items. Finally, I wrap things up by saying that if you accept the idea that the only reasonable explanation for an asset price change is a news event, and if you agree that news events are, by definition, unpredictable, then it follows that asset price changes are unpredictable! My students generally seem to buy the logic.

Eugene Fama, one of today's winners, looked at asset prices and showed that,over short time periods, the efficient markets hypothesis is true: past asset prices are unrelated to current asset prices, and therefore it is indeed impossible to use past asset prices to predict future asset prices.

Fama also showed that news tends to rapidly get embedded in asset prices. By the time you hear that there's been a salmonella outbreak in Burger King restaurants and call your broker with instructions to buy McDonald's stocks, it is already too late. A frenzy of buyers have already bid up McDonald's shares to such expensive heights that it would no longer be a good idea to buy it. Every bit of news leaves its mark on asset prices just as every tremor in our tectonic plates leaves a mark on a seismograph's printout. And, news being random, asset price fluctuations are a "random walk."

(Click to enlarge)

In measuring fluctuations in an asset's price, Fama had to be able to measure both the riskiness of the asset and the fluctuations in its price that are due to its riskiness. The efficient markets hypothesis understands that the riskier an asset, the faster its price must rise, for otherwise people wouldn't buy it. Consequently, Fama had to measure (a) an asset's riskiness, (b) how fast its price needed to rise to compensate for the asset's riskiness, and (c) how fast the asset's price actually rose. The residual -- that is (c) minus (b) -- is what Fama showed to fluctuate like a random walk.

While the short-run unpredictability of asset prices is now well established (for everybody except Wall Street conmen who have managed to build one of the wealthiest industries the world has ever seen, upon the lie that asset prices are indeed predictable and that they know how to predict stock prices), both Fama and Robert Shiller, another of today's winners, have shown that asset prices are predictable under some narrow circumstances.

The basic theory of the efficient markets hypothesis assumes that an asset's price at any given date is equal to the total income the buyer expects to earn from the asset over the future. In the case of a company's shares, asset income consists of dividends paid by the company. Shiller showed that dividend income tends to be stable over time. Therefore, if the efficient markets hypothesis is right that stock prices are equal to total future dividends, they should be roughly equal to total past dividends as well. Unfortunately for the theory, Shiller showed that, while dividend income tends to be stable over time, stock prices fluctuate wildly around dividend income. Yes, the theory is right in the sense that any gap between stock prices and dividend income tends to narrow over time, but the process tends to be slow. And this slowness in the closing of the gap between stock prices and dividend incomes makes stock prices predictable over longer time horizons: if a stock's current price is significantly below (above) dividend income over, say, the past twenty years, then it is likely that the stock price will rise (fall).

(Click to enlarge)

This finding of Shiller led to a lot of theorizing about the reason why the stock-prices-are-unpredictable result of the efficient markets theory fails over longer time horizons. One group of theorists developed a more sophisticated version of the efficient markets hypothesis to address the failure of the basic version. They argued that the excessive fluctuations in stock prices that Shiller observed may be caused by fluctuations in the way people compare incomes earned at different dates. In the previous paragraph, I noted that the basic theory assumes that "an asset's price at any given date is equal to the total income the buyer expects to earn from the asset over the future". I should have said "total discounted income" instead of total income. A dollar earned today is not equivalent to a dollar promised to you in 2020 (even if you are sure that the purchasing power of a 2013 dollar would be the same as the purchasing power of a 2020 dollar). Consequently, when assessing how much to pay for a stock, the buyer must decide how much is expected dividend income in 2015 worth to him and how much is expected dividend income in 2020 worth to him. These comparisons use a concept called the discount rate; if in your view a dollar in 2014 is equivalent to 0.80 cents in 2013, then your discount rate is 0.80. The basic version of the efficient markets hypothesis assumes constant discount rates. The more sophisticated version -- which was built to explain Shiller's finding that stock prices fluctuated a lot -- assumed that people's discount rates could fluctuate.

Theories, of course, need statistical confirmation. And that's where Lars Peter Hansen, today's third winner, comes in. The sophisticated version of the efficient markets hypothesis -- mentioned in the last paragraph -- could not be tested using available statistical tools. Hansen developed a new estimation technique called the generalized method of moments to address the difficulties. And when he applied his method, he ended up rejecting the sophisticated version efficient markets hypothesis as an explanation for Shiller's findings!

This shock had a major effect on how economists thought about asset prices. Models based on rational decision makers and well-functioning asset markets could not explain the big fluctuations observed by Shiller in asset prices. Some economists became convinced that systematic departures from rational behavior held the key to understanding why the efficient markets hypothesis fails for some longer time horizons. This led to a greater interest in behavioral finance and behavioral economics, which combine economics and psychology to understand markets. (Incidentally, I have been teaching a course on behavioral economics for the last few years.)

Like Shiller, Eugene Fama also showed in later work that there are some ways in which the efficient markets hypothesis fails! (This may have come as a surprise to many, considering that, early in his career, Fama had shown -- in support of the efficient markets hypothesis -- that past stock prices do not predict future stock prices and that news events quickly get absorbed in stock prices.) What's the nature of the failures of the efficient markets hypothesis identified by Fama?

The efficient markets hypothesis predicts that stocks whose prices are positively correlated with the average level of stock prices (for the entire stock market) should rise rapidly in price, whereas stocks whose prices are negatively correlated with the average level of stock prices should rise slowly in price. This has to do with the idea of hedging ones risks. If you love the Yankees and hate the Red Sox, you should bet money that the hated Red Sox would win. That way you'd be perfectly hedged: If the Yankees win (lose), you would be happy (sad) that they won (lost) and sad (happy) that you lost (won) a lot of money on your bet. In the same way, stocks that zig when the market as a whole zags are particularly desirable as a hedging tool. This makes stocks that are negatively correlated with the market very expensive to begin with and therefore unlikely to rise rapidly in the future. Conversely, stocks that are positively correlated with the market are useless as a hedge and therefore their prices must rise rapidly, for otherwise nobody would buy them.

All this sounds rather reasonable, does it not? Unfortunately, Fama tested this hypothesis and found no evidence for it! He found that a stock's other attributes -- such as its "total market value" and "book-to-market ratio," but not its correlation to the market as a whole -- are good predictors of its price (thereby weakening the idea that stock prices are unpredictable).

Economists do not have an explanation for Fama's finding. Again, my guess is that psychology is part of the answer. I also wonder whether the predictability identified by both Shiller and Fama (a) can be reliably exploited as a money-making strategy, and (b) whether they will persist in the data once traders understand them better and try to incorporate them into their trading strategies. After all, the basic argument for the efficient markets hypothesis is that predictability provides a profit opportunity and the rush to exploit the profit opportunity destroys the predictability.

For the average person, the work of today's laureates has led to the introduction of index funds. Economists have long been telling whoever would listen to them that they should not listen to Wall Street charlatans who claim that they are good at picking the right stock (or bond, or whatever). Instead, they should buy index funds that take your money and use it to buy a little bit of everything. The unpredictability of stock prices -- especially over short time horizons -- is now well established. So, by all means, buy stocks, but don't try to pick stocks. Just buy index funds that buy a little of every stock that's out there.

Finally, the public pronouncements of Fama and Shiller may suggest that they are at loggerheads. Fama believes that asset markets are largely efficient and Shiller sees them as occasionally prone to spasms of "irrational exuberance" (the title of one of Shiller's books). But the Bank of Sweden gave Fama and Shiller prizes for their research, not for their punditry in the media. The empirical work of these three prize winners can be kept separate from their ex cathedra pronouncements.

Saturday, September 07, 2013

Is Punishment Ever a Deterrent?

The US Congress -- and, indeed, the nation as a whole -- is currently debating whether or not to endorse President Obama's bid to punish the Syrian government of President Bashar Assad for its alleged use of chemical weapons in the Syrian civil war.

Obama's stated reason is that Assad needs to be punished for violating international norms against the use of chemical weapons (so that the use of such weapons is not repeated). In the words of Samantha Power, the US envoy to the UN, a failure to punish Assad would "give a green light to outrages that will threaten our security and haunt our conscience." A group of US rabbis and Jewish leaders have issued a petition that declares, "We fear that if this attack [by Assad] passes without a decisive response, we might open our newspapers to more images of mass graves from Syria -- and elsewhere -- in the near future." The idea is clear: punishment must be meted out because it would deter bad behavior.

Now, although the fat lady has definitely not sung, as I write this blog post, the tide of public opinion in the US seems to be turning against Obama. Critics have argued that

  1. in the absence of UN support, the US cannot anoint itself the world's cop
  2. UN inspectors have not yet submitted a report of the findings of their investigations in Syria
  3. violence is not an appropriate response to the alleged crimes of Assad
  4. even a limited initial attack could lead to deeper involvement
  5. the US needs a respite from armed conflicts in the Islamic world
  6. any military involvement in Syria would distract attention from vital domestic priorities
  7. the Syrian civil war does not pose a threat to the US
  8. Syria and its allies could retaliate against Americans
  9. any limited, "no boots on the ground," attack would not resolve the bigger issue of ending the Syrian civil war
  10. Assad's opponents -- should they wrest power from an Assad weakened by US attacks -- may behave in ways worse than Assad's; etc.

Here, I will ignore all the above issues and simply examine the internal logic of Obama's main idea: punishment of a crime deters the repetition of the crime. The idea sounds eminently logical, but let's put it under a microscope anyway.

To repeat, Obama says he wants to punish Assad because, if Assad is punished, he (Assad) would cease using chemical weapons (hereafter, CW). But why, you might ask, would Assad, once punished, never use CW again? Obama would say, if Assad's first use of CW is punished, he would expect any second use of CW to be punished also. As a result, Assad would not dare use CW a second time.

But why, you might ask, would Assad expect a second use of CW to be punished? After all, any second use of CW would disprove any claim that the punishment of the first use of CW would deter a second use of CW. Therefore, no longer able to claim that punishment is a deterrent, Obama would have no way to justify punishing a second use of CW by Assad. Therefore, if Assad considers Obama to be rational, he (Assad) would not assume that a second transgression would be punished even if the first transgression was.

Now, we can work backwards to unravel Obama's whole argument. As Assad will not fear a second punishment for a second use of CW, Obama will have no reason to punish the first use of CW either. Don't forget that the justification for punishing Assad's first use of CW was that the punishment would convince Assad that a second use of CW would invite a second round of punishment. But we just saw that a second use of CW would not be punished. Therefore, there would be no justification for any punishment for Assad's first use of CW either.

The only way the idea that "punishment is a deterrent" can survive is if the punisher is irrational enough to keep believing that punishment is a deterrent in the face of repeated disproof of the very idea. If Obama is so irrational as to punish one use of CW after another all the while saying that the punishment is necessary to deter any future use of CW in spite of the fact that all previous instances of CW use are disproof of the idea that punishment is a deterrent, then and only then would Assad be deterred. Facing such an irrational punisher, Assad would have no reason to use CW and would be a very, very good boy.

So, Mr. President, please don't attack Syria. You are not the infinitely irrational person described in the previous paragraph who keeps saying "Punishment will deter the next use of CW" again and again even though each use of CW disproves his claim. Please recognize that there is an n such that after n episodes of CW use -- followed in each case by punishment -- you will finally see the light, give in to reason and admit that you can no longer claim with a straight face that punishment is deterrent and that you will therefore stop punishing any future use of CW. And if you will certainly abandon the "punishment is a deterrent" idea after n episodes, there really is no rational reason to not abandon the idea after n - 1 episodes, and so on and on.

In the end, the point is that it really would not be rational to attack Syria thinking that punishing Assad would deter future use of CW. You could, of course, attack Syria on other grounds. For example, you could attack Syria in order to find and destroy Syria's CW stockpiles. This justification would not be as logically indefensible as the "punishment is a deterrent" justification. However, finding all of Assad's hidden CW stockpiles may not be easy, and it would certainly require American "boots on the ground." Moreover, even if you get all of Assad's CW stockpiles, you will not be able to stay in Syria forever; you will have to bring the troops home at some point. And what would stop Assad from rebuilding his CW stockpiles at that point? After all, he would still have his CW recipes, right?

So, in the end, Mr. President, you don't have too many options. Just calm down and take a deep breath.

Thursday, September 05, 2013

What Ails Indian Manufacturing?

Keith Bradsher has a terrific must-read report in The New York Times today that encapsulates many aspects of the nightmare that Indian manufacturing is in. Here are some highlights: A factory owner employs fewer than 50 workers and holds on to antiquated equipment for fear of exceeding employment and investment limits that would trigger suffocating labor laws. The 35-mile trip from the factory to the nearest port takes 4 to 7 hours. And yet, speeds any faster would ruin the factory's trucks because of the potholes. As a result of a serious lack of highways, factories need to locate in urban areas, making them uncompetitive because of the high rents. Elsewhere, rent control reduces investment in buildings that could house factories. A seven-employee factory that makes aluminum wire "is regulated by more than a dozen government agencies, each of which sends a separate inspector each year before issuing licenses for things as diverse as electricity use and water pollution. Many of the inspectors demand bribes." The factory's electricity costs are twice what Chinese competitors pay. Domestic firms have stopped investing. Foreign firms have taken an anywhere-but-India approach. (Check out this graph that compares foreign direct investment per capita in China, India, and Cambodia.)

It is scarcely possible to imagine worse government than what India has had for the last God-knows-how-many years. If we classify governments into two groups -- those that primarily see themselves as the only restraint on business rapacity, and those that primarily see themselves as an essential support system for business success -- it is abundantly clear -- at least from Bradsher's reference to all those government inspectors and to the terrible infrastructure -- which kind of government India now has.

India is a vibrant democracy. Her citizens must demand a reorientation of government. The business-throttling government must go, and a business-supportive government must take its place. The people must learn to harangue every administrator with a simple question: "What have you done lately to make Indian businesses more competitive?"

Friday, August 23, 2013

What to do with all the NSA data

As is well known by now, the National Security Agency (NSA) in the United States has been snooping -- without warrant -- on all electronic communication by foreigners (based on the idea that every foreigner is a potential terrorist). Now, it occurs to me that this data belongs to the American people, and they have the right to insist that the NSA extract the full fruits of this data and not use it only for counter-terrorism. For this purpose, I suggest the NSA hold a competition in which people all over the world will send in suggestions on how the data collected by the NSA should be mined for purposes other than counter-terrorism. A board of judges selected, perhaps, by the American Civil Liberties Union will rank the suggestions. The NSA will then mine the data as directed by, say, the top fifty suggestions and publish the results, without revealing any personal information. (I don't see why the NSA would object to this extra work; it would not interfere with what the NSA has been doing.)

So, what would you like to know from the NSA's surveillance stash? Would you like to know how a scientist who has just discovered something exciting expresses her excitement to a colleague? How about poems in lovers' letters? Wouldn't you like to read them (as long as the lovers' anonymity is not breached)? If you are a sociologist, would you like to know how often children email their parents and how the frequency varies with age? Would you like to know how the emigrant's heartbreak is expressed in letters back home? Would you like to know the secret family recipes that mothers send their daughters? What would you like to know about all those foreigners that the NSA sees as potential terrorists?

Saturday, April 27, 2013

That Confounded Bridge Isn't Anywhere Here. It's in Brooklyn!

(Click picture to enlarge.)

This one, from this week's New Yorker, is an instant Roz Chast classic.

One more: I'm not Kenneth, and I don't know the frequency!

JSOC in Gardez, Afghanistan, in February 2010

Jeremy Scahill, an award-winning journalist for The Nation, has just come out with a new book, "Dirty Wars," and a documentary of the same name. Scahill focuses on covert operations conducted by the CIA’s Special Activities Division and the Joint Special Operations Command. At around 32:00 minutes into this interview on New York's WNYC public radio station, Scahill discusses an incident at Gardez in Afghanistan in February 2010 in which JSOC killed several civilians including two pregnant women and instead of admitting that they had made a mistake based on bad information, they dug the bullets out of the women's bodies to cover their tracks and blamed the women's deaths first on the Taliban and then on honor killings by the women's relatives. Later, the cruel facts came out and JSOC's head Admiral McRaven had to apologize.

After a Google search, all I could find was this (curiously undated) report on the ABC News web site that covers the episode as well as the gruesome cover up with the cute hook that McRaven gave the aggrieved family a gift of two sheep, following Afghan custom.

I think very few people saw even this one report at the time; I certainly did not. Many thanks to Scahill for resurrecting this atrocity from the information void.