Robert Shiller of “Irrational Exuberance” has given us the answer to our problems in the Sunday New York Times. See “Stuck in Neutral? Reset the Mood!” http://www.nytimes.com/2010/01/31/business/economy/31view.html?scp=1&sq=robert%20shiller&st=cse. Shiller argues that, “In reality, business recessions are caused by a curious mix of rational and irrational behavior. Negative feedback cycles, in which pessimism inhibits economic activity, are hard to stop and can stretch the financial system past its breaking point.”
“Solutions for the economy must address not only the structural instability of our financial institutions, but also these problems in the hearts and minds of workers and investors—problems that may otherwise persist for many years.”
The solution: people must believe in the cause! “Reset the Mood!” “In most civilian fields, job satisfaction may not be a life-or-death matter, but a relatively uninterested, insecure work force is unlikely to bring about a vigorous recovery.”
But, the problem goes beyond the current malaise. Shiller advises us to look at the whole post-World War II period. He cites data from the Bureau of Labor Statistics and states that the annual growth of business output per labor hour averaged 3.2% from 1948 to 1973. From 1973 to 2008 the growth rate was 1.9%. He quotes Samuel Bowles of the Santa Fe Institute who has argued that the causes of this slowdown “are to be found as much in the loss of ‘hearts and minds’ of workers and investors as in the technology.”
A cause of this “loss of ‘hearts and minds’ of workers and investors” is not presented. Let me provide a possible cause: inflation!
Since January 1961 through 2009, the purchasing power of $1.00 has declined by about 85%, depending upon the price index used. That is, a $1.00 that could purchase $1.00 when John Kennedy became president could only purchase around $0.15 in 2009.
The “guns and butter” expenditure pattern of the federal government in the 1960s resulted in the wage and price freeze that came about in August 1971 along with the separation of the United States dollar from gold. The excessive inflation of the latter part of the 1970s resulted in the Federal Reserve tightening of monetary policy which finally broke the back of inflation in the early 1980s. Yet, even though the United States went through a period of moderate price inflation during the next twenty years or so (the Great Moderation) credit inflation continued. (For a review of what I mean by credit inflation see http://seekingalpha.com/article/184475-financial-regulation-in-the-information-age-part-c.)
This period of inflation had two major impacts on the United States economy. First, American manufacturers worried less about productivity than they did about getting products to market. Inflation does this to producers. Why? Because the pressure is on manufacturers to quickly get in new equipment so that they can meet the rising demand for goods and this means that executives focus less on the longer-lived, more productive plant and equipment and give their attention to more short-lived investments. As a consequence, productivity suffers!
The impact of this change in the composition of the capital stock of the United States is reflected in two other measures. First, capital utilization in manufacturing industry has continued to decline from the 1960s to the present time. (See chart: http://research.stlouisfed.org/fred2/series/TCU?cid=3.) For example, capacity utilization was above 90% in the middle of the 1960s. Through all the cycles in capacity utilization over the next 45 years, the peak rate constantly declined. In February 1973 the rate was slightly below 89%. The next peak was in December 1978 and was below 87%; then about 85% in January 1989; and again in January 1995 and in November 1997. The next peak came in August 2006 at about 81%. The most recent trough in capacity utilization came in June 2009 and has rebounded to 72% in December 2009. Expectations: it will not reach 81% again.
In addition, labor force participation has changed dramatically during this time period. Labor force participation increased substantially from the latter part of the 1960s until the latter part of the 1980s, primarily due to more women taking part in the measured labor force. Since the late 1980s the growth of total labor force participation began to slow down and in the 200s total labor force participation began to decline as more and more people became discouraged in looking for a job or only could find temporary employment. In 2009 the number of under-employed individuals of working age amounted to between 17%-18% of the labor force. Thus, we have unused capacity in the labor force as well.
The second major impact this period of inflation had on the United States economy was on the use and creation of debt. Inflation is good for debt creation! But, the foundation for the increase in debt during this time was the Federal Government, as the gross federal debt increased at an annual rate of 7.85% per year for the period of time from fiscal 1961 through fiscal 2009. The federal debt held by the public rose by 7.31% over the same time period.
Private debt, of course, increased very, very rapidly during this time period as did the financial innovation that spread debt further and further through the economy. Inflation is good for debt and it is also good for employment in the area of finance and financial services. As is well known there was a tremendous shift in the work force during this time from non-financial firms to financial firms. Furthermore, labor productivity does not increase as much annually in the finance industry as it does in non-finance.
Why should the labor force put its “hearts and minds” behind the future of the United States economic machine?
One sees no end to the environment of “credit inflation” created by the federal government. Estimates of federal government budget deficits still range in the $15-$18 trillion range for the next ten years which would more than double the gross federal debt that now exists. Then there are questions relating to the Federal Reserve’s inflation of the monetary base and the possibility that the central bank can pull off a magical “exit” strategy where the Fed removes roughly $1.1 trillion “excess” reserves from the banking system without causing any disruptions. The eminent scholar of the Federal Reserve System, Allan Meltzer, seems to have serious doubts about the Fed being able to pull this off. (See http://online.wsj.com/article/SB20001424052748704375604575023632319560448.html#mod=todays_us_opinion.) The failure to succeed here, along with the rise in the federal debt, would just further underwrite credit inflation in the whole economy.
The international investment community continues to have concerns over the ability of the United States to do anything different from what it has done over the last 50 years or so. There is nothing to indicate anything more than “business as usual” in Washington, D. C. If this is true, then we will see continuing credit inflation, sluggish performance in labor productivity, continued declines in labor force participation, and further softness in capacity utilization. And, if the environment of credit inflation continues, finance and financial innovation will continue to thrive.
We don’t need a change in the “hearts and minds” of the labor force. The change in “hearts and minds” that is needed is in the politicians in the federal government.
Showing posts with label Robert Shiller. Show all posts
Showing posts with label Robert Shiller. Show all posts
Monday, February 1, 2010
Wednesday, January 28, 2009
Are Derivatives the Problem?
Bob Shiller, the Yale economist, has gotten a lot of press in recent days supporting the use of derivatives and arguing against the use of the efficient markets model in understanding financial (and non-financial) markets. I am supportive of what he is trying to say. In this post I present my reasoning for this support…you can go to Bob’s articles in the Wall Street Journal and elsewhere and his upcoming book (along with his many other books) to get his view.
First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.
The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.
And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.
Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!
People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.
So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.
Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!
My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.
In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.
When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.
My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.
What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.
Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into dot.com stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in dot.com stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.
Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.
If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.
Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.
Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.
First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.
The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.
And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.
Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!
People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.
So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.
Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!
My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.
In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.
When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.
My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.
What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.
Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into dot.com stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in dot.com stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.
Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.
If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.
Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.
Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.
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