Economist Channel

Unintended consequences of well-intentioned policies, unexpected behavioral changes in response to ignored incentives, unusual supply (or demand) responses to demand (or supply) interventions, and clever new pathways for changes to happen are the sorts of mechanisms that make economics fun, and I hope useful to cause-and-effect understanding of human affairs.

A case in point is an Atlantic article from 2012 that a friend pointed me to last week, by Richard Sander and Stuart Taylor Jr.

... UCLA, an elite school that used large racial preferences until the Proposition 209 ban [on overt racial preferences] took effect in 1998... Many predicted that over time blacks and Hispanics would virtually disappear from the UCLA campus.

And there was indeed a post-209 drop in minority enrollment as preferences were phased out. Although it was smaller and more short-lived than anticipated, it was still quite substantial: a 50 percent drop in black freshman enrollment and a 25 percent drop for Hispanics...

[However,]

...The total number of black and Hispanic students receiving bachelor's degrees were the same for the five classes after Prop 209 as for the five classes before.

How was this possible? 

Indeed, I too would have guessed, if I didn't think hard about it, that eliminating racial preferences would have to have reduced the number of minorities who graduated, and that the affirmative action argument would have gone on to other pros and cons. But that's wrong.

First, the ban on preferences produced better-matched students at UCLA, students who were more likely to graduate. The black four-year graduation rate at UCLA doubled from the early 1990s to the years after Prop 209.

Yes. Half the admits but double the graduation rate leaves constant the number of graduates.

Second, strong black and Hispanic students accepted UCLA offers of admission at much higher rates after the preferences ban went into effect; their choices seem to suggest that they were eager to attend a school where the stigma of a preference could not be attached to them. This mitigated the drop in enrollment.

Third, many minority students who would have been admitted to UCLA with weak qualifications before Prop 209 were admitted to less elite schools instead; those who proved their academic mettle were able to transfer up to UCLA and graduate there.

Thus, Prop 209 changed the minority experience at UCLA from one of frequent failure to much more consistent success. The school granted as many bachelor degrees to minority students as it did before Prop 209 while admitting many fewer and thus dramatically reducing failure and drop-out rates. 

To be absolutely clear, this post is about pathways. I do not wish to wade into a perilous pro or anti affirmative action debate, a basically radioactive topic for white male economists. (Though I am pleased to report a quick Google search that suggests both Sanders and Taylor still employed, something that might not happen if their book were published today.)

And a proponent of affirmative action could nonetheless make many arguments consistent with this work.  Perhaps dropping out of UCLA is good for people. Perhaps more minorities on campus is useful for white students' social perceptions, even if it harms its intended beneficiaries. Perhaps things were going on at other universities that drove minority upperclasspeople UCLA's way. UCLA is part of the California state system, which encourages transfers at year two, which is not the case everywhere. I also don't know how the numbers are holding up post 2012. Finally, racial preferences seem to have advantaged whites by keeping asians out, which is an interesting scandal by the silence surrounding it.

Today's post is not about this larger argument.

I'm willing to bet Brad DeLong still blogs I'm racist for even mentioning the topic, but that will be an interesting test of today's political climate.

Justin Baer and Ryan Tracy have an excellent article in the Wall Street Journal commemorating the tenth anniversary of the Bear Stearns bailout.

The Federal Reserve tried to limit the damage with extraordinary actions, first extending the firm credit before forcing it into a hasty weekend shotgun marriage to JPMorgan Chase with $29 billion in assistance.

More specifically,

Ten years ago, Bear’s crisis week began with rumors of liquidity problems following steep losses from mortgage bonds. Mr. Schwartz, the CEO, phoned JPMorgan Chief Executive James Dimon to ask for a simple overnight loan. By that Thursday, Bear’s lenders and clients had backed away, and the firm was running out of cash. Mr. Schwartz called Mr. Geithner for more help.

Fearing a Bear-induced panic could spread throughout the banking system, the Fed arranged a $12.9 billion emergency loan routed through JPMorgan. It ultimately agreed to purchase $29.97 billion in toxic Bear assets.

First, Bear lost a lot of money in mortgage backed securities. Second, like Lehman to follow, Bear was mostly financing that investment with borrowed money, and short-term borrowed money at that, not with its own money, i.e. equity capital. Small losses then made it more likely Bear would not be able to pay back its debtors. Third, there was a run.  Short term creditors ran out the doors just like Jimmy Stewart's depositors in a Wonderful Life. More interestingly, Bear's broker-dealer clients started running too. Just how investment banks like Bear were using their broker-dealer clients to fund investments is a great lesson of the event.  Darrell Duffie lays this out beautifully in The failure mechanics of dealer banks and later How big banks fail.


So, if you want to stop a run, you need to convince creditors that their money is safe. Usually, you do that by issuing more equity, "recapitalization,'' But at this point, new equity holders understand that most of their money will go to pay off creditors who otherwise aren't getting anything, "debt overhang." So we need to find a source of new equity for whom the firm will be valuable enough that it's worth paying off the creditors to get it. That's the idea of one of these last minute sales to another firm, JP Morgan.

In this case, that failed too. There wasn't enough value in the firm left. It took $29 billion more to give the appearance of a buyout which would keep Bear going as part of JP Morgan, and more importantly to pay off the creditors. (That word "reacapitalization" more and more in the passive voice, tends to mean money from the government.)

Bailouts are not of the company or the management. It is all about making sure creditors get paid, so they don't run. Bailouts are always creditor bailouts.

Needless to say, this bailout did not in the end stop the financial crisis, and $29 billion would soon seem like couch change.

So, where are we now?

"Key players in the bailout, many of whom remain in finance, have spent the last decade arguing about what was done, defending decisions made then and wondering whether it could happen again. The consensus: It would be unlikely for another big firm to get into such trouble, or for the government to orchestrate such a bailout"

I found this interesting, especially the last statement. For the other universally held truth (false in my view, but I'm a tiny minority) is that letting Lehman go under was a huge mistake and led to the financial crisis. If only the Fed had saved Lehman as it did Bear, the story goes, things would not have been so bad. So why would the government not orchestrate a bailout?

"Veteran Wall Street lawyer Rodgin Cohen, who helped shape the deal for Bear Stearns, says that if a crippled firm were on the brink today, none of its peers would arrive with a rescue. “Nobody will ever again buy a severely troubled institution,” he says. “Period.”"

Many officials in Washington feel another bailout is just as unlikely. 

Why not?

The first line of defense has always been one of these arranged last-minute marriages, in which a healthier firm takes over a failing one. This will not happen again.

Nearly everyone in charge on Wall Street today, including JPMorgan’s Mr. Dimon, says they would never buy a collapsing firm like Bear.

“No, we would not do something like Bear Stearns again—in fact, I don’t think our board would let me take the call,” Mr. Dimon wrote in his 2014 letter to shareholders. “These are expensive lessons I will not forget.”

In addition to the cost of bringing the two firms together, JPMorgan was saddled with billions of dollars in legal bills and regulatory penalties. Months after the Bear deal, JPMorgan made a similar last-minute agreement to buy Washington Mutual Inc. Of JPMorgan’s nearly $19 billion in legal costs from the mortgage crisis, some 70% stemmed from Bear and WaMu, Mr. Dimon wrote.

There were many other such deals in 2008. Wells Fargo & Co. bought Wachovia Corp., Bank of America Corp. acquired Merrill Lynch & Co. and Countrywide Financial Corp., and Toronto-Dominion Bank bought Commerce Bancorp. Today, many of these Wall Street executives say they feel betrayed by the government for hitting them with penalties tied to actions by firms they were pressured to acquire.

These days, a big financial firm rescuing another would also have to consider new restrictions on risk-taking. Banks today must pass regulatory tests before paying out profits to shareholders. In that environment, executives may be more reluctant to buy assets from a desperate seller. 

Loud and clear. Over and over, the government asks a big bank to help out by taking over a failing bank, which means agreeing to pay all that failing bank's debts.  But this time, after the fact, the government made the new owners pay billions in fines for the old company's debts. Take my trash out, asks your neighbor, and you say "sure," then he calls the EPA to report on the toxic waste now in your trash barrel. Not again. And if that weren't enough, the government's own regulations will prohibit it.

So if a bailout is needed, private help won't be there.

Well, what about government help? We got $700 billion of that too last time.

Fed help like that would be illegal today. The 2010 Dodd-Frank financial-regulation law stipulates that emergency Fed lending must be “broad-based” and cannot be “established for the purpose of assisting a single and specific company.” Financial firms, like other corporations, are supposed to go bankrupt, not get bailed out.

So what is supposed to happen? "Orderly liquidation."

If regulators and the Treasury secretary assert a bankruptcy would destabilize the financial system, Dodd-Frank provides a new backstop called the Orderly Liquidation Authority. The government would take over the failing firm, wiping out shareholders. After a weekend of work by federal officials, a new company, owned by creditors of the old firm, would open Monday morning. The government would be able lend money to the new company to keep the lights on while the government sells it off in pieces.

That is supposed to prevent a panic because people who had been doing business with the failing firm would know they could continue to do so, at least for a while.

In sum, the lifejackets (shotgun marriages) and lifeboats (government bailouts), distasteful as they are, are likely gone. Speedy bankruptcy isn't here yet. We are relying on a new and untested idea, the watertight compartments.

I have long been suspicious of "orderly liquidation." The whole premise is that big banks are too complicated to go through bankruptcy court. So, the Treasury Secretary, Fed Chair and a few other officials are going to figure out who gets what over a weekend? What would you do if a big bank owed you a few billions, was on the brink, and you suspected these fine officials would be meeting this weekend to divvy up the carcass? How about run now?

What if orderly liquidation doesn’t prevent a panic? In a crisis, problems at one firm can lead investors to “run” to cut their exposures everywhere. Even healthy companies can’t get credit, damaging Main Street as badly as Wall Street. In that scenario, there may be little U.S. regulators can do on their own. Congress might be asked to reinstate the bailout authority it took away after 2008.

“Drafting big books, massive documents, having big teams—that’s all a good idea,” says Gary Parr, a longtime deal maker who advised Bear on its sale to JPMorgan. “But when you have a company get into a liquidity crunch, if things are going really fast, you don’t have time to study a book.”

The best of all worlds is one in which nobody expects a bailout, it comes once to stop a run, and then we put the moral hazard genie back in the bottle. The worst of all worlds is one in which everyone expects a bailout, but then either by legal restriction or decision it does not come. Nobody has fire extinguishers any more, and the fire house has burned down.

Where will the next crisis come from? It always comes from a new and unexpected source, so don't plan on subprime mortgages funneled through investment banks. Look instead and ask, where is there a mountain of debt that can't be paid back, a bunch of really obscure accounting, off the books credit guarantees? China's great wall of debt suggests one answer.

The other worry  " Congress might be asked to reinstate the bailout authority it took away after 2008." Yes, but even that was authority to use borrowed money. The last crisis cost us something like $5 to $10 trillion. If the US asks for that much money again, can we get it?

But all of this ignores the basic point. Financial crises are not about the failure of specific institutions. Financial crises are about runs. One way to stop runs is to convince short term creditors that no institution will ever lose money again, or that there is a big bailout ready. The other way is to fund risky investments with lots more equity. Not to beat a dead horse over and over again, but the real lesson of Bear Stearns and Lehman is what happens if you fund  risky investments with a huge amount of short term debt. That can be fixed.

(Actually, subprime mortgages aren't even very risky. Google's self driving car is way more risky. All corporate cashflows are way more risky. Why are we spending all this money policing pools of mortgages, about the safest asset there is? Answer, because they are funded by huge amounts of run-prone short-term debt.)

A short oped for the Wall Street Journal here  on stock buybacks. As usual, they ask me not to post the whole thing for 30 days though you can find it ungated if you search. An excerpt:

... Buybacks do not automatically make shareholders wealthier. Suppose Company A has $100 cash and a factory worth $100. It has issued two shares, each worth $100. The company’s shareholders have $200 in wealth.  Imagine the company uses its $100 in cash to buy back one share. Now its shareholders have one share worth $100, and $100 in cash. Their wealth remains the same.

Wouldn’t it be better if the company invested the extra cash? Wasn’t that the point of the tax cut? Perhaps. But maybe this company doesn’t have any ideas worth investing in. Not every company needs to expand at any given moment.

Now suppose Company B has an idea for a profitable new venture that will cost $100 to get going. The most natural move for investors is to invest their $100 in Company B by buying its stock or bonds. With the infusion of cash, Company B can now fund its venture.
 [Left out: The alternative would be for company A to lend the money to company B or to buy its stock. But why are the managers of company A, out of its own ideas, better than its investors at spotting other companies with new projects to invest the stockholders’ money?]

The frequent rise in stock price when companies announce buybacks proves the point. In my example, Company A’s share price stays fixed at $100 when it buys back a share. But suppose before the buyback investors were nervous the company would waste $40 of the $100 cash. Imagine an overpriced merger or excessive executive bonuses. Not every investment is wise! 

The $100, stuck inside Company A, would be valued by the market at $60 and the company’s total value would be $160, or $80 a share. If it spent the $100 to buy back one share, the other share would rise from $80 to $100, the value of its good factory. 

When a company without great ideas repurchases shares, the price of the remaining shares rise. This stock price rise is no gift to shareholders. It is just the market’s recognition that $100 has been saved from inefficient investment.

Full oped in 30 days.

Update: 

Based on follow up commentary, it's pretty clear than 99% of people do not understand the point: It's not about what companies do with today's profits. The case for buybacks is not that cash must chase investment. The point of the tax cut is the profitability of new investment. Without that, somebody will still just sit on the cash. With that, money will find its way to new investment. Otherwise, we're just putting money from the right pocket to the left pocket. Investment in the end comes when it is profitable, looking forward. Nothing about who gets what part of today's profits has anything to do with it. I will stress this next time! A good learning experience.

Tyler Cowen has a good Bloomberg View focusing on this point, my emphasis:

A basic principle of economic reasoning is to think in terms of real resources, not just the first-round flows of money. If a major corporation engages in buybacks, that simply transfers money from one set of hands to another -- from the corporate entity to the shareholders. It doesn’t destroy real resources or determine their final disposition. The money could still go to a venture capital fund, or into private equity or a real estate investment trust, in addition to numerous other undertakings, all of which might boost investment and real wages.

An oped on tariffs, for Fox news here. That tariffs are bad is rather obvious to readers of this blog, but perhaps marshaling and digesting things we've known for 250 years is worthwhile.


In a remarkable achievement, President Trump has united the nation’s economists by proposing tariffs on imported steel and aluminum, tariffs designed to reduce imports of those goods. Tariffs are bad for the economy. Tariffs on raw materials, produced by machine-intensive dirty declining industries are worse. Trade is good.

Trade is good. Why? Follow the money. If China sells us, say, a solar panel, what does it do with the dollars? There is only one thing to do with dollars — buy American goods, invest in America, or buy our government debt. Oh, and we also get a nice cheap solar panel.

China might use the dollars to buy, say, wheat from Australia, so it looks like China sells us more than we sell them. But then Australia must use the dollars here in America. Dollars always come home to roost.  So how much more one country sells us than we sell them — the “bilateral trade deficit” — really is pretty meaningless.

The rest of the world sells us more than we sell them. But the rest of the world uses every cent of the extra dollars it gets from that trade to invest in the U.S. and to buy our government bonds. If we sell the whole world exactly as much as they sell us every year — in other words, if there were no overall U.S. trade deficit — we’re the ones who would have to start saving huge much larger amounts of our incomes in order to invest in U.S. companies, give mortgages to people to buy houses, and to fund the governments’ $1 trillion deficits.


Think of it this way: You run a huge “trade deficit” with the grocery store. Why not grow your own food? Well, you’re not very good at growing food. And if you do, the grocer will not have money to buy what you make, or to give to the bank to fund your mortgage.

So, trade is good. And tariffs? Tariffs are not good. Tariffs on steel hurt businesses that use steel, especially those that compete with imported products made of steel. Tariffs hurt consumers, who pay more for steel-using products. But perhaps the greatest damage is to the steel industry itself. Tariffs, like all protection, shield the industry from competition. And industries shielded from competition do not innovate, do not cut costs, do not make better products. Only when the Big Three faced import competition did they start to make better cars, and cut costs.

If it is good for each country to protect its businesses with tariffs, then it is good for each state to do the same, i.e. California should keep out those cheap Arizona surfboards. A key to U.S. prosperity is precisely our Constitution’s firm ban on state politicians’ desire to please local industries with protection. Until the EU came along, the U.S. was the world’s largest free trade area. Hint: Bigger is better.

Why is this so hard to understand? Tariffs, like all protection from competition, are great for the protected business and its workers, at least for a while. If you're a practical businessperson you think the way to get the economy going is to just to replicate for the economy what is good for your business, and hand out protection to everyone. But protection only helps one business at the expense of all the others, and at the expense of consumers, and the damage is worse than the gain. What is good for an individual business is not good, scaled up, for the economy as a whole. Business people and bankers turned policy makers miss that.

Tariffs, like other protections, also help visible, large, and politically powerful constituencies. The larger pain is spread throughout the economy, in ways most of us may not even notice in day-to-day living. But it adds up.

Some of the blame belongs to Congress. The trade laws invite protection. The standard for protection is only that the industry is hurt. Imagine if United Airlines could demand that Southwest pay tariffs – an extra tax at an airport – and in order to do so United needs only to show that Southwest might hurt United’s profits.

The “national security” clause under which the Trump administration is acting is weaker still. Even the defense department doesn’t want this tariff!

We pass populist laws, and then count on administrations not to enforce them. Well, President Trump may help here too, by acting on silly laws and forcing Congress to pass sane laws.

Perhaps some of the blame belongs to economists as well. The words “deficit” and “imbalance” make it sound like something is wrong with trade.

Tariffs do have one thing going for them however – they’re better than quotas! With a tariff, at least we can measure and limit the damage — steel will be 25 percent too expensive. But you can still buy it when you need it. Under a quota, in which countries are only allowed to sell a certain amount, the damage can be much larger and you never even know.

John H. Cochrane is a Senior Fellow of the Hoover Institution and an Adjunct Scholar of the Cato Institute.

Updates:

There is so much good stuff on trade, it's hard to know when to stop. A friend writes

"we blockade wartime enemies to stop the flow of goods, and levy tariffs on ourselves to do the same thing!"

A colleague catches me being mercantilist. What if the dollars stay overseas, he asks? The answer is, Great! We can print dollars cheaper than the Chinese can make solar panels. Working to make exports to buy imports is a cost not a benefit. And if China wants to tax its citizens to send us cheap solar panels, or steel, the proper response is a nice thank you card with flowers and chocolates.

I cannot resist the urge to notice that at the same time we are imposing sanctions on Iran, Russia and North Korea to ... stop them from importing things. So, we are doing to ourselves exactly what we are dong at great expense to these, to hurt them.

A friend urged me to read the comments on Fox. If economists want to understand what we're up against this is a good sobering read. The amazing thing is that most of the commenters seem not to be steel workers or steel executives. They genuinely believe that laws which will force them to pay a lot more for the benefit of a very few, and will actually lower their wages or eliminate their jobs, are a good thing. They might get that banning machines is bad, but if the exact same thing -- produce more at lower cost -- is labeled "China," they don't. The art of rhetoric is understanding your audience's frame of mind, and these comments are a good education for us. Alas, I think explaining trade to the public, which is a bit like explaining why yes the earth goes around the sun from a scientific point of view, is so boring that most economists don't bother. Me included, usually, I must admit.

Once per decade or so it is worth revisiting the famous 1930 economists' letter on Tariffs. (The link, at econjournalwatch.org, has a concise history and links to more.) 1028 economists -- a huge proportion of the number then around -- signed the following, urging President Hoover to veto the Smoot Hawley tariff.

We know how it turned out. No, we did not win that trade war. Well, not until about 1945.

What will this one lead to? I see some hope in that President Trump is at last uniting the country. As Greg Mankiw points out

How often do Jeffrey Sachs and the Wall Street Journal editoral writers agree?

Perhaps, as with DACA, the President using the existing law, which allows and even encourages widespread protectionism, this action will spur Congress to pass trade laws that require a bit more than vague "injury" to industry or "national security" fantasies. But I am straining to find a silver lining.

The darker possibility. Many administrations start with some policy victories -- judicial nominees, deregulation, tax reform -- and then over reach. This may be the start of over reach.

Rereading the letter, it is impressive for stressing simple truths that apparently remain mysterious to many even today. If we buy a good from overseas, the dollar must come back, either as a purchase of American goods or investment in American capital. Conversely that purchase or investment cannot happen if we do not allow foreigners to sell us things. Open trade is important to peace and stability, not just prosperity. It  stresses the final effects on people who end up paying more and working less, not just downstream producers.

Plus ça change, plus c'est la même chose.

The undersigned American economists and teachers of economics strongly urge that any measure which provides for a general upward revision of tariff rates be denied passage by Congress, or if passed, be vetoed by the President. 

We are convinced that increased protective duties would be a mistake. They would operate, in general, to increase the prices which domestic consumers would have to pay. By raising prices they would encourage concerns with higher costs to undertake production, thus compelling the consumer to subsidize waste and inefficiency in industry. At the same time they would force him to pay higher rates of profit to established firms which enjoyed lower production costs. A higher level of protection, such as is contemplated by both the House and Senate bills, would therefore raise the cost of living and injure the great majority of our citizens.

Few people could hope to gain from such a change. Miners, construction, transportation and public utility workers, professional people and those employed in banks, hotels, newspaper offices, in the wholesale and retail trades, and scores of other occupations would clearly lose, since they produce no products which could be protected by tariff barriers.

The vast majority of farmers, also, would lose. Their cotton, corn, lard, and wheat are export crops and are sold in the world market. They have no important competition in the home market. They can not benefit, therefore, from any tariff which is imposed upon the basic commodities which they produce. They would lose through the increased duties on manufactured goods, however, and in a double fashion. First, as consumers they would have to pay still higher prices for the products, made of textiles, chemicals, iron, and steel, which they buy. Second, as producers, their ability to sell their products would be further restricted by the barriers placed in the way of foreigners who wished to sell manufactured goods to us.

Our export trade, in general, would suffer. Countries can not permanently buy from us unless they are permitted to sell to us, and the more we restrict the importation of goods from them by means of ever higher tariffs the more we reduce the possibility of our exporting to them. This applies to such exporting industries as copper, automobiles, agricultural machinery, typewriters, and the like fully as much as it does to farming. The difficulties of these industries are likely to be increased still further if we pass a higher tariff. There are already many evidences that such action would inevitably provoke other countries to pay us back in kind by levying retaliatory duties against our goods. There are few more ironical spectacles than that of the American Government as it seeks, on the one hand, to promote exports through the activity of the Bureau of Foreign and Domestic Commerce, while, on the other hand, by increasing tariffs it makes exportation ever more difficult. President Hoover has well said, in his message to Congress on April 16, 1929, “It is obviously unwise protection which sacrifices a greater amount of employment in exports to gain a less amount of employment from imports.”

We do not believe that American manufacturers, in general, need higher tariffs. The report of the President’s committee on recent economics changes has shown that industrial efficiency has increased, that costs have fallen, that profits have grown with amazing rapidity since the end of the war. Already our factories supply our people with over 96 percent of the manufactured goods which they consume, and our producers look to foreign markets to absorb the increasing output of their machines. Further barriers to trade will serve them not well, but ill. Many of our citizens have invested their money in foreign enterprises. The Department of Commerce has estimated that such investments, entirely aside from the war debts, amounted to between $12,555,000,000 and $14,555,000,000 on January 1, 1929. These investors, too, would suffer if protective duties were to be increased, since such action would make it still more difficult for their foreign creditors to pay them the interest due them.

America is now facing the problem of unemployment. Her labor can find work only if her factories can sell their products. Higher tariffs would not promote such sales. We can not increase employment by restricting trade. American industry, in the present crisis, might well be spared the burden of adjusting itself to new schedules of protective duties.

Finally, we would urge our Government to consider the bitterness which a policy of higher tariffs would inevitably inject into our international relations. The United States was ably represented at the World Economic Conference which was held under the auspices of the League of Nations in 1927. This conference adopted a resolution announcing that “the time has come to put an end to the increase in tariffs and move in the opposite direction.” The higher duties proposed in our pending legislation violate the spirit of this agreement and plainly invite other nations to compete with us in raising further barriers to trade. A tariff war does not furnish good soil for the growth of world peace.

A debt crisis does not come slowly and predictably. This year's short term bond holders, a very risk averse lot, are mostly interested in whether next year, new bondholders will show up, to lend the government money to pay this year's bondholders back. Bondholders can run on small jitters over that expectation.

When bondholders get nervous, they demand higher interest rates. More than higher interest rates, they diversify their portfolios, or just refuse. Debt gets "hard to sell" at any price. A different class of bondholders, willing to take risks for better rates, must come in to replace the safety-oriented clientele that currently holds short-term government debt.

As interest rates rise, interest costs on the debt rise. At $20 trillion of debt, when interest rates rise to 5%, interest costs rise to $1 trillion dollars, essentially doubling the deficit. That makes markets more nervous, they demand even higher interest rates, and when that spiral continues, you have a full blown debt crisis on your hands.

Short term debt compounds the problem. Since the US has borrowed very short term, interest increases make their way to the budget more quickly. If the US had borrowed everything in 30 year bonds, the spiral mechanism from higher rates to higher deficits would be cut off.

The crisis typically comes in bad times -- when in a war, recession, or financial crisis, the government suddenly needs to borrow a lot more and markets doubt its ability to repay.

But there is a case for a crisis to happen in good times as well. We have known for decades that the fundamental US problem is promised entitlement spending far beyond what our current tax system can fund. Markets have, sensibly I think, presumed that the US would fix this problem sooner or later. It's not that hard as a matter of economics. Well, say markets in 2005, OK for now, you have a war on terror and a war in Iraq on your hands, we'll trust you to fix entitlements later. Well, say markets in 2012, OK for now, you're recovering from a massive financial panic and great recession. We'll trust you to fix entitlements later, and we'll even lend you another $10 trillion dollars. But what's our excuse now? At 4% unemployment, after 8 years of uninterrupted growth, if we can't sit down now and solve the problem, when will we? Markets have a right to think perhaps America is so fractured we won't be able to fix this in time. Or, more accurately, markets have a right to worry that next year's markets will have that worry, and get out now.

All this is well known, and most commenters including me think that day is in the future. But the future comes often quicker than we think.

With that prelude, two pieces of news strike me as distant early warning signs. Here, from Torsten Sløk's excellent email distribution are two graphs of the bid-to-cover ratio in Treasury auctions.



Torsten's interpretation:

The first chart below shows that the bid-to-cover ratio at 4-week T-bill auctions is currently at the lowest level in almost ten years.... demand is also structurally weaker when you look at 10-year auctions, see the second chart. The main risk with issuing a lot of short-dated paper such as 4-week T-bills is that in 4 weeks it all needs to be rolled over and added to new issuance in the pipeline. In other words, the more short-dated paper is issued, the bigger the snowball in front of the US Treasury gets. 

Things are so far looking ok, but the risks are rising that the US could have a full-blown EM-style fiscal crisis with insufficient demand for US government debt, and such a loss of confidence in US Treasury markets would obviously be very negative for the US dollar and US stocks and US credit. The fact that this is happening with a backdrop of rising inflation is not helpful. Investors in all asset classes need to watch very carefully how US Treasury auctions go for any signs of weaker demand.

The last part is the mechanism I described above. As an ivory tower economist, I tend to overlook such technical issues. If the bid to cover ratio is low, well, then that just means we need higher rates. But higher rates aren't a panacea as above, since higher rates make paying it back harder still. As I look at debt crises, also, it isn't just a matter of higher rates. There comes a point that the usual people aren't buying at all.

Again, we're not there yet, and I think we have a long way to go. But this is a little rumble.

The second tremor is Why International Investors Aren’t Buying U.S. Debt in the Wall Street Journal.  The overall message is also that international investors are getting nervous.

US 10 year yields are 2.9% already. German yields are 0.68%. Why aren't people buying our debt? Well, number one, they are worrying a further slide in the dollar. Which comes when next year's international bond holders really don't want to hold US debt.

Most of the article is.. well, difficult for this former finance professor to follow. The article claims that one used to be able to lock in the difference, "Last year, buying Treasurys and swapping the proceeds back into euros provided European investors with a higher return than buying German sovereign bonds."[my emphasis] This sounds like arbitrage, "covered interest parity violations." That arbitrage is not perfect, but my impression is that it's not whole percentage points either. And you really can't lock in 10 years of funding. Besides which, someone else is on the risk-taking side of the swap. So the interviewed traders must be only partially hedging the difference. Perhaps it's really "uncovered interest parity," where you borrow Europe 0.68% invest in the US 2.9% and pray or only partially hedge the exchange rate risk. (On that, "The New Fama Puzzle by Matthieu Bussiere, Menzie D. Chinn, Laurent Ferrara, Jonas Heipertz, blog post at econbrowser documents that uncovered interest parity, where you invest in the high yield currency and take the risk, is losing its profitability. Interest spreads seem to correspond to future exchange rate changes after all.)

All to follow up on for another day. Mostly, it rang a bell as a little tremor that people who answer WSJ reporter's phone calls are expressing nervousness about US debt.

Again, these are little rumbles. I still think that a full blown crisis will come only amid a large international crisis, featuring some big country defaults (Italy?), big financial trouble in China, perhaps a war, state and local pension failures, and the US comes to markets with unresolved entitlements and asks for another $10 trillion. But I could be wrong. We live on an earthquake fault of debt, and the one thing I know from my own past forecasting ability (I have lived through 1987, the dot com boom and bust, 2008, the recent boom, and more, and saw none of them coming in real time) that I will not see it coming either.

Update:  Reply to Benjamin Cole, below. The US has never spent less on defense, as a fraction of GDP or of the federal budget, than it is doing today, since the 1930s. Here is defense / GDP. Defense / federal budget is even less, as the budget has expanded as a share of GDP.

DB's Torsten Sløk writes in his regular email analysis:

Yesterday I participated in the annual US Monetary Policy Forum here in Manhattan, and the 96-page paper presented concluded that we don’t really know if QE has worked. This was also the conclusion of the discussion, where several of the FOMC members present actively participated. Nobody in academia or at the Fed is able to show if QE, forward guidance, and negative interest rates are helpful or harmful policies. 

Despite this, everyone agreed yesterday that next time we have a recession, we will just do the same again. Eh, what? If we can’t show that a policy has worked and whether it is helpful or harmful how can we conclude that we will just do more next time? And if it did work, then removing it will have no consequences? There is a big intellectual inconsistency here.

Investors, on the other hand, have a different view. Almost all clients I discuss this topic with believe that QE lowered long rates, inflated stock prices, and narrowed credit spreads. Why? Because when the Fed and ECB buy government bonds, then the sellers of those government bonds take the cash they get and spend it on buying higher-yielding assets such as IG credit and dividend-paying equities. In other words, central bank policies lowered risk premia in financial markets, including in credit and equities. As QE, forward guidance, and negative interest rates come to an end, risk premia, including the term premium, should normalize and move back up again. And this process starts with the risk-free rate, i.e. Treasury yields moving higher, which is what we are observing at the moment.

These lovely paragraphs encapsulate well the academic and industry/policy view, and the tension in the former.

I'm interested by the latter tension: Industry and media commenters are deeply convinced that the zero interest rate and QE period had massive effects on financial markets, in particular lowering risk premiums and inflating price bubbles.



I'm deep in the academic view. The industry view forgets that the Fed does not just suck up bonds, it issues interest-bearing reserves in exchange. For every $1 of bond the market does not hold, the market has to hold $1 of additional reserves.  Industry analysis is very insightful about individual traders and investors and the mechanics of markets but forgets about adding up constraints and equilibrium which are the bread and butter of academia. You personally may sell a bond and put the money in to stocks. But someone else has to sell you that stock and hold the reserves.

The risk premium is the same if you borrow at 2% and lend at 4% than if you borrow at 4% and lend at 6%. So there is no relationship at all in basic economics between the level of interest rates and the risk premium, or between the maturity structure of outstanding government debt (reserves are just overnight government debt) and the risk premium. That one cannot see any movement at all in 10 year rates or inflation with QE is also noteworthy.

But us academics need to listen as well as to lecture. Often industry people know something we don't.    So I find this striking difference interesting. Though I haven't changed my mind yet.
Torsten wrote back:

TS: But that argument only holds in a closed economy, no? In other words, what if the US based seller of Treasuries to the Fed took the proceeds of their sale of US Treasuries and invested it in Indonesian government bonds?

JC: Then the seller of Indonesian government bonds now is sitting on US reserves.

TS: And what it the European insurance company used the cash they get for selling bunds to the ECB to buy US IG credit?

JC: Then the seller of US IG credit is now sitting on reserves. Someone is sitting on reserves. And reserves are now just very short term Treasury debt.

TS: Anyways, you may say the market view is partial equilibrium but almost everyone in the industry saw the portfolio substitution with their own eyes and believe that it is real.

JC: That helps. Yes, but they saw one side of the portfolio susbstitution. They did not see the other side of that substitution! I think in the end it's mostly foreign banks now sitting on the reserves, so those banks took deposits from someone who sold securities to your industry contacts.
A fascinating conversation..

The monetary policy forum is here. The paper is "A Skeptical View of the Impact of the Fed’s Balance Sheet'' by David Greenlaw (Morgan Stanley, so not everyone in industry has the industry view!) Jim Hamilton, Ethan S. Harris (Bank of America Merrill Lynch), and Ken West. It's excellent. It takes 96 pages (plus graphs) to put to rest verities that have been passed around unquestioningly for 8 years. Excerpts from the abstract:

The graph is federal surplus (up) or deficit (down), not counting interest costs, divided by potential GDP. I made it for another purpose, but it is interesting in these fiscally ... interesting .. times.

Taking interest costs out is a way of assessing overall fiscal stability. If you pay the interest on your credit card, the balance won't grow over time. Granted, interest costs are increasing -- 5% times a 100% debt/GDP ratio is a lot more than 5% times a 30% debt/GDP ratio, and interest costs threaten to crowd out much of the rest of the budget if interest rates go up. But still, as an overall measure of fiscal solvency, whether one way or another you are paying interest and then slowly working down debt, or if you are not even making the interest payments and the balance is growing over time,  is the relevant measure.

I divided by potential rather than actual GDP so that we would focus on the deficits, and not see variation induced by GDP. If GDP falls, then it makes deficit/GDP larger. The point is to detrend and scale deficits by some measure of our long-run ability to pay them. Yes, deficits after 2008 are even larger as a fraction of actual rather than potential GDP. So this is the conservative choice.

Now, comments on the graph. Once you net out interest costs, it is interesting how sober US fiscal policy actually has been over the years. In economic good times, we run primary surpluses. The impression that the US is always running deficits is primarily because of interest costs. Even the notorious "Reagan deficits" were primarily payments, occasioned by the huge spike in interest rates, on outstanding debt. On a tax minus expenditure basis, not much unusual was going on especially considering it was the bottom of the (then) worst recession since WWII. Only in the extreme of 1976, 1982, and 2002, in with steep recessions and in the later case war did we touch any primary deficits, and then pretty swiftly returned to surpluses.

Until 2008. The last 10 years really have been an anomaly in US fiscal policy. One may say that the huge recession demanded huge fiscal stimulus, or one may think $10 trillion in debt was wasted. In either case, what we just went through was huge.

And in the last data point, 2017, we are sliding again into territory only seen in severe recessions. That too is unusual.

Disclaimer: All of these measures are pretty bad. Surplus/deficit has lots of questionable reporting in it, and the interest cost only has explicit coupon payments. I thought it better here to show you how the easily available common numbers work than to get into a big measurement exercise. I'll be doing that later for the project that produced this graph, and may update.

Update: Sometimes a blog post makes a small point that can easily be misinterpreted in the broader context. So it is here.

The US fiscal situation is dire. The debt is now $20 trillion, larger as a fraction of GDP than any time since the end of WWII. Moreover, the promises our government has made to social security, medicare, medicaid, pensions and other entitlement programs far exceeds any projection of revenue. Jeff Miron wrote to chide me gently for apparently implying the opposite, which is certainly not my intent. One graph from his excellent "US Fiscal Imbalance Over Time":


Here, Jeff adds up the promises made each year for spending over the next 75 years. Others, including Larry Kotlikoff, make the same point by discounting the future payments, to estimate that the actual debt -- the present value of what the US owes less what it will take in --  is between $75 trillion and $200 trillion -- much more than the $20 trillion of actual GDP.

I've been one of those guys wandering around with a sign "the debt crisis is coming" so long that I forget to reiterate the point on occasion, and Jeff rightly points out my graph taken alone could be so misinterpreted.

In a nutshell, the problem is this: The US has accumulated a huge debt. Interest costs on that debt are already in the hundreds of billions per year. If interest rates rise, those costs will rise more. $20 trillion of debt times 5% interest rate is $1 trillion extra deficit, or even faster-rising debt. Unlike the case after WWII, when the spending was in the past, the US has also promised huge amount of spending in the future.

And, as Jeff points out, this did not start in 2008.  Entitlements have grown and crowded out regular spending. Now they are growing to crowd out interest payments. Soon they will grow more.

Update 2



Deficits / Potential GDP; Interest costs / Potential GDP; (Deficit + interest costs)/Potential GDP


Debt /  GDP.  (Thanks Vic Volpe for suggesting this better graph.)

Is this 1929, the beginning of the end? Or 2007? Is it 1974, annus horribilis in which the stock market drifted down 40% having something to do with stagflation, and did not recover until the 1980s? Is it 1987, a quick dip followed by recovery in a year? Or just an extended version of the flash crash, when the market went down 10% in a few hours, and bounced back by the end of the day? Are we in a "bubble" that's about to burst? How much does this have to do with the Fed? Of course I don't know the answer, but we can think through the logical possibilities.

(Note: This post has equations, graphs and quotes that tend to get mangled when it gets picked up. If it's mangled, come back to the original here.)

Why do prices fall?

Stock prices fall when there is bad news about future profits, or when the discount rate rises.

The discount rate is the rate investors require, looking forward, to get them to buy stocks. If people require a better rate of return, with no change in their expected cashflows, prices drop.

Stop and think about that a second, as it's counterintuitive. Yes, the only way to get a better return out of the same profits or dividends is for today's price to drop.

Another way to think about it: Suppose all of a sudden there are good profitable opportunities for your money -- bond interest rates rise, or it's a good time to take money out of markets and invest in your company. Well, people will try to move money to those alternatives. But the stock market is a hot potato; someone has to hold the stocks. So stock prices must decline until the rate of return going forward matches the other attractions on a risk-adjusted basis. Good news about returns going forward is bad news about a downward jump in stock prices.

Bad news about cashflows is, well, bad news. The dashed line shifts down. Your stocks are not going to pay off as well as before. Higher required returns are neutral, really, for long-term investors. The price drops today, but the higher returns mean the price will slowly recover, just as long-term government bonds do.

So is this a moment of bad cashflow news or higher discount rate?  Most commentary suggests it's not bad news about cashflows. The economy seems finally to be growing, and there isn't anything like a brewing subprime or other problem, as there was in 2007. Maybe we don't know about it, but one certainly doesn't read about it.

So let's think about discount rates. Why might investors require a higher return on stocks? Is it interest rates, a risk premium, and is the Fed behind it all?

Where are we? 

Are we  in a "bubble'' that is about to pop? Let's start by reviewing some facts. Here is the cumulative return on the NYSE since 1990. (This is the CRSP NYSE. Sadly the data stops 12/31/2017 so I don't show the recent drop. The larger index including NASDAQ shows a larger rise and fall in the tech boom and bust, but is otherwise about the same.)

Cumulative return NYSE since 1990. Source CRSP

This graph does not show anything terribly unusual about the recent period. Stocks drift up during expansions, and take a beating in recessions. There are also little blips like the Krugman election panic of November 2016. (Sorry, I couldn't resist.)  Why have stocks gone up so much? Well, mostly because the expansion has gone on so long. The recent period is also notable in that the little wiggles are much smaller -- less volatility. That ended last week too.

Update: Thanks to Torsten Slok at DB the last year follows. His point, it's sharp but not all that big.



Next, look at the price-dividend ratio. (For a variety of reasons this is a better valuation measure than the commonly used price earnings ratio. This (CRSP) measure of dividends includes all cash payment to shareholders. No, repurchases don't cause a problem.)

Price / dividend ratio, NYSE. Source CRSP

You can see prices were high relative to dividends in the booming 1960s; they really rose in the late 1990s before the big 2000 bust. Then you see the 2008 crisis and recovery, and more recent wiggles. You can see prices fall in recessions, even relative to dividends which also fall in recessions.

Where is the booming stock market? Stock prices relative to dividends have not grown at all since the end of the recession.  Well, evidently, dividends have been rising just as fast as prices in the current expansion -- which again weren't rising all that fast anyway. So the main reason stock prices are high is that dividends are high, and people expect that slow growth to continue.

So here we were before the recent drop. Are prices too high? Well, not as much as in 1999 for sure! But P/D is a lot higher than historical norms.  Is this the beginning of a drop back to historic levels like 30, or even 20? Or is this a new normal? There is way too much commentary lately that whatever we remember from 20 years ago was "normal" and that things have to go back to that. Not without a reason.

Interest rates and stock prices 

To think about this question we need some basics of what determines price-dividend ratios. Over long time periods, the return you get on stocks is the dividend yield -- how many dividends they pay per dollar invested plus the growth in dividends. Over short time periods you also get price appreciation per dividend, but over long time periods, the ratio of price to dividends comes back and price growth is the same as dividend growth.  In sum,

\[ r = \frac{D}{P} + g \]This is also where price comes from. The price you're willing to pay depends on the expected return going forward, and expected  dividend growth (Prices are high relative to current dividends if people expect a lot more dividends in the future.)\[  \frac{D}{P}  = r - g = r^l + r^e - g \]\[  \frac{P}{D}  =\frac{1}{r - g} =\frac{1}{ r^l + r^e - g}  \] Here I broke apart the expected return into components. First, the expected return on stocks is equal to the long-term real risk-free rate \(r^l\) plus the risk premium \(r^e\). This is just a definition -- the risk premium is \(r^e=r-r^l\).

So, looked at either as D/P or P/D, we now have the tools to think about what pushes stock prices around.

(There is nothing inherently ``rational'' or ``efficient markets'' about this. Behavioral finance just says the expectations are wrong, for example that people think \(g\) is big when in fact \(r\) is small.)

Stock prices are very sensitive to real interest rates, risk premiums, and growth expectations. At our current P/D of 40, for example, this means \(r-g=1/40=0.025\) or 2.5%. Just half a percent change  in expected return or growth rate, \(r-g=0.02\) would mean \(P/D=1/0.02=50\), a 25% rise in stock prices. Conversely, a half percent rise in real interest rates would mean \(r-g=0.03\), a decline to \(P/D=33\) a 16.7% fall.  No wonder stocks are (usually) volatile!

Now, to what's going on? If we take growth rate expectations off the table, then stock prices are moving because of changes in interest rates. And small interest rate changes do indeed imply big stock valuation changes -- though, again, take heart because it means the rate of return is higher, as in the first picture.

Does this relationship hold historically? Here is the D/P ratio (P/D upside down) and a measure of long-term real interest rates.

NYSE D/P, Cleveland Fed 10 Year real rate, and 10 year TIPS

(The problem with 10 year real rates is knowing what 10 year expected inflation is, given that we did not have TIPS. There are lots of other problems too, such as unwinding the liquidity premium in government bonds. Here I used the Cleveland Fed's real rate model, which is in part based on survey expectations. I added the 10 year TIPS yield where we have it to confirm the general pattern of the Cleveland Fed's calculation.)

This is a remarkable graph: The entire rise in valuations from 1980 to 2008 corresponds exactly to the decline in real interest rates.

By this measure, the decline in real rates was huge, from 7% to essentially 0%. Plug that in to \(P/D=1/(r-g)\) and we're done. Stock prices are exactly where they should be.

In fact, by this measure, stock prices are too low. In 2008, real rates kept right on trundling down another two percentage points, but the dividend yield stabilized.

Well, I was careful to say "corresponds to" not "caused by" for a reason. The risk premium and growth expectations changed as well. Arguably the move to a low-growth economy starting in 2000, cutting one to two percentage points off \(g\), offset the decline in real rate. Or perhaps the risk premium isn't as low as we think it is. This isn't just waffling -- the relationship is basically an identity. One of those options must be true. If the dividend yield is 2.5%, and the real interest rate is 0%, then \(r^e-g\) is 2.5%, and has grown since 2000. Either the risk premium has grown 2.5% -- so much for the ``low risk premium'' -- or growth expectations have fallen 2.5%. Or the long-term real rate is profoundly mismeasured here.

More on all this in a minute. But the graph reminds us 1) Real rates have come down a lot, and 2) persistent changes in real rates really are an important part of stock market valuations. Oh, and they have nothing to do with ``risk appetite'' and all that other blather. Stocks are valued like bonds plus risk. We are noticing here that the bond-like component got much more valuable. That alone, not the risk component or the growth component, accounts for two decades of huge price rises.

This actually updates significantly some of my own work, and the asset pricing consensus. The great question why do price-dividend ratios vary so much occupied us a lot in the late 1980s and early 1990s, including myself, John Campbell, Bob Shiller, Gene Fama and Ken French. The rough answer we came to -- pretty much all variation in D/P or P/D comes down to variation in risk premiums, the \(r^e=r-r^l\) term. The underlying fact is that times of high P/D are not reliably followed by higher dividend growth (Shiller), and they are reliably followed by low  excess returns (Fama and French). If you add it up, the risk premium effect neatly accounts for all the variation in P/D (Campbell and Shiller, me).

Well, in the data up to 1990, we didn't see much persistent variation in real rates of interest, and what we did see was not correlated well with stock prices. Well, that was 1990, and now is now. This graph suggests that in fact a lot of the recent variation in P/D corresponds to lower real interest rates.  Also, it's the low frequency, decade to decade movement in P/D that is not well accounted for by any models. An academic version of this observation needs to be written.

Practical bottom line: The stories that the recent stock price decline comes from rising long-term real interest rates make sense. They might be wrong, but they make sense. That's saying a lot more than most of the other stories being bandied around right now.

Interest rates, growth,  stock prices, and the Fed. 

The story is not that easy however. We have to think about real interest rates \(r\) and growth \(g\) together. And there is this puzzle to answer -- how can it be that good news about the economy sends the market down? If \(P/D=1/(r-g)\) more \(g\) should raise \(P\), no? It should shift up the dashed line in my first graph?

No. We have to think about where real interest rates come from. One of the most basic relationships in economics is that higher growth means higher real interest rates.  If everyone will be richer in the future -- growth -- they need an incentive to save and not blow it all today. And growth means a higher marginal product of capital, and hence higher interest rates. As a simple equation, \[ \text{real rate} = \gamma g \]where \(\gamma\) is a parameter, usually between about 1/2 and 2, and get ready for a bar fight at the AEA convention over just what value to use. 1% higher growth means about a half percent to two percent higher real interest rate.

(There is a second term too, important in understanding things like the financial crisis. More uncertainty means lower interest rates. Not today.)

If \(\gamma=1\), if one percent growth means one percent higher real interest rates, then higher growth has no effect at all on stock prices or price dividend ratios. (\(D/P = r^l + r^e - g.\) Raise \(r^l\) and \(g\) by the same amount.) If, as I think is more likely right in this case, \(\gamma>1\), then higher growth lowers stock prices. Yes. Higher growth means a higher discount rate as well as more dividends. The discount rate effect can overwhelm the cashflow effect.

This has nothing to do with the Fed. There is a natural human tendency to look for Agency, for some man or woman behind the curtain pulling all the strings, and these days that means the Fed. For example, the WSJ Editorial on stocks:

"The paradox of the equity-market correction is that it’s taking place even as the real economy looks stronger than it’s been since at least 2005 and maybe 1999. "

"So why are stocks falling amid all the good news? The best answer we’ve heard is that stocks are reflecting a return to volatility and risk after years of the Fed’s financial repression. With its quantitative easing bond purchases, the Fed has for a decade suppressed market price signals in bonds."

"Investors may finally be figuring out that the global quantitative-easing monetary party is ending."

Look back at my graph. Real interest rates have been on a slow downward trend since 1980. That trend is unbroken since 2008. There is not a whiff that QE or anything else has budged that trend. (Lots of good graphs on this point in 8 heresies of monetary policy here. ) If the Fed has anything to do with it, it is the slow victory over inflation expectations, not QE and a lot of talk.

Yes, the papers like to say that higher growth will induce the Fed to raise rates. The Fed can put a finger in this dike for a bit if they want to, but even the Fed cannot long fight the positive or negative relationship between real growth and real interest rates.

So it makes perfect sense, at least as a logical possibility, that more growth lowers stock prices! Again, this is like my lower line in the first picture -- and actually a bit better because we also raise the terminal point. If this is what happened, well, regret that you didn't see it happening and stay out during the dip, but be reassured the market will make it back.

Risk premiums 

What about the ``unusually low risk premium''? Aren't the Fed's ``massive QE and abnormally low interest rates distorting risk premiums and causing asset price bubbles?'' (The best definition of ``bubble'' I can muster is a risk premium that is too low, distorted somehow.)

Here is the contrary view. We are at the late summer of the business cycle. The economy is relatively healthy, at least if you're a stock market investor. (Many of these own companies.) Economic volatility is still at an all time low. Bonds are still giving pretty atrocious real returns. Yeah, stocks look pretty healthily priced -- as you contemplate your \(P/D = 1/(r^l + r^e - g)\) it looks like the extra return from stocks \(r^e\) is pretty low. But what else are you going to do with the money? You can afford a little risk. Contrariwise, the same investors in the bottom of the great recession, with very low \( P/D\) signaling a high risk premium \(r^e\), said to themselves or their brokers, yes, this is a buying opportunity, stocks will likely bounce back. But my business is in danger of closing, my house might get foreclosed, I just can't take any risk right now.

In short, it is perfectly rational for investors to be more risk-averse, and demand a higher risk premium \(r^e\) in the bottom of recessions, and to hold stocks despite a low risk premium in quiet good times like right now. And this has nothing to do with the Fed, QE, or anything else.

John Campbell and I wrote a simple model of this phenomenon a long time ago, and I've reviewed it several times since, most recently here. Sorry for flogging the same ideas, but this possibility still hasn't made it to, say, the Fed-obsessed WSJ editorial pages, to say nothing of the Trump-obsessed pages at other outlets.

John and I tied risk aversion to consumption trends. If consumption is high relative to the recent past, in good times, you more willing to hold risk. If consumption is declining relative to the recent past, you get more scared. Lots of other mechanisms, including debt, work much the same way. If you don't like the precise model, consumption relative to recent past is a good general business cycle indicator.

Let's look historically. Here is consumption less a moving average (I used \(x_t = \sum_{j=0}^\infty 0.9^j c_{t-j})\), plotted with the log of the price/dividend ratio. The two series have different scales. The point is to see the correlation.

Consumption minus a moving average, and log P/D on NYSE.

The pattern is longstanding. In good times, when consumption rises relative to recent past, stock valuations go up. In bad times, such as the great recession, consumption falls and so do stock valuations. People are scared. The same pattern happens regularly in the past.

The two lines drift apart, but as we saw above real interest rates account for that. Then the business-cycle related risk premium here accounts for the rises and dips.

And, if I may belabor the point, there was no QE, zero interest rates, and so forth going on in all these past instances when we see exactly the same pattern. Higher real interest rates are a regular, simple, utterly normal part of expansions, and lower risk premiums are a regular, simple, utterly normal part of expansions. 

I was interested to read Tyler Cowen at Bloomberg back in to this view, based entirely on intuition:

In a volatile and uncertain time politically, we have observed sky-high prices for blue-chip U.S. equities. Other asset prices also seem to be remarkably high: home values and rentals in many of the world’s top-tier cities, negative real rates and sometimes negative nominal rates on the safest government securities, and the formerly skyrocketing and still quite high price of Bitcoin and other crypto-assets.

Might all of those somewhat unusual asset prices be part of a common pattern? Consider that over the past few decades there has been a remarkable increase of wealth in the world, most of all in the emerging economies. Say you hold enough wealth to invest: What are your options?

In relative terms, the high-quality, highly liquid blue-chip assets will become expensive. So we end up with especially high price-to-earnings ratios and consistently negative real yields on safe government securities. Those price patterns don’t have to be bubbles. If this state of affairs persists, with a shortage of safe investment opportunities, those prices can stay high for a long time. They may go up further yet.

These high asset prices do reflect a reality of wealth creation. They are broadly bullish at the global scale, but they don’t have to demonstrate much if any good news about those assets per se. Rather there is an imbalance between world wealth and safe ways of transferring that wealth into the future

To sum this all up in a single nerdy finance sentence, in a world where wealth creation has outraced the evolution of good institutions, the risk premium may be more important than you think.

This view should not necessarily make you sleep at night however.  It means that a downturn will be accompanied by higher risk aversion again, and not only will dividends fall, prices will fall further. Moreover, historically, asset price falls have been preceded by periods of higher volatility. Alas, many periods of higher volatility have just faded away, so it's a warning sign not a signal.  Sure, this mechanism means they will bounce back, but if you are clairvoyant enough to see it coming it will be better to avoid the fall! If not, well, be read to buy when everyone else is scared -- if you are one of the lucky few who can afford not to be scared.

The VIX, volatility, technical factors 

There is another kind of ``discount factor variation,'' including 1987 and the flash crash. Sometimes the machinery of markets gets in the way, and prices fall more than they should. They quickly bounce back. If you can buy at the bottom you can make a fortune, but the prices fell precisely because it's hard to buy.

There were scattered report on Monday of hours long delays for retail customers to trade. (Can't find link.) But I do not get a sense this was a big clog in the markets. I would be curious to hear from people closer to markets.

The bigger news is the return of volatility -- big daily changes. To put this in historical perspective, here are two plots




The surprise, really, is just how low low volatility had become. Historically the stock market index has had a volatility around 15-20% per year -- a typical year saw a 15-20% change, and a typical day saw a \(15-20 / \sqrt{250} \approx \) one percent change. But, as you see in the top graph, volatility also declines in the late summer of the business cycle. Volatility has many occasional little eruptions, typically around price drops, and then washes away. Except when volatility rises in advance of the next recession and market decline. Which is this? I wish I knew.

Volatility is not about "fear" nor is it about "uncertainty." Volatility occurs when options change quickly. Constant bad news or good news just leads to constantly low or high prices. This is a sign of a time when either a lot of real information is hitting the market, or a lot of people are trying to process what's going on ahead of everyone else.

The "VIX bust" is hot in the news. A lot of people bet that the graph you saw above would not rise. To be ``short volatility'' means basically that you write insurance to people who worry about markets going down, (volatility is a big part of the value of put options) and you write insurance to people who are worried about events like right now in which markets start to move a lot. Hello, when you write insurance, occasionally you have to pay up.

As the graphs make clear, writing volatility insurance, or betting that volatility will continue to go down,  is like writing earthquake insurance. Not much happens for many years in a row, and you can post nice profits. Then it jumps and you lose big time. Anyone who did this based just on historical returns is now crying the tears of the greedy neophyte. But they have lots of company. Back in the 1990s, Long Term Capital Management went under, basically for betting that similar looking graphs would continue to go down.

Well, if after all these years people are at it, P.T. Barnum had a good word for them. But did this have something to do with the stock market crash? How Bets Against Volatility Fed the Stock Market Rout in WSJ is an example of this train of thought.

On first glance, sure, a lot of people lost a ton of money, and then sold out other risky positions. But Econ 101: for every buyer there is a seller.  Derivatives contracts are pure cases of this fact -- the net supply really is zero, for everybody who lost a dollar shorting VIX somebody else made a dollar buying it.

To get a story like this to go you need all sorts of market discombobulations. Somehow the people who lost money must be more important to markets than the people who made money. This can happen -- if a bunch of traders in a complex obscure security all lose money, and all try to sell, there is nobody to buy. But I don't really see that case here, and stocks are not a complex obscure security.

A trader friend also tells me that he has seen lots of people stop hedging -- so sure low volatility would continue that they don't cover the downside. He said many have lost a ton, and now are frantically selling to cover their positions. Such price pressure can have short run impacts, but does not last long.

Inflation and real interest rates 

So we're back at hints of higher long-term real interest rates as the main likely culprit behind this week's decline and gyrations.

Here too most of the stories don't make much sense. Inflation per se should not make much difference. If expected inflation rises, interest rates rise, but real interest rates are unaffected. Inflation may make the Fed act more quickly, but there is not much correlation between what the Fed does with short term rates and the behavior of 10 year or more rates that matter to the stock market -- or to corporate investment.



Yes, there is some correlation -- especially at the end of expansions, short and long rates rise together. But the correlation is a whole lot less than the usual Wizard of Oz behind the curtain stories. And even the Fed cannot move real rates for very long. There is a good chicken-and-egg question whether the Fed can hold short rates down for long when long rates want to rise. The Fed pretty much has to jump in front of the parade and pretend to lead it.

Inflation does seem finally to be rising. The fact that higher rates are associated with the dollar falling suggests that a lot of the higher rates are due to inflation, and TIPs have not moved (top graph.)

So, the question before us is, are long-term real rates finally rising -- back to something like the historical norm that held for centuries, and if so why?

The good story is that we are entering a period of higher growth. Depending on your partisan tastes, point to tax cuts and deregulation, or state that Obama medicine is finally kicking in. This would raise real growth, with \(\gamma>1\) lead to a small stock price decline, but higher stock returns and bond returns going forward.

There is a bad story too. Having passed a tax cut that left untouched will lead to trillion-dollar deficits, Congressional leaders just agreed to $300 billion more spending. The Ryan plan that tax cuts would be followed by entitlement reform may be evaporating. Publicly held debt is $20 trillion. At some point bond markets say no, and real rates go up because the risk premium goes up. The US is in danger that higher interest rates mean higher interest costs on that debt, which means higher deficits, which means higher interest rates. $20 trillion times 5% interest = $1 trillion in interest costs.

The former leads to some inflation if you believe in the Phillips curve. The latter leads to stagflation in a tight fiscal moment.

Which is it? I don't know, I'm an academic not a trader.

One consolation of the stock market decline: I hope we don't have to hear how all the corporate tax cut did was to boost the stock market!

Well, two days ago this was going to be a short post responding to the WSJ's view that the Fed is behind it all, and Tyler's nice intuition. It got a bit out of hand, but I hope it's still interesting.


****

Data Update (Geeks only).

P/D isn't really "better" than P/E or other measures. A measure is what it is, you have to specify a question before there is an answer. Ideally, we want a measure that isolates expected returns, and tells us if prices are higher or lower given the level of expected dividends.  So ideally, we would account for expected future dividends and the result would be a pure measure of expected returns (rational or not). P/D works pretty well that way because dividends are not very forecastable. Price divided by this year's dividends turns out to be a decent approximation to price divided by anyone's forecast of future dividends. But not perfect. P/E is less good that way because earnings bat about a bit more than dividends. For individual companies you can't use P/D, because so many of them do not pay dividends. Following Fama and French, the ratio of market value to book value is better there, because book value is usually positive, or not so frequently zero.

I use the CRSP definitions. I start from the CRSP return with and without dividends and infer the dividend yield. ''Dividends" here includes not only cash dividends but all cash payments to shareholders. So, if your small company gets bought by Google, and the shareholders get cash, that is a "dividend" payout. I suspect this accounts for the difference noted by WC Varones below. As others point out, earnings has all sorts of measurement issues, and also does not control for leverage.

Dividends are very seasonal, so you can't divide price by this month's dividends or you get a lot of noise. I use the last year's worth of dividends, brought forward by reinvesting them. This introduces some "return" into the dividend series. If you just sum dividends, though, identities like \(R_{t+1} = (P_{t+1}+D_{t+1})/P_t \) no longer hold in your annual data.

x = load('crsp_nyse_new_2018.txt');

caldt = x(:,1);
totval = x(:,2);
usdval  = x(:,3);
sprtrn = x(:,4);
spindx = x(:,5);
vwretd = x(:,6);
vwretx = x(:,7);

[yr,mo,day,crsp_date_number] = decode_date(caldt);

T = size(vwretd,1);
vwretda = (1+vwretd(1:T-11)).*(1+vwretd(2:T-10)).*(1+vwretd(3:T-9)).*...
          (1+vwretd(4:T-8)).*(1+vwretd(5:T-7)).*(1+vwretd(6:T-6)).*...
          (1+vwretd(7:T-5)).*(1+vwretd(8:T-4)).*(1+vwretd(9:T-3)).*...
          (1+vwretd(10:T-2)).*(1+vwretd(11:T-1)).*(1+vwretd(12:T));

vwretxa = (1+vwretx(1:T-11)).*(1+vwretx(2:T-10)).*(1+vwretx(3:T-9)).*...
          (1+vwretx(4:T-8)).*(1+vwretx(5:T-7)).*(1+vwretx(6:T-6)).*...
          (1+vwretx(7:T-5)).*(1+vwretx(8:T-4)).*(1+vwretx(9:T-3)).*...
          (1+vwretx(10:T-2)).*(1+vwretx(11:T-1)).*(1+vwretx(12:T));
   
vwdp = vwretda./vwretxa-1; %D_t+1/P_t+1 = [(P_t+1+D_t+1)/P_t] / [P_t+1/P_t] -1;
vwdda = vwdp(13:end)./vwdp(1:end-12).*vwretxa(13:end);   % D_t+1/D_t = D_t+1/P_t+1 / D_t/P_t * P_t+1/P_t
vwdda = [ones(23,1)*NaN; vwdda];
cumval = cumprod(1+vwretd);
vwdp = [ ones(11,1)*NaN; vwdp]; % keep length of series the same

I get stock data from CRSP via WRDS. This is the NYSE only. I can't post the full data, as it belongs to CRSP. Here is an excerpt that will let you calculate the last year, and check that things are right if you download the whole thing.

%crsp_nyse_new_2018.txt
%   caldt            totval                  usdval                 sprtrn         spindx        vwretd        vwretx
19260130       27624240.80       27412916.20      0.022472       12.74      0.000561     -0.001395
19260227       26752064.10       27600952.10     -0.043956       12.18     -0.033046     -0.036587
19260331       25083173.40       26683758.10     -0.059113       11.46     -0.064002     -0.070021
19260430       25886743.80       24899755.60      0.022688       11.72      0.037019      0.034031
...
20160129    17059005700.00    17976992500.00     -0.050735     1940.24     -0.050111     -0.051700
20160229    16986848800.00    17001893900.00     -0.004128     1932.23      0.005104      0.002251
20160331    18122913200.00    16951468600.00      0.065991     2059.74      0.072190      0.069562
20160429    18503144900.00    18082712100.00      0.002699     2065.30      0.023324      0.021716
20160531    18479138100.00    18410229900.00      0.015329     2096.96      0.006124      0.003392
20160630    18613173100.00    18422135300.00      0.000906     2098.86      0.011175      0.008957
20160729    19054705700.00    18557630600.00      0.035610     2173.60      0.028433      0.026872
20160831    18993464300.00    19049575300.00     -0.001219     2170.95      0.000196     -0.002532
20160930    18829544800.00    18880924600.00     -0.001234     2168.27     -0.003876     -0.005878
20161031    18404742600.00    18802632900.00     -0.019426     2126.15     -0.021331     -0.022944
20161130    19220882900.00    18383296300.00      0.034174     2198.81      0.048548      0.045701
20161230    19568491300.00    19178151000.00      0.018201     2238.83      0.021566      0.019486
20170131    19824534000.00    19526674900.00      0.017884     2278.87      0.014007      0.012623
20170228    20355248600.00    19781803200.00      0.037198     2363.64      0.031422      0.028905
20170331    20237616500.00    20334429600.00     -0.000389     2362.72     -0.003961     -0.006103
20170428    20286715000.00    20194157100.00      0.009091     2384.20      0.003950      0.002468
20170531    20299003900.00    20276905500.00      0.011576     2411.80      0.002199     -0.000507
20170630    20602218600.00    20256933000.00      0.004814     2423.41      0.018204      0.016235
20170731    20747539100.00    20488018000.00      0.019349     2470.30      0.015290      0.013394
20170831    20593088100.00    20742392900.00      0.000546     2471.65     -0.005133     -0.007874
20170929    21147810200.00    20381001300.00      0.019303     2519.36      0.030435      0.028662
20171031    21343546700.00    21130998500.00      0.022188     2575.26      0.011831      0.010360
20171130    21904734200.00    21302790800.00      0.028083     2647.58      0.030537      0.027670
20171229    22016063100.00    21683038400.00      0.009832     2673.61      0.015914      0.014117