The Ambrosini Critique

Essential reading from NotSneaky.

My sense is that epsilon (the effect contraction in the financial sector will have on the non-financial sector) is small in the short run and zero in the long run. There are some transaction costs in finding a new bank for “real” economy businesses if their old ones stop providing credit, but in the end we’re talking about a couple strokes on a keyboard and maybe a walk further down the block.

Is there any “micro evidence” that can help us pin down this parameter?

Also, the large dip in financial paper with no corresponding dip in the non-financial sector on the first chart here is evidence of a small epsilon.

As long as there’s at least one bank standing at the end of all this, I don’t think epsilon can get that big. So maybe the bailout is attempting to throw money at this problem hoping to avoid this non-linearity.

In the long run, epsilon is zero as everyone in the non-financial sector has found alternative sources of credit. The fact that a bunch of smart ex-bankers will become smart middle managers in the real sector is gravy. But because someone was stupid-efficient at moving electronic bits shaped as dollars around doesn’t mean they’ll be good at moving electronic bits shaped as goods and services and it probably means they’re just plain bad at moving atoms around (although, Bankers tend to work out a lot).

Using NotSneaky’s handy chart, I predict a recession of about 2% peak to trough.

UPDATE: We’re on our way. GDP down 0.3% last quarter.

The science guys at blogginghead.tv talk about Haidt’s work:

they’re reacting to this video:

I think they’re wrong that Haidt’s taxonomy is normatively slanted against conservatives.

What is a credit crunch? At first, I thought when people were using this term they meant credit markets weren’t in equilibrium. There was no market for credit. Then when people started talking about the increasing TED spread — basically the price of very short term loans — I thought they meant a credit crunch was a contraction of credit supply. You know banks were all of a sudden more risk averse and they weren’t extending credit that should be extended.

But then someone said, “hey, volumes of credit are actually increasing!” Basically, if supply is decreasing, we’d expect increasing prices, e.g. an increase in the TED spread, but also decreases in quantities, e.g. lower volumes. If volumes are up and prices are up, this is consistent with increasing demand.

To which Tyler Cowen replies with this weirdness. Basically, he’s saying a credit crunch is an impending decrease in supply (or demand even) for credit. Why is this weird? A commenter on that post explains:

“As for the current financial crisis, my view of the data is that many borrowers have been drawing on their pre-existing lines of credit like crazy, for fear that their chances to borrow may be drying up. “

So, your view of the data is that an increase in the amount of loans and credit available is a sign of a freezing of credit and an unwillingness for banks to lend. This is a very convenient position to take. A reduction of loans and credit is a sign of a credit crunch and an increase in loans and credit is also a sign of a credit crunch. This is like the game of flipping a coin where if you flip heads you win and if you flip tails I lose.

“Even now it remains unclear whether these options will be replenished and of course if they are not that means trouble.”

I see…so, we are not in trouble yet, but because in the future we might possibly have a reduction in loans and credit, that definitely means we are in a credit crunch now.

“It does not necessarily show up in current period credit flow data and in fact it may show up counterintuitively as a spike in borrowing.”

A spike in borrowing also means a spike in lending from the banks. But a credit crunch is where banks are unwilling to lend. Now, with new Orwellian double speak, a credit crunch is when banks are willing to lend to everyone and his brother. Some credit crunch.

“I am puzzled by Alex’a admission that there is a recession; no matter which way you assign the causality, doesn’t that mean credit should be contracting?”

Causality does matter. If borrowers choose not to borrow this is not a credit crunch. A reduction in demand for loans due to a recession would not be considered a credit crunch. The credit crunch would have to originate on the supply side. Banks would have to be unwilling to lend to borrowers for there to be a credit crunch. A reduction in loans and credit is a necessary but not sufficient condition for there to be a credit crunch.

Investments are the most volitile component of national income. When GDP is high, investment goes really high and when GDP is low, investment is really low. We’d expect, if we’re entering a recession, to see investment and thus the demand for credit go down. Its hard to call this normal contraction of demand for credit a credit crunch.

The data aren’t telling us we’re in a credit crunch, given a half-way meaningful definition of the phrase “credit crunch”. In fact, the data are consistent with increases in demand for credit and so increases in investment.

In the first couple of seconds of this video you see a guy holding a coffee cup in the lower left hand corner. That’s me!

Oh and these other guys talked about the financial crisis:

Recommendation: Prof. Taylor’s the best (and first) speaker. The second dude talks about standard investment strategies (stocks are risky!) and probably you can skip him. The third dude, a historian, talked too briefly about history and made a lame plug for the need for fiscal stimulus.

Basically his argument is that four years after the government brought the economy to its knees during the depression, President Roosevelt needed to stimulate aggregate demand. Well, today’s economy is I-guess-sorta-maybe to its knees and well people have been talking about how this might be a depression and wow can you believe the similarities between now and the Great Depression, I mean jeez… where was I… oh, right, so yeah we need to implement my pet policy! QED.

(h/t that other dude in the death star… thanks for figuring out how to embed video, btw)

Fellow grad student, Bed Mandel, has a paper coming out in AER¹ called Art as an Investment and Conspicuous Consumption Good (pdf):

This paper provides a simple and empirically plausible model of artworks as investment vehicles. It reconciles the observation that average financial returns for collectibles are low and volatile with the theory of consumption-based asset pricing. Art assets are appealing both for their ability to transfer consumption over time and their use as signals of wealth, as in the literature on the demand for luxuries. Adding art value into utility, returns also reflect this ‘conspicuous consumption’ dividend; as a result, average financial returns are low. Risk premia for artworks are predicted to be modest or even negative.

He cites Veblan, but the best line is the last:

In a boast, a friend once told me that his art was a better investment than all other assets, including …financial securities and real estate. Accounting for his utility in telling me so, that is indeed likely.

Oh, and Prof. Kling, you’ll notice equations 5-7 are Euler equations. I defy you make the claim that Ben is just “producing stochastic calculus porn to satisfy [his] urge for mathematical masturbation.” I’d say you actually learn something about Art looking at those equations.

BTW, Ben is on the job market this year. Snap him up before its too late!

1. holy shit! [↩]

Its time to start stocking up on the spam and bottled water — to run for the hills — if politicians start talking like this again:

For the first time in the history of depression, dividends, profits, and the cost of living, have been reduced before wages have suffered…. They were maintained until the cost of living had decreased and the profits had practically vanished. They are now the highest real wages in the world.

Prices need to adjust. It is their destiny. If prices can’t adjust, quantities will adjust. By “quantities”, I mean your job and by “adjust”, I mean you’ll lose it.

In other words, cool kids don’t vote for politicians that use phrases like “price controls” or “wage maintenance”.

I wanted to make the following comment on this post at gnxp¹ , but something’s broken:

Isn’t the original author just pointing out that there’s different normative dimensions to evaluate the worth of a field of study? Its easy to find dimensions that favor science and its easy to find dimensions that favor non-science. Thus, both fields can be “good”, “useful”, or whatever.

Personally, I think the normative dimensions that judge science above non-science are better, but those are my aesthetic judgments. That said, if I have an open-minded person in front of me, I can get close to convincing him I’m right.

What do you think razib, is the beauty of science in our genes and is this why religious folk have to spend so much more time than scientists at evangelism?

Blogging isn’t about conversation, its about showing the world how smart you are… and how can I do that if the comments are broken!

1. Its a good post that I was going to find an excuse to link to anyway. So, yeah, read the whole thing. [↩]

Nobel laureate Paul Krugman meet Nobel laureate Ned Phelps. Ned, Paul.

Say, you two seem to have different opinions about the possibility that recessions lead to changes in the structural rate of unemployment. Can you talk amongst yourselves and get back to us with an answer?

(h/t MR. BTW, given their relative expertise, my priors are closer to Phelps’ view.)

Apparently, I’m obliged to do this. I’ve said good and bad things about Prof. Krugman in the past (see this link for the good and for links to the bad).

I think:

• he absolutely deserves this prize… some of my research is based on his “love of varieties” stuff and I dig economic geography
• its great that he does so much to popularize economic thinking (even if he sometimes gets in wrong… still he encourages the right debate)
• the timing of the prize and the fact he got it alone suggest probably got it for political reasons (i.e. why now? Bush is out of office like any day now.)
• commenters making the above point appear to have no clue about the great extent of Prof. Krugman’s intellectual contributions

Prof. Feenstra told us in lecture today that he was Krugman’s first student at MIT. Here’s Prof. Krugman on his students: “A more important regret is that while the MIT course evaluations rate me as a pretty good lecturer, I have not yet succeeded in generating a string of really fine students, the kind who reflect glory on their teacher.” He must have hit a dry spell after his first student… In any case, this gives me two degrees of separation from the Nobel prize!

I got this email from my dad:

Ok, you are the trained expert on this. In 100 words or less please explain what the hell is going on with the market and what will be the final outcome. (ps: your inheritance just went down over [30%] in the last seven days!)
J. William Ambrosini CPA

My reply which I hope is wrong in the “you can’t get all the details right in a short essay” sense and not a “what the hell is he talking about” sense:

What the hell is going on?

Prices in houses have decreased a lot because we were in a housing bubble. This means a lot more people are delinquent and defaulting on their mortgages because credit ratings algorithms were attuned to an environment of ever-increasing home prices. This may have been prevented if banks didn’t move to score based credit ratings in the 90’s and if people with poor credit weren’t encouraged to buy homes… but who knows what would prevent asset bubbles.

What’s the effect?

First, in the banking sector, this newly discovered risk is spreading like ripples in a pond. Mortgages were repackaged as “mortgage backed securities” and sold and resold. This had the effect of spreading risk (a good thing) but it spread it in a way people can’t account for. We’re in a situation now where we know a lot of assets are worth less than we thought, because they have more risk than we thought, but we don’t know exactly which assets. People are nervous to buy anything related to mortgage assets, even good assets, because they’re afraid they might actually be bad. That’s why these assets are called “toxic”. Nobody wants to touch them. People don’t even want to touch banks that had positions in these types of assets (which are most banks).

Second, in the “real” economy the credit expansion caused by high house prices led to over-expansion of capital so now we have a lot of excess capacity. This isn’t covered as much in the press but I think its may be as much of a problem as the financial stuff. Basically, people were borrowing against the inflated value of their homes and consuming a lot. This extra consumption prompted businesses to increase capacity — to expand their business. But this extra consumption dried up when the house prices tanked and businesses are stuck with a lot more capacity than they need. This means investment that would have happened, even without the housing bubble induced consumption, won’t happen now.

What am I worried about?

I’m worried about the effect this all will have on the “real” economy. As banks struggle to get rid of these bad assets they’re reluctant to make normal loans to businesses. This makes it harder for companies to make payroll or to get loans in order to expand capacity. This is how the “paper” economy has an effect on the “real” economy and this is why this financial mess may cause a recession. Also, over capacity means businesses will have less demand for capital goods, there will be less investment and this may mean the recession will be protracted. The good news is that China and the world economy in general are expanding like gang-busters. This “over” capacity might not be.

What am I really worried about?

The government screwing things up worse. The great depression was really a bad recession that the government made much, much worse. Government made a lot of mistakes, but the biggest was in its attempts to control prices. President Hoover basically had a deal with big business to keep wages high at their current level. Because wages couldn’t drop as they needed to, unemployment was high (if you can’t reduce your employees wages, you have to fire them) and so aggregate demand was low (people didn’t have jobs so they weren’t keen to spend money). There’s two ways to deal with low aggregate demand: increase government expenditures and let prices/wages adjust back to the full employment level. Increasing government expenditure is a good short term solution but it has to be paid for eventually. Letting prices adjust, on the other hand is painful in the short run (the employed people have to live with wage decreases), but its the only solution that works in the long run. Eventually, prices have to adjust. During the depression, government didn’t let wages adjust down for nearly a decade and we had a depression for… you guessed it, nearly a decade.

Anyway, this is more than 100 words. But this is my sense of what’s happening. I expect a short recession as the banking sector reorganizes unless there’s lots of over-capacity. But if you see politicians making a lot of noise about controlling prices, we’re in a world of hurt.

J. William Ambrosini Jr.

PS – Short term movements in the stock market get the headlines but they convey no useful information. If stock prices represent discounted future cash flows, I find it inconceivable that future cash flows will be 30% less than they were a month ago (before the 30% decrease in stock prices). Even if we have Depression 2.0, I can’t imagine future profits will take that big of a hit even in discounted terms. In other words, my inheritance took no such hit!

Just a tad over 100 words… by the way, a point similar to the one I made about over-capacity was made by Prof. Phelps the other day (via The Economist).