I’m on TV!

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)

Art as investment

Fellow grad student, Bed Mandel, has a paper coming out in AER ((holy shit!)) 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!

Emailing Senior Ambrosini

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).

Ack! There IS an “asset bubble” variable in the Taylor rule

And it was right under my nose this whole time. Fellow Grad student at UCD and job market candidate, Takeshi Yagihashi, estimated a Taylor rule with credit channel variables. He finds that the Fed seems to care about credit channel efficiency more than the output gap when making policy and he finds interest rate smoothing isn’t that big a concern ((I have a hard time believing the Fed doesn’t care about smoothing… why does it move in such small increments even when everyone knows its going to move more in the future? why not all at once?)).

And of course I studied credit channel models last year, the deficiency is in me not the theory or the UCD monetary curriculum. I just didn’t “get” the policy implications of those models.

AND guess who wrote the papers that give the theoretical underpinnings for the rules Takeshi estimated? I’ll give you one guess. Hint: he has a beard and he has to worry about credit channel problems.

The end of mercantilism in England

Over a hundred years before the Wealth of Nations, Sam Pepys:

To another question of mine he made me fully understand that the old law of prohibiting bullion to be exported, is, and ever was a folly and an injury, rather than good. Arguing thus, that if the exportations exceed importations, then the balance must be brought home in money, which, when our merchants know cannot be carried out again, they will forbear to bring home in money, but let it lie abroad for trade, or keepe in foreign banks: or if our importations exceed our exportations, then, to keepe credit, the merchants will and must find ways of carrying out money by stealth, which is a most easy thing to do, and is every where done; and therefore the law against it signifies nothing in the world. Besides, that it is seen, that where money is free, there is great plenty; where it is restrained, as here, there is a great want, as in Spayne.

Of albedo, emissivity and Calvo pricing

I’ve said before that the climate change discussion reminds me a lot of macroeconomics. This similarity has driven my skepticism that the science is locked. I know we don’t have macroeconomics figured out; it seems unlikely we have the climate figured out.

Here’s a great discussion on the sensitivity of temperature to changes in CO2. The earth is absorbing energy and its emitting energy. Where these balance determines the temperature. The earth doesn’t perfectly absorb all the energy it receives and similarly it doesn’t perfectly emit energy. The efficiency of absorption is called the albedo and the efficiency of emission is called emissivity. Of course, the efficiency of absorption and emission determines the equilibrium temperature. There’s lots of factors that determine efficiency, albedo and emissivity, but a simplifying assumption is to assume they’re both constant. This is something economists are used to… “assuming all else is equal, blah blah blah.”

Assuming albedo and emissivity are constant is an ok thing to do as long as we’re talking about small changes in the climate.

Where climatologists talk about the relationship between CO2 and temperature, macro economists like to talk about the relationship between inflation and the economy’s output. The relationship comes about because prices companies charge and the wages people earn don’t change very fast to economic conditions. All else equal (!), we’d expect workers to demand higher wages the moment inflation is higher and we’d expect firms to change their prices just as quickly. But this doesn’t happen. It takes a while for workers to renegotiate their wages and it takes a while for companies to change the price tags on their goods. We call this sticky prices.

One way to model sticky prices is by assuming only a fixed percentage of firms can update their prices at a time (pdf). A random number of firms is selected each quarter. For those lucky firms the Calvo Fairy taps the firm’s managers on their shoulders and they swing in to action changing prices. They set their prices to the best prices today (to maximize profit) and they know the fairy may not visit them next time (or the time after that or the time after that) so they make sure to set the price to give them the highest expected profit in the future. The rest of the firms have to live with whatever prices they set in the past.

That the number of firms that update their prices is a constant fraction is an ok assumption as long as we’re talking about small changes in the economy.

However, as you can imagine, if inflation is really high firms will have a bigger incentive to raise their prices and the assumption that only a fixed number of companies will update their prices becomes unrealistic. Similarly, constant albedo and emissivity become unrealistic assumptions when big changes happen to the climate.

BTW, here’s another great write-up on that site about the long term connection between CO2 and temperature.

Texting the Fed

I think this is cool.

Prof. Cogley warned us against textual analysis a la Romer and Romer today in lecture. Figuring this is a plot to steer us away from interesting research topics (he wants to keep them for himself, of course), I dove right into the Fed meeting notes and did some textual analysis. Below are some results (using this tool):

More talk about velocity under Volker, but less talk about inflation and unemployment.

Money is just a commodity…

Slashdot reports on the gaining popularity of a virtual money in China:

It’s the QQ coin — online play money created by marketers to sell such things as virtual flowers for instant-message buddies, cellphone ringtones and magical swords for online games. In recent weeks, the QQ coin’s real-world value has risen as much as 70%. It’s the most extreme case of a so-called virtual currency blurring the boundaries between the online and real worlds — and challenging legal limits.

Someone comments:

Currency is just an agreement on a medium to symbolize value.

Common misconception, but one which governments are happy to foster. Actually, currency is a commodity in exactly the same way as coffee, bread, oil, gold, pork bellies.You see if currency were really a medium which symbolised value, it wouldn’t change much. Bread, coffee, gold etc would pretty much always cost the same, they would always have the same value throughout time. Instead what happens is that over time, everything becomes more expensive, inflation. What’s happening is that the currency is losing it’s value. It does that because there’s more of it; supply and demand. When the government(‘s bankers) print money, all the existing money in circulation decreases in value because there is more of it around.

So, no, there’s no fundamental difference between real and virtual money, just as there’s no fundamental difference between real money and a kg of coffee.

Except one thing: we imagine the government is able, through controlling the money supply, to smooth short-run business cycles. If the government doesn’t control the money supply, it can’t do this. So so-called virtual currencies undermine the power of monetary policy.

Labor contracts in the U.S., for example, usually cover a year, or more, and they’re denominated in dollars. Some people believe the government’s monetary power comes from the fact people write long-term contracts, like wage contracts, in the government controlled currency. So the government shouldn’t start sweating about “virtual” currencies until it starts seeing long-term contracts written in currencies it doesn’t control (…like stock options…).