I ran into Jim again yesterday. Actually it would be more true to say that he ambushed me. I turned a corner and there he was. After the way he treated me in our first discussion (reported here) I was not particularly looking forward to talking to him again.
Jim said: “I enjoyed our last discussion”. I nodded agreement as I wondered why I wasn’t shaking my head the other way. Meanwhile, Jim was saying: “I heard that you wrote up our last discussion on your blog”. I must have looked a bit concerned because Jim said: “That’s OK. I don’t mind helping you with your blog, as long as you are accurate in reporting what I say and don’t make me look stupid”. I told Jim that might not be easy, but I could tell from the way he was looking that he obviously didn’t think it would be a joking matter if I made him look stupid - even though I wasn’t using his correct name on my blog. So I added that I was not going to report his expletives. Jim said that was OK. He claimed that he didn’t swear in any case, but if I wanted to I could use some bleeps now and then just to add emphasis. He said: “I won’t mind if you use a bit of poetic licence now and then, as long as you don’t make me look stupid”.
After he had bought me a beer Jim said that wanted to ask me something else. He said: “You believe that free markets are perfect don’t you?” I responded that I wasn’t quite sure what he was getting at. I told him that in my view all markets are imperfect, but when governments try to regulate them they often make matters worse. Jim said: “No, that’s not what I mean. I’m talking about capital markets – share prices and bond prices. Do you think those markets are close to perfect?”
At that point I explained to Jim that what he was talking about was the efficient markets hypothesis that prices always reflect all relevant information. I said it seemed to me that investors have the strongest possible incentive to make informed decisions because their personal wealth is at stake – and equity prices reflect the information on which investors base their decisions.
Jim said: “I’m not sure I understand. Are you saying that individual investors all have the same expectations about future prospects of particular firms?” I acknowledged that individuals have a lot of different views about the future. I suggested that even though a lot of investors think they can beat the market, the market averages out these different expectations, so those who do better than the market tend to be balanced by those who do worse than the market.
Jim nodded for me to continue. I explained that people who invest in funds with low management fees, whose weightings of individual shares in their portfolio are similar to a share market index, often do better than those who pay high management fees to funds that undertake a lot of research.
Jim said: “I suppose if someone has just lost half their capital on the share market they will not feel so bad if the value of their portfolio has fallen in proportion to the index and they have been paying low management fees.” I agreed.
Then Jim asked: “What do you think of Warren Buffett’s view that it is possible to beat the market because people are often irrational – they let greed take over and then they panic when fear takes over”. I said that I like Buffett’s approach to investing, but I wasn’t too keen on his politics.
Jim ignored the latter remark and asked: “So what advice do you think the Oracle of Omaha would give to novice investors about where to put their money?” I said that I imagined that he would tell them to put their money into Berkshire Hathaway. Jim replied: “Well, you don’t know everything! Buffett says that novice investors should stick with low-cost index funds.”
Postscript:
I checked to see whether or not Jim had just made this up. Warren Buffett actually gave this advice in April this year (reported here).
Friday, November 28, 2008
Tuesday, November 25, 2008
Can budget deficits cure the debt problem?
When I first met Jim (that is not his real name) a few days ago he seemed like a fairly harmless businessman. But when he heard that I was an economist, he said that there was something he wanted to ask me.
I had the feeling that I would not like Jim’s question, so I mentioned that I had retired. Jim pretended not to hear. He said: “The current financial crisis was caused by too much debt wasn’t it? Before I could respond, he had added: “So, tell me how the world’s governments are going to solve the problem by having bigger budget deficits and more debt?”
I tried to get out of answering by saying that I didn’t know much about short-term macro-economic management. That response didn’t satisfy Jim. He said: “Come on, you must have some idea about what governments are trying to achieve.”
I started my explanation by going back to the cause of the problem. Making my explanation as simple as possible, I said that the problem had arisen basically because lending institutions in the U.S. thought that it was safe to lend a high proportion of the value of houses because they felt that house prices would continue to rise. This meant that when the bubble burst and house prices fell, a lot of borrowers had debts that were greater than the value of their houses. So defaults started to increase and that created big problems for banks.
At that point Jim interrupted. “I know all that”, he said, “what I don’t understand is why the governments didn’t just let the rotten banks fail”. I explained that the financial system had become like a house of cards, built on the expectation that some financial institutions were too big to fail. When the U.S. government let one bank collapse, this led to a crisis of confidence in the whole financial system.
Jim looked skeptical. “You still haven’t answered my question”, he said. “How can governments solve the problem by creating budget deficits? Doesn’t this just make the problem worse for countries that have been living beyond their means. Shouldn’t they be living within their means rather than going further into debt?”
I told Jim that I thought that was a good point, but the problem was how to get from where we are now to where we want to be. I suggested that the idea behind what governments were attempting to do was not stupid because they were trying to restore confidence and to avoid increased unemployment. I said that if you look at an economy and see a lot of people becoming unemployed and a lot of spare capacity emerging, this suggests that consumer demand is too low, not too high. I also explained that governments don’t actually have to go into debt to fund their deficits. They have the power to create the additional money that they spend.
Jim then looked alarmed. “Do you mean that they might use the printing presses like Robert Mugabe does? So we could end up with hyperinflation like in Zimbabwe?”
I tried to calm Jim down by telling him that at the moment a lot of economists – those who know about these things - seem to be more worried about deflation than inflation. They are worried that we might get stuck in a situation like that in Japan in the 1990s, with falling prices and economic stagnation. I said that the policy aim was to give economies just enough of a boost to restore economic growth without inflation.
Jim seemed to understand. He said: “So what these economists are trying to do is a bit like getting a satellite into the right orbit – they just want to give the economy the right amount of thrust?” I acknowledged that the policy problem could be a bit like that.
Jim smiled before he added: “Yeah, well I reckon that’s the problem with you economists. You think you are f***ing rocket scientists!”
I had the feeling that I would not like Jim’s question, so I mentioned that I had retired. Jim pretended not to hear. He said: “The current financial crisis was caused by too much debt wasn’t it? Before I could respond, he had added: “So, tell me how the world’s governments are going to solve the problem by having bigger budget deficits and more debt?”
I tried to get out of answering by saying that I didn’t know much about short-term macro-economic management. That response didn’t satisfy Jim. He said: “Come on, you must have some idea about what governments are trying to achieve.”
I started my explanation by going back to the cause of the problem. Making my explanation as simple as possible, I said that the problem had arisen basically because lending institutions in the U.S. thought that it was safe to lend a high proportion of the value of houses because they felt that house prices would continue to rise. This meant that when the bubble burst and house prices fell, a lot of borrowers had debts that were greater than the value of their houses. So defaults started to increase and that created big problems for banks.
At that point Jim interrupted. “I know all that”, he said, “what I don’t understand is why the governments didn’t just let the rotten banks fail”. I explained that the financial system had become like a house of cards, built on the expectation that some financial institutions were too big to fail. When the U.S. government let one bank collapse, this led to a crisis of confidence in the whole financial system.
Jim looked skeptical. “You still haven’t answered my question”, he said. “How can governments solve the problem by creating budget deficits? Doesn’t this just make the problem worse for countries that have been living beyond their means. Shouldn’t they be living within their means rather than going further into debt?”
I told Jim that I thought that was a good point, but the problem was how to get from where we are now to where we want to be. I suggested that the idea behind what governments were attempting to do was not stupid because they were trying to restore confidence and to avoid increased unemployment. I said that if you look at an economy and see a lot of people becoming unemployed and a lot of spare capacity emerging, this suggests that consumer demand is too low, not too high. I also explained that governments don’t actually have to go into debt to fund their deficits. They have the power to create the additional money that they spend.
Jim then looked alarmed. “Do you mean that they might use the printing presses like Robert Mugabe does? So we could end up with hyperinflation like in Zimbabwe?”
I tried to calm Jim down by telling him that at the moment a lot of economists – those who know about these things - seem to be more worried about deflation than inflation. They are worried that we might get stuck in a situation like that in Japan in the 1990s, with falling prices and economic stagnation. I said that the policy aim was to give economies just enough of a boost to restore economic growth without inflation.
Jim seemed to understand. He said: “So what these economists are trying to do is a bit like getting a satellite into the right orbit – they just want to give the economy the right amount of thrust?” I acknowledged that the policy problem could be a bit like that.
Jim smiled before he added: “Yeah, well I reckon that’s the problem with you economists. You think you are f***ing rocket scientists!”
Saturday, November 22, 2008
What is the rate of economic growth implied by current equity prices?
There is a standard joke among economists that equity markets have predicted about 10 of the last 5 recessions. As the joke acknowledges, equity prices embody predictions of future earnings and this implies that they also embody predictions of economic growth rates.
So, what is the rate of economic growth implied by current equity prices?
A good way to think about this is to consider why there is a difference between the current average dividend yield (annual dividends per share as a percentage of the current share price) and the real bond yield (bond yield minus expected inflation rate). This difference is required to cover two elements: the equity risk premium and the expected future rate of growth in dividends. If it is reasonable to assume that the expected rate of growth in dividends will be equal to the rate of economic growth over the longer term, the market’s expected rate of economic growth is given by:
y = (r – p) + x – d
where: y = expected real GDP growth rate;
(r – p) = real long term bond yield;
x = the equity risk premium; and
d = dividend yield.
So, it is a simple matter to calculate y if we know r, p, x and d. Unfortunately, however, there are a couple of thorny issues that need to be considered regarding appropriate numbers to use for the real bond yield and the equity risk premium.
When I last looked at this question (about five years ago) I decided that it would be more appropriate to use a long term average real bond yield than a current real bond yield. If the current bond yield is used, the results seem to become unduly sensitive to current monetary policy settings. In my calculations for Australia I used a real bond yield of 4.5 percent.
What rate of equity risk premium is appropriate? The equity risk premium is one of the few topics for which it could actually be reasonable to claim that if you laid all economists end to end, they still would not reach a conclusion. To cut a long story very short, I used the average equity risk premium implied by the relationship between GDP growth rates, average real bond yields and average dividend yields in Australia over the previous 20 years. This implied an equity risk premium of about 3.3 percent. (I am prepared to make available an unpublished paper discussing the methodology to anyone requesting it by email.)
When I did the arithmetic with the dividend yield prevailing in August 2003 (4.3 percent), I came to the conclusion that the expected real GDP growth rate for Australia implied by then current equity prices was 3.5 percent per annum. Since this was only marginally above the average growth rate for the previous 20 years, it did not seem to me to be unduly optimistic.
When I do this arithmetic now, with the current average dividend yield (6.6 percent on 18 November, 2008), it suggests that the expected real GDP growth rate for Australia implied by current equity prices is 1.2 percent per annum. That seems to me to imply that current share prices in Australia embody an unduly pessimistic view of longer term economic growth prospects.
Health warning:
There is a rumour going around among former work colleagues that when I was living off my earnings as an economic consultant I was heard to say, more than once, that free economic advice was not worth much. That rumour is true, but I have since changed my opinion. There is no truth at all in the rumour that I have been heard expressing the view that there are three kinds of economists: those who can count and those who can’t. I tried to say that once, but I ended up saying that I didn’t know whether I should be considered to be in the first or second category.
So, what is the rate of economic growth implied by current equity prices?
A good way to think about this is to consider why there is a difference between the current average dividend yield (annual dividends per share as a percentage of the current share price) and the real bond yield (bond yield minus expected inflation rate). This difference is required to cover two elements: the equity risk premium and the expected future rate of growth in dividends. If it is reasonable to assume that the expected rate of growth in dividends will be equal to the rate of economic growth over the longer term, the market’s expected rate of economic growth is given by:
y = (r – p) + x – d
where: y = expected real GDP growth rate;
(r – p) = real long term bond yield;
x = the equity risk premium; and
d = dividend yield.
So, it is a simple matter to calculate y if we know r, p, x and d. Unfortunately, however, there are a couple of thorny issues that need to be considered regarding appropriate numbers to use for the real bond yield and the equity risk premium.
When I last looked at this question (about five years ago) I decided that it would be more appropriate to use a long term average real bond yield than a current real bond yield. If the current bond yield is used, the results seem to become unduly sensitive to current monetary policy settings. In my calculations for Australia I used a real bond yield of 4.5 percent.
What rate of equity risk premium is appropriate? The equity risk premium is one of the few topics for which it could actually be reasonable to claim that if you laid all economists end to end, they still would not reach a conclusion. To cut a long story very short, I used the average equity risk premium implied by the relationship between GDP growth rates, average real bond yields and average dividend yields in Australia over the previous 20 years. This implied an equity risk premium of about 3.3 percent. (I am prepared to make available an unpublished paper discussing the methodology to anyone requesting it by email.)
When I did the arithmetic with the dividend yield prevailing in August 2003 (4.3 percent), I came to the conclusion that the expected real GDP growth rate for Australia implied by then current equity prices was 3.5 percent per annum. Since this was only marginally above the average growth rate for the previous 20 years, it did not seem to me to be unduly optimistic.
When I do this arithmetic now, with the current average dividend yield (6.6 percent on 18 November, 2008), it suggests that the expected real GDP growth rate for Australia implied by current equity prices is 1.2 percent per annum. That seems to me to imply that current share prices in Australia embody an unduly pessimistic view of longer term economic growth prospects.
Health warning:
There is a rumour going around among former work colleagues that when I was living off my earnings as an economic consultant I was heard to say, more than once, that free economic advice was not worth much. That rumour is true, but I have since changed my opinion. There is no truth at all in the rumour that I have been heard expressing the view that there are three kinds of economists: those who can count and those who can’t. I tried to say that once, but I ended up saying that I didn’t know whether I should be considered to be in the first or second category.
Tuesday, November 18, 2008
Does the free market corrode moral character?
The Templeton Foundation recently asked 13 leading scholars and public figures to provide their answers to this question (here).
It seems to me that the main points in the answers can be summarised (very briefly) as follows:
· Free markets are inherently good because they reflect personal choices.
· Other systems, e.g. provision of goods via political processes, tend to result in worse moral outcomes because they lack competitive disciplines and are more prone to corruption.
· The outcomes of market processes reflect (and perhaps amplify) the values that people hold. Moral decadence is not the only possible outcome.
· Participation in mutually beneficial exchange encourages trustworthy behaviour and increased trust. Markets tend to reward diligence, good judgement and prudence.
· Market incentives and competitive pressures sometimes encourage people to act imprudently and to break moral codes.
· Markets tend to undermine some traditional values.
· Markets widen our circle of empathy. As a result of globalisation people in different parts the world come to view each other as business partners and friends.
Some of these points are more valid than others, but all seem familiar. In a contribution on his blog, however, Will Wilkinson sketched out what seems to me to be a new way of thinking about some of these issues (here). My interpretation of his argument is that shifts in the moral norms that are required as the means to achieve moral ends (longevity, health, wealth, happiness etc) are inevitable as the market system finds ways to achieve these ends more effectively. The process is analogous to technological innovation, except what is involved is a shift in the socio-economic structure that is the means of achieving moral ends, rather than a change in technology. Market processes corrode traditional moral norms, but this is an integral part of moral progress.
Loyalty could be an example of a traditional norm that has become less valued in many contexts. There was a time when tribal loyalty was of the utmost importance to the survival of kith and kin, but this has become irrelevant in modern societies. With increased mobility, loyalty to particular communities and employers is probably not as important as it once was. Greater value may be placed on such characteristics as emotional intelligence or ability to adapt to different social and work environments.
However, it seems to me that the corrosion of traditional moral norms by markets cannot always be viewed as benign. For example, I doubt whether anyone ever benefits from allowing modes of thought and action characteristic of the market (e.g. strict reciprocity) to contaminate their most intimate relationships. As Jerry Muller has shown, concerns that market norms might permeate all human behaviour have been a common cause of concern about free markets over the last few centuries (previously discussed here).
In any case, why should every real or imagined tendency toward undesirable corrosion of moral character be attributed to free markets? The obvious point that many people do not seem to recognise is that we do not have free markets. With regard to the current financial crisis, can the imprudent behaviour of major lending institutions be attributed to free markets when there has been a long history of bailouts of financial firms whose failure could possibly have threatened confidence in the financial system? Can the short-termism associated with senior executive remuneration packages be attributed to free markets without considering the effects of tax considerations on the way these packages have been structured?
It seems to me that the main points in the answers can be summarised (very briefly) as follows:
· Free markets are inherently good because they reflect personal choices.
· Other systems, e.g. provision of goods via political processes, tend to result in worse moral outcomes because they lack competitive disciplines and are more prone to corruption.
· The outcomes of market processes reflect (and perhaps amplify) the values that people hold. Moral decadence is not the only possible outcome.
· Participation in mutually beneficial exchange encourages trustworthy behaviour and increased trust. Markets tend to reward diligence, good judgement and prudence.
· Market incentives and competitive pressures sometimes encourage people to act imprudently and to break moral codes.
· Markets tend to undermine some traditional values.
· Markets widen our circle of empathy. As a result of globalisation people in different parts the world come to view each other as business partners and friends.
Some of these points are more valid than others, but all seem familiar. In a contribution on his blog, however, Will Wilkinson sketched out what seems to me to be a new way of thinking about some of these issues (here). My interpretation of his argument is that shifts in the moral norms that are required as the means to achieve moral ends (longevity, health, wealth, happiness etc) are inevitable as the market system finds ways to achieve these ends more effectively. The process is analogous to technological innovation, except what is involved is a shift in the socio-economic structure that is the means of achieving moral ends, rather than a change in technology. Market processes corrode traditional moral norms, but this is an integral part of moral progress.
Loyalty could be an example of a traditional norm that has become less valued in many contexts. There was a time when tribal loyalty was of the utmost importance to the survival of kith and kin, but this has become irrelevant in modern societies. With increased mobility, loyalty to particular communities and employers is probably not as important as it once was. Greater value may be placed on such characteristics as emotional intelligence or ability to adapt to different social and work environments.
However, it seems to me that the corrosion of traditional moral norms by markets cannot always be viewed as benign. For example, I doubt whether anyone ever benefits from allowing modes of thought and action characteristic of the market (e.g. strict reciprocity) to contaminate their most intimate relationships. As Jerry Muller has shown, concerns that market norms might permeate all human behaviour have been a common cause of concern about free markets over the last few centuries (previously discussed here).
* * *
In any case, why should every real or imagined tendency toward undesirable corrosion of moral character be attributed to free markets? The obvious point that many people do not seem to recognise is that we do not have free markets. With regard to the current financial crisis, can the imprudent behaviour of major lending institutions be attributed to free markets when there has been a long history of bailouts of financial firms whose failure could possibly have threatened confidence in the financial system? Can the short-termism associated with senior executive remuneration packages be attributed to free markets without considering the effects of tax considerations on the way these packages have been structured?
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