Sunday, November 1, 2009

Education Serial Malinvestment

I was reading a post from Mish the other day about education malinvestment and wondered if I could model it. But first let me re-post the letter that started Mish off.

When I attended law school at George Washington U in 1969, the tuition was $1,900 a semester. I worked my way through and had no debts when I began to practice law.
Later, student loans became the norm. The loans were subsidized, encouraging students to become indebted rather than build sweat equity in themselves. Student loans also took parents off the hook for saving to pay for their childrens’ education. The result was still more government dependency.

Screwing up the marketplace with subsidies, drove up the price of education, encouraged institutions to grow based on government support, and placed undue emphasis (economically) on higher and frequently useless education.
We should expect the higher education market to suffer a similar fate to the real estate market, where subsidies, encouraging people to buy what they could not afford (and did not need) led them to a result that, when compared to their investment in time and treasure, was uneconomical.
Eugene Holloway

It seems like a very logical argument, but then I wanted to check what the real price was by inflating via CPI, and also comparing median household income for college graduates in 1969 to today.

He said that it cost 1,900 per semester and the price level has risen 487.52% since them, so in terms today that is $9,262.88. This is 617 dollars per credit hour assuming a full time course load of 15 credits. In my last year in my MBA at a private university the tuition was 1,040 a credit hour so even controlling for inflation the price for a graduate education has risen faster than other prices. [The premium is 68.56%] However, this is only one side of the puzzle, we also need to see what the income level has risen to as well.

With an advance degree the Census shows that in 2000 earned 55,242. The historical data set is not great for tracking down incomes by levels of education. However, in 2000 the median household earned 41,990, so there is a 31.56% premium for the advanced degree. The data set only goes back to 1975 but keeping the same premium when the 1975 median income was 11,800 is $15,524 for an advanced degree. When we inflate the salary so as to make an apples to apples comparison we then find out that the 1975 graduate salary would be $51,705. So there has been an increase in return to attaining a higher degree, but the premium here is 6.84%.

The veil of prices is very tricky. It is easy to allow yourself to look at an old bill and then compare it to one today, but you have fooled yourself since prices of goods and services including most importantly the wage portion of services have increased over time. On this basis, people who have an advanced degree today are better off than those that gained one back in the early 1970s.

Master’s Degree Cost: 64 credits









After tax Monthly Income



Student Loan Cost



% of Monthly Income



As you can see it becomes a little gray as to whether it is a good choice or not. It is a high amount of your disposable income but I also assume that it is paid back in 15 years, whereas these loans can be strecthed to 30 and even 40 years in some cases. It also depends on your cynicism to decide if getting a good job is more like winning a lottery than merit and skills based.

However, this recession might not be the same as previous versions. Salaries might plummet due to the supply of willing labor that hunts for employment. It will be interesting to watch this unfold over the next few years to see if this cohort of graduate students did make a bad economic bargain by going into debt to gain further education.

One of the key teachings that I received during my MBA was from my grouchy advanced finance teacher, by advanced I mean he taught the investment course and the futures & options course. Basically, he called us all idiots. He said and I quote, you make a bargain and you go into debt. You have a certain amount of payments to make at certain times. That's fine. However, you have no idea what your income is going to be. You could have a high-flying job and then get laid off. You may never attain the MBA salary, but it does not matter you still have that debt. The debt does not care and you have to pay it each month. The key is to keep your debt as low as possible so that when fate invariably intervenes with your income statement you can still make those payments until better economic times come back.

On to the model.

Here is the basic supply and demand curve shown along the price and quantity axis.

The government hopes by subsidizing the student loan market, which is a noble cause because having a better educated workforce not only makes for a better electorate but also is one of the only way that advanced economies can continue growth, will increase the supply of schools offering education.


What we are seeing is an inducement for people to take on more education and the price rising. (This is not scaled at all, just showing the move.) So more students are getting degrees but Harvard can only hand out so many a year, thus, the cost must rise.

In truth what is happening is a little of both. Anectdotal evidence when I was obtaining my undergraduate degree at the University of Florida, the only "real" choices in the state was there or Florida State (that is if you did not get into Florida). Now, however, there are comparable educations offered at Central Florida, South Florida, there is a new university in Southwest Florida. So the state system has expanded to accept more students but prices have still risen. So the way I see it, I would model it like this...

How do I know this is correct? Here is the student population for each year of undergraduates and graduates.

You can see that even though prices have gone up by about roughly 60% the undergraduate population has grown by 238.36% and the population of the graduate students has risen 322.46%. Except for the total US population has grown over time as well, so we would need to control for that as well.

So the number belie Mr Holloway's argument and augment mine. Yes, prices have risen but the median salary for college educated workers has risen as well. The population is better off than it was before. The aggregate numbers of students has grown almost 3x as much the price difference meaning that higher learning schools are responding to the inducement to take on more students via financial aid, but it also shows that the demand is rising as well because of the government's program.

As I stated above and in other posts there are only a few "things" in an economy that can improve GDP and the standard of living for a country. For advanced countries there are even less because they will have already exhausted some of their natural resources and fully employed their labor. The last main way to better itself is through technology inlcuding the advancement of knowledge to have a better trained work force that is more productive.

While any program can invariably be run better; the Federal Student loan program has been a success on the whole for students have made use of it.

Thursday, October 29, 2009

I hope this is not affirmation bias...

This discussion follows up nicely with Rosenberg's piece from earlier.

Employment: Some slides

Brad DeLong with no commentary provides these slides on his website.

This is what happens when you find a stranger in the Alps

Google announces a GPS system and down goes Garmin and Tom Tom.

A Gold Idea

Source Tudor Management

This is a chart that shows the market cap of gold in relation to the global money supply [blue](proxied by M2 of the G-20) and the US money supply [orange.] So relatively the metal is still cheap, even despite it's recent run up.

I took a long position in it in mid-December 2008 and feel it will be a good hedge until we (the market) can determine the austerity of the monetary/fiscal/political regimes in place around the globe. For a quick example of my dire view of the regimes here is David Rosenberg commenting on the US,

The government thought it could buy some time with this gimmick but of the 690,000 units that got sold, only 125,000 or less than 20% were truly incremental buying (according to In other word, the payback on future sales performance is going to be significant. Instead of wasting time and money trying to prevent households from kicking the spending and borrowing habit, shouldn’t the government be concentrating on helping the population save for retirement; helping the youth solve this 20%+ unemployment rate; finding ways in the fiscal system to promote growth in the capital stock, and improve skills and productivity enhancement?

That fact that equity markets are anal over whether an $8,000 tax credit for first-time buyers is extended or not should not be the focus of policymakers because this subsidy does not address the real fundamental problems in the economy, which is a defunct credit system, a jobs crisis, an massive overhang of vacant homes, apartments, shopping malls and office buildings — not to mention an economy that is becoming dangerously addicted to government
stimulus. As an example of what the government can do without adding further to what is already a burdensome debt load is to reverse the dramatic downtrend in skilled-worker immigration flows (have a look at the front page of the WSJ — slump Sinks Visa Program). Part of the problem — “the anti-immigrant tide in Washington.”

We see on page 2 of the FT, that the Obama team is now contemplating tax credits for new jobs created by companies — a gimmick that Jimmy Carter tried in the late 1970s (if we recall, two recessions followed quickly thereafter). But are companies really lacking in cash right now? Is that why they are not hiring, or is it a subdued and generally uncertain economic outlook? Or the fact that bank credit is contracting at a 15% annual rate and impairing the small business
sector’s ability to secure working capital. Or maybe domestic demand is just plain soft, notwithstanding a brief Q3 bump. A company may well use a tax credit from Uncle Sam to hire a worker, but if business is slow, what is the new worker going to do? File papers? Clip booklets? How does that add to productivity growth? The country needs a job and skills strategy for the future and here we have politicians still pulling out tired gimmicks from failed
presidencies. No wonder confidence is as low as it is.

We may seem overly critical, but if all this fiscal short-termism is what we can expect out of the Washington economic brain trust, then the prospect for a durable economic recovery and the transition to the next sustainable expansion will prove even more elusive than we currently think. The deficit is already 10% of GDP and government debt as a share of GDP is quickly approaching the 100% milestone. The budget plan for the future, at this point, has to be
carefully thought out because we are running out of fiscal bullets.

A Good idea

The House has released its proposal for financial regulatory reform. While some of it is dicey, including the Resolution Fund (it charges fees to the surviving firms to pay for the failed firm) and also the wind down provision specifically excludes secured bond holders. All in all it is rather vague, which given the history means the regulators will have the tools but not the will to enforce the law.

This particular section though, was pretty spot on in regards to securitization.
Credit Risk Retention I have thought all along that the originate-to-distribute model was flawed because it favored applying teaser rates to allow the borrower to make the minimum amount of payments necessary to then sell their loan asset into the securitized pool. It will be interesting to see, again the wording is vague, how this portion gets hammered out. It's one thing if the pools, is just that a pool which pays out regular cash flows. However, if the pool is tranched so that i-bank can create super senior tranches all the way down to the equity tranche, then what portion will the originator have to keep. Would it be just the equity portion which suffers first loss or will it be a portion of each tranche? (If you have no idea what I am talking about with tranching please click here for a primer.)


Wednesday, October 28, 2009

Correlation, correlation but where art thou causation

This chart is produced from a data set kept by Yale and Robert Shiller. It shows the 10 year price earning ratio in a scatter chart plotted against the actual 10 year return.

It looks like it could be follow a logarithmic or power law function, and is definitely not linear.

However, we can see that as the PE level is lower the returns are higher. So I made another chart just showing the different levels of PE <5,>25. Here it is.

So while each section has a considerable range between its high and low points, you see lower highs and lower lows as you move from left to right. So this Shiller might be on to something.

Currently Mr. Shiller's has us at 19.48, at the market low in March we briefly nuzzled 13.32 so in the 6 month expansion we have seen the multiple increase by 6x!!!

Last chart

So you can see the bubbles like in 1929 and 2000 were all caused by multiple expansion, as they correlate tightly in those periods. However, in more recent times (2003 - 2007) you can see that earnings kept growing while the price of the index rose in accordance [the P/E line is flat while the red index line moves upward] Finally, as I stated above this last move seems to be all about the multiple expansion as opposed to real growth prospects.

I'd be happy to keep up momentum trading for awhile, even after this week's set back but I think we will test the 750 level again before the Great Recession is over.

Life as a Consumer

Yuppie 911 is a darkly amusing side effect of our lives as a consumer.

The Grand Canyon's Royal Arch loop, the National Park Service warns, "has a million ways to get into serious trouble" for those lacking skill and good judgment. One evening the fathers-and-sons team activated their beacon when they ran out of water.

Rescuers, who did not know the nature of the call, could not launch the helicopter until morning. When the rescuers arrived, the group had found a stream and declined help.

That night, they activated the emergency beacon again. This time the Arizona Department of Public Safety helicopter, which has night vision capabilities, launched into emergency mode.

When rescuers found them, the hikers were worried they might become dehydrated because the water they found tasted salty. They declined an evacuation, and the crew left water.

The following morning the group called for help again. This time, according to a park service report, rescuers took them out and cited the leader for "creating a hazardous condition" for the rescue teams.

Just goes to show, that as emergency services become accessible it needs to have consequences just like 911. Prank calls to 911 can result in arrest and fines, therefore it would make sense to apply those same rules and punishments to calls to rescue services. As a benevolent dictator, I would first outlaw the beacons. The emergency service provider cannot speak with the signaler, so there is no way of knowing what the emergency is or how critical the situation is, thus they are inherently dangerous and expensive tools. Then once the service is set up via sat-phones or regular cellular phones let calls for rescues because of "salty water" be faced with fines and repayments of the cost of rescue personnel and equipment.

Basically, these signaling devices have removed the fear that you can get into trouble in the wilderness, so that people take risks that they might not take if they did not have the safety device. It is what an economist might call a moral hazard. Another interesting take is called the Tullock effect.

Strategic Non-Foreclosure

Just saw this! Pretty strong affirmation of my post "Lifecycle of Bad Mortgages Surprisingly Uncorrelated"

Strategic Non-Foreclosure: "

This morning, we discussed Strategic Mortgage Default. This afternoon, let’s look at Strategic Non-Foreclosure.

Data via LPS‘ Monthly Mortgage Monitor shows a growing disparity between delinquencies and foreclosure starts. In other words, as more people fall behind on their mortgages, banks are becoming increasingly leery of putting them into foreclosure.

LPS calls this “Shadow Foreclosure Inventory” – The number of loans deteriorating further into delinquent status is more than twice the volume of foreclosure starts.

Why would they wait? Some of it is voluntary foreclosure abatement, some mortgage mod delays. Yet the chart below implies something beyond that. Perhaps its strategic.

Consider: The bank may have other (more expensive?) local properties that would be effected by a foreclosure. They may be waiting for a more advantageous time of year to put the homes up for sale. But I suspect the biggest reason are costs: Until foreclosure, the nominal owner remains liable for all state, real estate and local school taxes. Plus, some localities require regular maintenance (mow yard, clean street, shovel sidewalk, etc.)

Hence, not foreclosing not only gives the owner time to get current, but may also prevent the bank from accruing expenses . . .

Here is LPS chart:


click for larger graph

Shadow Foreclosure Inventory

Data as of September 30, 2009 Month-end


As Annaly Salvos notes:

“As the graph illustrates, delinquencies are rising, but foreclosure starts are not. As of September 2009, 90+deterioration more than doubled actual foreclosure starts. LPS has dubbed this “shadow foreclosure inventory.” Higher unemployment begets delinquencies and defaults, but foreclosures aren’t flowing through due to modification efforts and various moratoria. Depending on the success of programs like HAMP, more than a few of these loans are still destined for foreclosure.”

Good stuff.


Hat tip Scott F!


September 2009 Mortgage Performance Observations

LPS Mortgage Monitor, October 15, 2009

Who Knows What Evil Lurks In The Hearts of Men?

Annaly Salvos

October 27th, 2009


Tuesday, October 27, 2009

Serial Inventory Growth (Home Edition)

I live to read David Rosenberg's daily missives, so you can imagine my disappointment on Thursday when he said he was not going to be posting one on Friday morning. Well, he made up for it in spades on Monday.

I just wanted to highlight one section though he sent a 16 pager and it is about a topic that I have been fascinated by, housing inventory.

David presents this as his ultimate rebuff of the NAR's exciting existing home sales report on Monday. Along with this musing "which dragged the months’ supply to 7.8 from 9.3 in July and August and the 11.3 months’ peak in April 2008. This may seem like a great level, but keep in
mind that during more normal market conditions, the average months’ supply is between 4.5 and 5.0 months. However, this could be the calm before the storm as first-time homebuyers rush into the housing market to take advantage of the $8,000 tax credit that is about to expire that the end of November. According to the National Association of Realtors, this is indeed what is happening – “first- time home buyers accounted for more than 45% of home sales during the past year…”

David points out that Census bureau keeps track of year round vacant housing units, which is currently at 3.5 million homes. Additionally, 300,000 homes are being foreclosed on each month. So instead of looking at the drop of month's supply of housing from 9.3 to 7.8, what we really have is 15 months, and growing, supply of homes. Ouch!

Looks like I will be a serial renter for awhile longer.

AD & AS in concert and in dischord

Shifts in Aggregate Demand
First, we begin with a chart.

This chart shows the Aggregate Demand (AD) curve, the Aggregate Supply (AS) curve and the Long Run Aggregate Supply (LRAS) curve. Currently, it is in equilibrium with the price level at the natural rate of output of the economy. From our previous posts, we know that the AS and AD curves can shift, which will cause short term fluctuations in the economy. Now we can use this model to explore why things happen, like they did in 2007 and 2008.

So let's examine the recent crisis, more closely. In a nutshell, loans were given to bad credit risks with little to no documentation because in the originate to distribute model, the borrower would only need to meet a minimum amount of payments before the loans could be sold to investors. Investors, relying on the advice of credit rating agencies, believed that the securitized pools offered superior returns for the high credit ratings and bought these investments. After, it was revealed that most of these investments were, when the tide rolled out swimming naked. This caused people to stop consuming and start saving as their financial asset portfolio and housing investments were no longer worth as much as was believed. Thus, the chart.

Here you can see that AD curve shifts downward [to the left] to a new equilibrium in the short run but that there is an output gap between what the economy can normally produce. We saw this when looking at the CBO's GDP projections, shown here.

You can picture that the gap between the actual GDP in black and the thinner natural output line is the same in the chart above where it is shown the gap between short run equilibrium and its gap from the darker red line which indicates the natural output of the economy. Eventually, [shown below] the gap will close again just like in the CBO's projections.

Here the output gap is closed by the short term AS curve adjusting to the new pricing paradigm as the veil of prices is lifted. Stated another way, as the costs of goods/services decline workers will not need as great a wage to maintain their standard of living. The workers will then return to work at the new lower wage and capacity in the economy will return to normal.

All of the above assumes that policymakers do nothing. That is, if they followed an Austrian School of Thought, that any policy will invariably make matters worse and instead the free market should be allowed to work to clear prices. Instead, what usually happens, is that policymakers tend to use fiscal and monetary stimulus to stop the process at price equilibrium 2 and return it to price equilibrium 1.

Again, usually, the Federal Reserve will act first to loosen the money supply, which through the financial system will drop interest rates making it more attractive to buy capital goods via financing and will make business opportunities more attractive. If this does not work, then in concert, the fiscal authorities can undertake stimulus by borrowing when the private sector will not, to invest in capital goods. This should have a multiplier effect in that companies hired by the government will then give money to their employees who then spend it on consumption ... until economic growth ensues.

Shifts in Aggregate Supply
This usually comes about in changes in the cost of production to firms. There is some interesting work done by Professor Jim Hamilton in this area with regards to oil and the global economy, a post is here, so we will run with it. In his post, he uses econometrics to describe the global economy and its growth from 2004 to 2008. He shows that the price of oil could have risen to 142 dollars per barrel on fundamentals alone. This cost shock affects many areas of the economy because oil is not only used to transport so many goods around the globe but it literally makes up goods as well.

Some examples,
products that contain petroleum that could be affected by oil prices: Antiseptics, Baby strollers, Balloons, Bandages, Cameras, Candles, Clothing, CDs and DVDs, Computers, Crayons, Dentures, Deodorant, Diapers, Food preservatives, Garbage bags, Glue, Hair dryers, Ink, Insecticides, Medical equipment, Nylon rope, Pacemakers, Photographs, Roofing, Shampoo, Shaving cream, Soft contact lenses, Telephones, Toothpaste, Toys, Vitamin capsules. Source: Ohio Petroleum Council

So the tripling of oil prices would shift the AS curve to the left, which is to state that the cost of production is higher at any price level. This causes an output gap and perhaps even more perversely, prices rise. As shown in the chart below.

We can see this in actual practice by looking at a chart from Dr. Hamilton.

Here the natural rate of output is the green dotted line and the back line is the actual. You can see that the professor's model does an accurate job of describing the oil shock and its affect on GDP.

So now what happens. Well a couple of things can happen:

The natural rate of output of the economy could fall permanently, this would shift the dark red LR AS curve to the left to meet the new price point.

Alternatively, the government can stoke AD curve [via the same mechanisms described above] so that the equilibrium rises to the natural rate of output again but at the cost of permanently higher cost of goods/services.

Finally, the sticky wage theory would propose a scenario like this: because the economy is stagnating but at the same time shows inflation, herein called stagflation, the workers will see their cost of living declining and demand higher wages to compensate them. Firms will lose more money as the cost of goods/services (inputs) continue to rise, called the wage-price spiral. Eventually, the under-utilization (output gap) though will cause more workers to be unemployed. Unemployed workers will work for less thus dropping the costs to firms and make it more profitable to produce more goods. Eventually you return to the original price equilibrium 1.

Economic Odds and Ends

Great chart from Calculated Risk

I had looked at this earlier with total borrowing but this chart focuses solely on the mortgage market. Here you can see how securitization really takes hold at the end of 2004 through 2006, somewhere in the order of 40% of the market. Since then there was a switch into bank portfolio loans as the securitizations came onto the bank's balance sheets, and finally the current state where the GSEs (Frannie and Ginnie) now make up 90+% of the market.

Good annotated chart from Mish Shedlock

Here you can clearly see the dichotomy of the recessions pre-1982 and post and it is a tale of two eras. Job recoveries have always been a "lagging indicator," but I wonder now if NBER calls the end of the recession too soon [queue conspiracy theorists "Nothing to see here. Move along."] So the recession of the 90's and the twin killings in the 2000's have both had job losses continue into the recovery. We should expect that job losses will continue into 2010 and possible 2011, most likely with an upper limit of over 10.5%, that is on the U-3 number. If you look at the broader unemployment situation ( underemployed, discouraged, part time, etc) we are already nearing the 20% mark.

Serial Solipsism

Not too long after watching The Century of the Self along comes a new take, in a different field, presenting the same symptoms that the documentary does. In the first paragraph the author has you imagine other people and their pain; how it does not bother you. However, if you were one of the people in pain then it would become significant. Thus, your own pleasure and pain are more significant to you than anyone else. You are egocentric, you are a consumer, who votes and buys what is best for yourself; which leaves the task of squaring our recurring self-interest with the common good, day after day.

Caspar Hare would like you to try a thought experiment. Consider that 100,000 people around the world tomorrow will suffer epileptic seizures. "That probably doesn't trouble you tremendously," says Hare, an associate professor in MIT's Department of Linguistics and Philosophy.

Now imagine that one those 100,000 people will be you. "In that case you probably would be troubled," observes Hare, speaking in his office. If this is your reaction, he says, "You regard you own pleasures and pains as being especially significant." Which seems natural, Hare adds. "We have a tendency to think that what we care about is important in and of itself."

Yet this tendency creates an apparent inconsistency. You cannot claim your own well-being is uniquely meaningful, more important than the well-being of others, and expect anyone else to regard that notion as an objective fact, something that could be part of a universally acceptable morality.

How should we reconcile these differing perspectives? In recent decades, many philosophers have dismissed our self-interest as a kind of illusion. Indeed, a major current of contemporary thinking has questioned whether a stable "self" exists at all. "We are not what we believe," the British philosopher Derek Parfit has written. Rather, this view holds, we are nothing more than ever-shifting collections of mental and physiological states, lacking a definite, lasting identity.

The joy of solipsism

Hare has leaped into this philosophical fray with a distinctly different view, which he outlines in his new book, "On Myself, and Other, Less Important Subjects," published this fall by Princeton University Press. The fact that we care so much about ourselves, Hare thinks, tells us something deep about the world: It is correct after all, he believes, to regard our pleasures and pains as uniquely important among all pleasures and pains in the universe.

So if we think our self-interest is singularly significant, we are not being fooled. Instead, the fact that we know ourselves best reinforces our sense of individuality over time; we do have stable identities, and our minds are more than a shifting kaleidoscope of impressions. Our ability to make moral judgments flows from this fact.

On the other hand, Hare asserts, our minds are independent enough from the rest of the world that, when other people state their pleasures and pains are present, we should not regard their statements as true. Instead, Hare writes, we should regard those claims as "false, but rightly so."

In so arguing, Hare is reviving the philosophical concept of solipsism — the notion that one's own self has a special status in the world. More specifically, Hare claims in his book that we exist in a mildly solipsistic state he calls "egocentric presentism." To make sound moral judgments despite this condition, Hare asserts, just takes an act of imagination.

Thus Hare states that of course he would rather that he suffer a hangnail than that someone else's leg be crushed, even knowing the other person's pain would not be present. "For an egocentric presentist," writes Hare, "empathizing with an unfortunate [person] involves imagining that the unfortunate has present experiences."

Other philosophers note that Hare's ideas appear counterintuitive. "The argument seems controversial on the surface because it goes against common sense," says Berit Brogaard, an associate professor of philosophy at the Australian National University and the University of Missouri, St. Louis. "There is something eyebrow-raising about it," says Benj Hellie, an associate professor of philosophy at the University of Toronto.

Hare, however, does not think his own theory is radical. "One way to be a solipsist is to insist that other people don't have inner lives," explains Hare. "Another is that there are no other people. But I'm not saying either of these things. I'm not denying that other people exist, are fully conscious, and have brains and minds like my own."

Is universal morality possible?

For this reason, asserts Hare, solipsism need not lead us down a slippery slope into a world where, say, violence toward others could be tolerated. "Even if we give special significance to our own pleasures and pains," says Hare, "we don't go about ruthlessly trying to maximize our own pleasure and others' pain." He calls that "a crude caricature of human psychology," popularized by the 17th-century English philosopher Thomas Hobbes.

We may be self-centered, Hare argues, but not solely moved by self-interest: "It's certainly possible to think your self-interest is important without thinking it's the most important thing in the world." Still, Brogaard, for one, thinks Hare's ideas "are even more extreme" than Hare believes they are. By accepting that we are solipsistic, she believes, we may sacrifice the idea that there is an objective universal morality.

If so, the modestly solipsistic state Hare describes — in which we are still social and moral creatures — represents a trade-off. We may lose our ability to define an objective moral system. But we do have stable selves that can craft moral judgments. "My book is putting perspectival questions back into the ontology, into our picture of the way the world is," says Hare.

That still leaves the task of squaring our recurring self-interest with the common good, day after day. But that is at least a task for which we can each take responsibility, as distinct selves. "Caspar is pointing to a problem we have to come to terms with," says Hellie.

Monday, October 26, 2009

Aggreagte Supply

Back on the 14th I began working on short run models of the economy. The first post focused on Aggregate Demand, now I will continue on to aggregate supply and finally I will work with them to create an equilibrium.

Like the AD line, the AS line tells you how much good/services an economy will provide across the pricing continuum. Most economist believe that in the long run the AS curve is vertical in the long run. This is because it is based upon the natural resources of a country, its capital, its labor and its technology. It relies on these inputs to create output goods & services. Thus, pricing will not really have an effect "in the long run" on what an economy produces. This is because prices are a nominal feature of the economy, if you took two countries with identical economies except A had 3x as much money in circulation as B, then the prices of goods in country A would be three times more expensive but both economies would produce the same amount of output.
However, in the short run the veil of prices may allow for economic fluctuations, which is what this post focuses on.

Here is the chart of the economy in the long run. If the pricing level rises or falls it should not effect the long run output of the economy. However, we might ask what can shift the AS left or right?

Above we mentioned natural resources of a country, its capital, its labor and its technology as factors that can affect the LR AS curve, so we should look at these variables in turn.
  • Natural Resources -not as big an effect on the US at this point, but it is very important for say Mongolia. Basically, as new mineral deposits are found this will shift the curve outward; dwindling reserves, if that happened in Saudi Arabia, would have the opposite effect of shifting AS down.
  • Capital - factories, machines, houses, worker knowledge. Any effect on these variables will affect the LR AS, and it is a perfect correlation. A storm that permanently disables a factory would shift the LR AS curve down, left.
  • Labor - Again a perfect correlation, additions add to the AS curve and subtractions remove from it. If a plague attacks the citizens of France, the loss of workers would shift the AS curve downward [left] as France would no longer be able to produce as much as it had in the past.
  • Technology - additions to technological knowledge will make processes more efficient. This is what has enabled crop yields to double from 1950 to 1980 and triple by 2008. The addition of technology adds to the LR AS curve.

Next, we can see how an economy shifts around in the long run.

As the economy adds technology, workers and capital its LR supply curve shifts outward. Holding everything else equal (ceteris paribus) this will cause prices to decline. [Right chart] However, the Federal Reserve mandate is to maintain price stability, so it will be increasing the monetary supply so that aggregate demand increases in accord with shifts in the AS curve. So in the second graph, we show the secondary effect in red arrows as the Fed adds money to keep prices stable at P1* and P3*.

We can also more importantly view the AS curve in the short term, which is why we have undertaken this post. Economists believe that the supply curve slopes upward (from bottom right to upper left) so that the quantity of goods/services supplied increases with increases in the price level. The theory underpinning this idea, at least the one I subscribe to, is called sticky-wage theory. The idea, is that wages do not adjust to changing economic environments as quickly as the price of other goods/services. One aspect may be contracts, like union contracts, and another might be that firms rarely drop wages and instead tend to lay off workers.

So you can imagine a company that pays it's worker 20 cents for each good it makes, which costs 1 dollar total including the wage. In the upcoming year the price level falls so that the firm receives on average 95 cents. It cannot asks its workers to take the 5% cut in their wages, so it must suffer. Now the company is less profitable, so it may lay off workers and cut capacity. Over time wages will match the new price level but in the meanwhile employment and production remain below its optimal level. Sound familiar workforce 2008?

Thus, you can see since price level has decreased the factory will provide less goods. This of course works in the reverse, if the price level is higher the firm will higher more workers and create more goods.

There are some other theories as well including menu costs (this posits that it takes time for suppliers of goods/services to communicate changes of prices to their customers, like changing the menu board at a fast food restaurant) and mis-perceptions theory (this posits something like gasoline prices at the pump in 2008, when you see those numbers rolling like a slot machine once a week, you think that all prices are rising.) Thus, they conclude that they need to ask more for wages or increase the amount of goods they supply at their job. Both these theories explore why the curve slopes upward.

Now we can ask why the short run AS curve might shift. All three theories should give you some idea that the key in the short run is expectations. If the price level is different than what is expected than the supply curve can either shift outward (gasoline prices rising) or inward based upon what the consumers think that price level will be.

BusinessWeek, I love and despise you

New economic article by BusinessWeek talks about how bottlenecks could cause inflation. Ostensibly a "economic bottleneck" follows the same logic as water through a pipe. It would be limited by the exit of each section of the pipe. If there are not enough factories, or steel or workers than firms will not be able to respond to increased demand. Thus, prices will rise in a short period to allow the market to clear.

Seems plausible, the author even cites James Bullard, President of the St. Louis Federal Reserve Bank in which he points to the stagflation period after the recession in 1974. He states that the Fed at the time overestimated the productive capacity of the economy and inflation resulted until Mr. Volcker killed it in the early 1980s.

Three charts in retort.

This is duration of median unemployment hitting all time highs. These are workers who have not had work in almost 6 months. You think their demands for pay will be higher or lower than that of the workers in the 1975 who had been out of work for 3 months?

Here is the employment-to-population graph. You can see we have a lot of room to fall to hit the level of jobs related to the entire population that we experienced in the 1975 recession.

Finally, you can see here that unemployment rate is also higher than that of the 1970s, also showing that inflationary fears are very dim.

Now the article does take a balanced view of the economic environment. The author still feels that deflation is the bigger threat at this point, but that inflation always needs to be watched. While I can agree with the sentiment, I find it very dull to be espousing this information in this manner to the non-economic audience reading Businessweek. It is a very nuanced argument that needs to be made, just like the one Bullard made that the article cites.

What the Fed is doing is telegraphing its actions for when it actually defeats deflation. There are methods in which it stops buying Treasury securities, where it stops repo'ing [very short term loans to i-banks] collateral, where it stops buying MBS, stops buying Frannie paper and removes reserves from banks by changing the amount of interest it credits to banks. This will remove the monetary stimulus from the economy very quickly, if needs to be, but can also be done at the margin, like a Father guiding the handlebars on his child's bicycle.

Given the last paragraph, I find it very disenginous to discuss inflation to an audience that does not understand what the Fed has done, and is going to do. BW should be cheering on the Federal Reserve and hoping for inflation because deflation is far, far worse.

Sunday, October 25, 2009


I was going to do a post on Existing Home Sales and how they were not up except in a bizarro world. Barry not only got off a rant but then backed it up with another post explaining why his rant was correct. I recommend both of them.

So I'll just put up Calculated Risk's chart of the action.

These are non-seasonally adjusted. CR likes to use the previous 5 years of data for each of the month so you can make a comparison. The thinking is something along the line of month-on-month growth may not tell the whole story because there are underlying reasons why September sales are always lower than August. [It's because people have to move before school year starts to have their children start on time.] Here we can see sales were up year-on-year, which is a positive. However the headline Big Rebound in Existing-Home Sales Shows First-Time Buyer Momentum belies the fact sales actually dropped from August. Also as TBP reports the tax credit is also extending the sales season as buyers are motivated to close before the November deadline. NAR though has skin in the game in distorting the data in a manner which looks the most beneficial to them like Edward Bernays script tells them to do.

Finally, one last idea on existing home sales (EHS) effect on the economy; it is not that big. It is most certainly not as big as a new home sale. A new home sale has raw materials being turned into a sale. EHS are secondary market activity, akin to equities, it just shifts money from one party to another. If the previous owner made renovations and upgraded the home than their is an addition to the capital stock of housing but secondary markets of themselves add little to the economy. [commissions, etc]

Thursday, October 22, 2009

Serial Drivel: Someone new to take over for James C Cooper

I stumbled upon this post from Real Clear Markets via ZeroHedge. A quick aside: I have a love hate relationship with ZeroHedge. They produce some great research but they also engage in yellow journalism without real well thought out analysis as well. A la Hearst, this drives a lot of people to their website. For now the balance is well on the former but this link to RCM was clearly the latter.

The author of this piece is John Tamny. It took some extensive searching to find out who the author is. His signature says he is an economic adviser to two companies but not recognizing the companies, please forgive my ignorance, I continued looking about the intertubes. I found this:
Prior to his present work, Mr. Tamny worked at the Cato Institute, and before that in private wealth management for Credit Suisse and Goldman Sachs. Mr. Tamny received a BA in Government from the University of Texas at Austin, and an MBA from Vanderbilt University's Owen Graduate School of Management. He lives in Washington, D.C.

Now I have an MBA, so I definitely understand the value of the degree, but putting up an MBA grad with a Government undergrad versus a Nobel Prize winning economist, well... maybe he will be agreeing with Mr. Krugman.

1st the headline has Paul Krugman's name and the word myth. This immediately sends off warning bells in my head. I generally follow on economic matters, (not so much political)
Brad DeLong’s Krugman rule:

Rule #1. Paul Krugman is always right.
Rule #2. If you think Paul Krugman is wrong, see Rule #1

Here is an excerpt from the article.
As Krugman put it in the
New York Times, "The truth is that the falling dollar is good news." Krugman's reasoning here is that a weak dollar makes it easier for U.S. companies to export. A nice thought at first glance, but what Krugman ignores is that we can't export unless we're importing, and a weak dollar makes imports more expensive. Trade always balances.

Supposedly, according to John's logic, trade always balances. He seems to posit that imports and exports form an identity, similarly to the idea that National Savings must equal Investment and Net Capital Outflow. I couldn't find any literature anywhere that states this is so, perhaps it is a black swan.

Let's examine this a little further. Let's imagine a steel conglomerate who mines its own ore, processes it and then sells it to the highest bidder. A falling dollar makes this conglomerate's goods cheaper. It sells the goods in the export market and then has euros, or yen in exchange. Now here is where John's logic may come into play. Since it has the yen, it then needs to decide whether to purchase something from Japan or sell the yen to gain dollars which it can pay its employees. The latter is where the fungible nature of money comes into play. However, it seems John believes that it can only be the former. I wonder if he has a model or a chart to back up his assertion.

Back to the article: So while a weak dollar might in the near-term make U.S. goods attractive, the globalization of production means that the costs of the myriad imported inputs that go into the creation of U.S. goods will eventually have to rise. Inflation steals the benefits of devaluation...

So I took the change in dollar's nominal exchange rate and compared it to inflation (computed via CPI) in the United States to see if I could come up with a correlation.

There is a very weak correlation of +0.2, meaning that it can explain 20% of the variation. However, it is in the wrong direction. The plus sign indicates that as the dollar's value increases then inflation occurs, and when it devalues this becomes disinflationary. That cannot be correct, right?

Let's look at a common way to gauge commodity price inflation versus the dollar via oil prices.

Very interesting. Correlation= 0.3. This means that as oil induced inflation was striking the globe the dollar rose to counteract the effects of inflation. From 1973 to 1999 as the oil rose in price so did the dollar, the story at the time was that Europeans and Asians would have to bid up dollars to make their oil purchases. . Seems plausible.

From 2000 to 2008 the correlation rose in reverse -0.8. So as oil price has risen the dollar has fallen in value. Now it is in reverse from the previous period. Although, ostensibly the mechanism has not changed, these same areas of the world are not bidding up the dollar to make their oil purchases. So which is it? Not much can be ascertained.

So let us look somewhere else. Perhaps China, we import a lot from them, right?

In the Blue we have the US$/Yuan and the red line is the price level for imports from China. So we have a 21% rise appreciation of the yuan [restated a 21% devaluation of the dollar] from 2004 to 2007 to a 7% appreciation of the price level. Then the Yuan stopped appreciating, and yet even though apples-to-apples same yuan as the exchange rate hold steady due to their sterilization of dollar purchases, the price level fell making the total change in import price level from 2004 to 2009 3%. 21% devaluation equals 3% rise in prices.

If you accept this argument it seems to be a devaluation brings about a very, very slight increase in prices for Americans including American exporters.

As my friend Walter Sobchak said "Donny, you are out of your element."

John then transgresses into how this import induced inflation affects all manners of the US financial and capitalistic system. He makes a litany of errors confusing real and nominal prices, what capital is and is not, what investment is and is not and finally what saving is and is not. However, you can stop reading because as it has been made abundantly clearly in this essay the foundation John rests his argument upon is made up not only of sand, but quicksand at that.

If there is anything you should take away from today it is this:
Rule #1. Paul Krugman is always right.
Rule #2. If you think Paul Krugman is wrong, see Rule #1

Oh and if you are interested, while I was searching for John's credentials I found these nuggets of wisdom that may make you avoid his opinion. (All were found on the 1st page of Google's search results for his name.)

Lifecycle of bad mortgages, surprisingly uncorrelated

I found this chart at Barry Ritholtz serially excellent website The Big Picture and of course it made me think, a lot.

At first I was just watching the categories swell up as people who took on debt they could not really afford just could not make the monthly payments any more. Then, I wondered about people who just stopped paying once they realized that the house was worth less than the mortgage contract they were paying for it.

Then I realized something else, that the categories are a function of time as well. First there are the thirty days late, which eventually leads to 60 days late, then 90+ days late [that plus sign will be key], then into foreclosure and finally real estate owned [bank owned.]

Now, of course, one category does not guarantee a transition to the following category. One could have a medical emergency, need the cash for a surgery and then hover in 30 day late category. However, there should still be an amount of correlation for the categories. As the 30 days late category rises, so too should the 60 day category and 90 day. In fact as the arrows show all categories do show a positive slope.

In fact, one should expect to see a pig-in-the-python effect. Look at the graph below, a demographic graph of the United States population, and imagine it on its side.
For some reason I cannot animate it. Please click here to see the chart move.

Imagine the 30 days late are the baby boomers. You can see the large effect [pig] they have as they move from the head to the rear of the distribution [python.] We should see the same for the mortgages. Not a perfect correlation because as I said above there are ways to save yourself from the foreclosure route. But...

Instead what I see is really a throughput problem. Let's look at the graph again with some new arrows.

As you can now see I simplified to just two arrows, 30 days late and 90+ days late. I discounted the seemingly aberrational June month for 30 days late. I then started the arrow for 90+ days late at a lag of 4 months because obviously these mortgages would pick up only after the initial delay in payment. What is happening is that the 30 and 60 day loans are making it to 90+ days and then sitting there. Slowly, the foreclosure and REO process is picking up but those two steps are slowing the assembly line down.

So the key issue for investors to consider is the plus. If you are going out an looking for a house right now, you must be cognizant that the banks own tons of houses that are in the 90+ day delinquent status and would be foreclosed upon except the banks do not have the manpower or willpower to further the process. Additionally the 30 day late loans are still rising meaning that even more houses have yet to find the pool of 90+ days late. If the house you are looking at has multiple bidders I would walk away, especially if they are bidding with cash.

Wednesday, October 21, 2009


David Rosenberg of Gluskin Sheff has been railing against the markets expecting a V-shaped recovery. So I went to the CBO to see what a V-shaped recovery would look like and it is below.

Basically from where we are at we would follow the red arrow and see growth rates of over 6.4% to return the economy back to its trend.

Here is where the document is a little suspect as it predicts the return to trend within 5 years which seems to be, um, a tad, convenient. I guess my argument would be more with the angle of the L.

Regardless, the CBO still sees an L-shaped recovery.

So what does the equity market know from reading the economic reports that the CBO does not know?