Month: July 2008

Props to Dean Baker. 

Short-selling can play a very important role in the market. If
informed investors recognize that a stock is over-valued they perform a
valuable service by selling it short and pushing down its stock price.
This can both deprive the company of capital and be a signal to other
actors in the market that the company might not be as healthy as is
generally believed.

The economy would have benefited enormously if large numbers of
traders had shorted Fannie and Freddie 4 years ago when they were
buying up hundreds of billions of mortgages issued to buyers who bought
homes at bubble-inflated prices. This would have stopped the bubble
years ago. Similarly, we could have prevented the financial chaos at
Merrill Lynch, Citigroup, Bear Stearns and the rest, if traders had
recognized their financial shenanigans and aggressively shorted their
stock. In the same vein, heavy shorting by informed investors could
have prevented the boom and bust of the tech bubble.

The decision to intervene against short-selling is completely
inconsistent with the belief in the wisdom of the markets. Of course
short-sellers can be wrong and depress stock prices more than is
justified by fundamentals, but so what? The government doesn’t
intervene when it thinks investors have exaggerated the true value of a
stock. The public has no more reason to fear under-valued stock prices
than over-valued stock prices. This one-sided intervention by SEC is
hard to justify on any grounds.

Wow, we usually think about U.S. bonds as being the "risk-free" asset but with a credit default swap you can buy insurance on a US default and the price of such insurance is way up.

The change in price is a shock but to put things in perspective do note that the price for insuring US debt is now higher than for German debt but similar to that for Japanese and British debt.  We are still far from Argentinian levels.

Hat tip to at, in the comments to my post on the peso problem.

In Nudge Thaler and Sunstein motivate their Save More Tomorrow plan with the following unfortunate illustration:

Consider, for example, the case of Tony Snow, the former White House press secretary, who resigned at age fifty-two in 2007 to return to the private sector.  He said his motivation for leaving was financial.  "I ran out of money," he told reporters…Before serving as press secretary, Snow worked a much more lucrative gig as a Fox News Channel anchor.  But he arrived at the White House not having learned Retirement 101 lessons.  "Snow conceded: ‘As a matter of fact, I was even too dopey to get in on a 401(k).’

Sadly, Snow’s choices now look optimal.  Ok, I know that may be in poor taste but let’s try to rescue this observation with some theorizing.  Are we more likely to commit the error of saving too much or too little?

There are people who don’t save much because they have very low incomes, their behavior does not seem to be in error, especially when we take into consideration the various welfare programs that will cover people in their old age.

So let’s focus on people with moderate to high incomes.  Thaler and Sunstein say that we are more likely to make errors when the benefits are upfront and the costs are delayed.  Eating too much chocolate being a classic example.  Ok, that suggests we may save too little.

T. and S. also argue that the less frequent a decision the more likely are errors.  Frequency, however, cuts both ways – we only die once – so that’s a wash.

Over confidence and in particular the idea that we are special and will live a long life suggests the error is saving too much.  Note that we also tend to think that our partner will be alive as well.  My wife once asked me whether we were saving enough for "our" retirement.  "Sure," I said, "don’t forget one of us will probably die before the other and I’m not saving for your future husband."  "Why," she replied with a sigh, "can’t economists be more human?"   

Availability bias probably also suggests we save too much – we see people who saved too little in the street but the ones who saved too much are dead and gone. 

In theory, optimal saving equalizes the marginal utility of income across one’s lifetime – some programs like Kotlikoff’s ESPlanner attempt to calculate such an eqi-marginal utility flow and Kotlikoff’s finding is that a large fraction of Americans, some 40%, are saving too much.  Kotlikoff’s program takes into account that we may need less wealth when we are old and retired (e.g. less transportation for work related reasons) but not that the marginal utility of wealth may be lower when we are old.  (e.g. Money’s not so valuable if you don’t need it to or can’t use it to attract a mate.)  Thus over-saving may be even more common than Kotlikoff suggests.

I do not know which error is more prevalent but if we are to be neither spendthrift nor miser we need to recognize both types of error.

Over the two previous days oil fell $10.50 a barrel.  By definition this is driven by news about supply and demand but has so much news come out so quickly?

Here are two ways to think about the mechanisms at work.  First, some producers could supply more but they figure that China will be buying more tomorrow so maybe it is better to wait.  If they see a signal that future global demand will be lower, they are less likely to let oil sit in the ground.  In other words the market develops the expectation — true or not — that oil supply will rise more rapidly than had been thought (or "decline less rapidly" may in some cases be a more accurate phrase but the net direction of the effect is the same).  Lower expected demand is thus paired with greater expected supply and that tends to make price volatile.  Higher expected demand is paired with lower expected supply in similar fashion. noting in either case that you can make lots of different assumptions about the relative timing of the expected changes.

Second, any new information leads to more trading and to more trading at different ranges of price and quantity.  This trading reveals more information about the elasticities of market supply and demand curves and that information in turn feeds back into the market price.  In a nutshell, some initial price and quantity movements lead to further price and quantity movements.

Neither of these phenomenon are correctly called "bubbles" but neither do they fit the story where the price of oil is determined by fundamentals alone.  "Expectations" is a central word here, noting that only time will tell whether or not the expectations are rooted in reality or not.

He always had a talent for the bottom line.  On the mortgage agencies he writes:

What went wrong? The illusion that the companies were doing virtuous
work made it impossible to build a political case for serious
regulation. When there were social failures the companies always blamed
their need to perform for the shareholders. When there were business
failures it was always the result of their social obligations.
Government budget discipline was not appropriate because it was always
emphasized that they were "private companies.” But market discipline
was nearly nonexistent given the general perception — now validated —
that their debt was government backed. Little wonder with gains
privatized and losses socialized that the enterprises have gambled
their way into financial catastrophe.

I wonder how general the lesson here might be. My fear is fairly
general. Inherent in the multiple objectives urged for creative
capitalists is a loss of accountability with respect to performance.
The sense that the mission is virtuous is always a great club for
beating down skeptics. When institutions have special responsibilities
it is necessary that they be supported in competition to the detriment
of market efficiency.

It is hard in this world to do well. It is hard to do good. When I
hear a claim that an institution is going to do both, I reach for my
wallet. You should too.

Here is more.  Larry Summers was my professor for Macro II and every lecture was a joy.  "Lecture" isn’t even the right word, it was more like turning on a faucet.

Find them here, hat tip to Tim Harford.

Let’s see what New York Times readers think.  Right now there’s only one comment and it’s not totally encouraging:

Triple the minimum wage.

That would bring it more in line with
increases in efficiency and rates in the late 70s. People make more,
they spend more. All the money is just tied up in investments now, like
bonds in Fannie and Freddie.

But surely the quality of the answers will improve as the day passes, no?  No?  No?

Help!