Month: September 2009

Recent results on inequality

This new paper is from Robert J. Gordon and it points to some very important results, rooftop results you might say:

The rise in American inequality has been exaggerated both in magnitude
and timing. Commentators lament the large gap between the growth rates
of real median household income and of private sector productivity.
This paper shows that a conceptually consistent measure of this growth
gap over 1979 to 2007 is only one-tenth of the conventional measure.
Further, the timing of the rise of inequality is often misunderstood.
By some measures inequality stopped growing after 2000 and by others
inequality has not grown since 1993. This cessation of inequality’s
secular rise in 2000 is evident from the growth of Census mean vs.
median income, and in the income share of the top one percent of the
income distribution. The income share of the 91st to 95th percentile
has not increased since 1983, and the income ratio of the 90th to 10th
percentile has barely increased since 1986. Further, despite a
transient decline in labor’s income share in 2000-06, by mid-2009
labor’s share had returned virtually to the same value as in 1983,
1991, and 2001.

contributions in the inequality literature have raised questions about
previous research on skill-biased technical change and the managerial
power of CEOs. Directly supporting our theme of prior exaggeration of
the rise of inequality is new research showing that price indexes for
the poor rise more slowly than for the rich, causing most empirical
measures of inequality to overstate the growth of real income of the
rich vs. the poor. Further, as much as two-thirds of the post-1980
increase in the college wage premium disappears when allowance is made
for the faster rise in the cost of living in cities where the college
educated congregate and for the lower quality of housing in those
cities. A continuing tendency for life expectancy to increase faster
among the rich than among the poor reflects the joint impact of
education on both economic and health outcomes, some of which are
driven by the behavioral choices of the less educated.

I don't yet see an ungated version.  If you go to pp.8-9, you'll see that since 2000 (not including the financial crisis), it is quite possible that inequality has been decreasing, not increasing.  That's exactly the period of time when complaints about inequality reached new heights.

Franz Liszt’s Transcendental Etudes

Many of the criticisms of Liszt stick, but you can't judge these pieces by the standards of a Bach fugue.  If there's anything in classical music that comes close to the ecstasy of The Clash, or the beauty of Brian Eno, it is these works.  The Etudes are also nearly impossible to play and as monomaniacal works they try to contain everything pianistic.  A new version of the Etudes has appeared, by Miroslav Kultyshev.  It starts slow but by Mazeppa (YouTube here) the listener takes notice.  There are many bad or unlistenable versions of the Etudes but the recordings by Freddy Kempf (download here), Kemal Gekic,(YouTube here) and Vladimir Ovchinikov are of note.  Nikolai Lugansky (YouTube only) is good with the dynamics.  It is somehow appropriate that none of these talented pianists has met with major success more generally, as if other music is somehow "too little" for them.  Or they sold their souls to the devil to play the Etudes and they are, underneath the surface, shattered empty men.

Questions of merit

Can it really be that the G20 is about to adopt elaborate
banker-compensation rules without a single study showing that
compensation incentives contributed to the crisis??

If anyone knows of any such studies, PLEASE CONTACT ME at edcritrev at gmail dot com.

That is Jeffrey Friedman, from the comments.  Please leave your reading suggestions in the comments here.  So far no one in the previous set of comments has come up with anything statistical, not even weak evidence.  Nada.  Please don't let the world violate Cowen's 2nd Law, which promises: "There's a literature on everything."

What it means to predict a crisis

Some economists are trying to get macroeconomics off the hook by arguing that by their very nature crises are unpredictable.  Thus David Levine aggressively argues that "our models don't just fail to predict the timing of financial crises – they say that we cannot."

There are three problems with this argument.  First, it assumes what is it at question – namely whether what Levine calls "our models" are good models.  Perhaps behavioral models could better predict the timing of financial crises.  I will not push this argument but I do believe that current events call for a greater than normal willingness to think beyond the confines of the models that one defends.

Second, it's not true that "our models" tell us that we can never predict a financial crisis.  In some cases, our models predict the exact moment that a crisis will occur and these models are perfectly consistent with, indeed require, rational expectations.  It is perhaps no accident that Paul Krugman has specialized in these types of models.

Third, the word timing is misleading.  Let's accept that a crisis cannot be predicted to the day or even to the year.  Nevertheless, it is perfectly reasonably and fully consistent with rational expectations to predict an increased probability of a crisis. 

If you play Russian Roulette with 1 bullet and 100 chambers in your pistol, I can't predict when the crisis will occur.  If you play with 10 bullets, I still can't predict when the crisis will occur but I can say with certainty that the risk has increased by a factor of ten.  Analogously, nothing in modern economics makes it theoretically impossible to forecast that greater leverage and higher than normal price to rental rates, to name just two possibilities, increase the probability of crisis.  Nor does modern theory make it theoretically impossible to forecast that conditions are such that if a crisis does occur it will be a big one.

All of this is true even in the context of stock markets.  Efficient markets theory implies that any two stocks will have similar risk-adjusted returns it does not imply that the risk of bankruptcy is the same for any two firms.  It is perfectly reasonable to say that Google revenues are going to have to increase at a historically unprecedented rate or the stock will plummet.  It is even consistent with efficient markets theory to predict that the probability of Google stock falling is much greater than the probability of it rising (but if it rises it will rise very far, very fast).

Thus the "we could not have predicted the crisis even in theory" argument is a weak defense–even with rational-actor, rational-expectations models there are plenty of senses in which economists could have better predicted the crisis and, although this is yet to be seen, perhaps they could and will do even better with other sorts of models. 

Did the structure of banker pay cause the crisis?

This is an old topic but it is in the headlines again, so I pass this along, from Jeff Friedman:

This “executive compensation” theory of the crisis
is now the keystone of the conventional wisdom, having been embraced by
President Obama, the leaders of France and Germany, and virtually the
entire financial press. But if anyone has evidence for the
executive-compensation thesis, they have yet to produce it. It’s a
great theory. It “makes sense”–we all know how greedy bankers are! But
is it true?

The evidence that has been produced suggests that it is false.

one thing, bankers were often compensated in stock as well as with
bonuses, and the value of this stock was wiped out because of the
investments in question. Richard Fuld of Lehman Brothers lost $1
billion this way; Sanford Weill of Citigroup lost half that amount. A
study by René Stulz and Rüdiger Fahlenbrach[3] showed that banks with
CEOs who held a lot of stock in the bank did worse
than banks with CEOs who held less stock, suggesting that the bankers
were simply ignorant of the risks their institutions were taking.
Journalists’ and insiders’ books about individual banks[4] bear out
this hypothesis: At Bear Stearns and Lehman Brothers, for example, the
decision makers did not recognize the risks until it was too late,
despite their personal investments in the banks’ stock.

The Stulz and Fahlenbrach abstract reads as follows:

investigate whether bank performance during the credit crisis of 2008
is related to CEO incentives and share ownership before the crisis and
whether CEOs reduced their equity stakes in their banks in anticipation
of the crisis. There is no evidence that banks with CEOs whose
incentives were better aligned with the interests of their shareholders
performed better during the crisis and some evidence that these banks
actually performed worse both in terms of stock returns and in terms of
accounting return on equity. Further, option compensation did not have
an adverse impact on bank performance during the crisis. Bank CEOs did
not reduce their holdings of shares in anticipation of the crisis or
during the crisis; further, there is no evidence that they hedged their
equity exposure. Consequently, they suffered extremely large wealth
losses as a result of the crisis.

It's entirely fair to argue that these tests are not decisive.  But still, the evidence isn't there — at least not yet — that executive pay was in fact the big problem.

I thank Jeff Friedman for the pointer.

What went wrong in the economics profession?

I've been putting off this topic but reactions to Krugman's essay don't seem to go away.  Mark Thoma links to everyone.  Here is a Krugman post,criticizing Chicago School economists.  Via Greg Mankiw, David Levine offers the latest broadside.  Here is Alexander Rosenberg criticizing John Cochrane.

I would have preferred it if this debate had focused on what real business cycle theory — whatever its limitations — has to offer.  For instance if you are postulating a "jobless recovery," most likely you are invoking ideas from real business cycle theory.  RBC theory has been a major contribution, even if it doesn't explain the core of the recent financial crisis or even if it has some very limited one-person models.  If you think seriously about the persistence of business cycles over time, or the spread of business cycles from one sector to another, probably you are invoking ideas from real business cycle theory.  For all its prominence, Keynesian economics tends to portray states of affairs and it often has difficulty presenting a business cycle per se, such as the time paths of variables across the entire range of the cycle.  RBC theorists have formalized what a cyclical explanation, in the full sense of that term, has to look like and so they have done a big service to Keynesian ideas also.

At this point the debate is more a topic of sociology than substance.  The substantive issues will be better worked through in other forums; this forum has been spoiled.  The remaining lesson — and perhaps the major lesson — is that the Jacksonian mode of discourse does not very well suit a discussion of macroeconomic theory.

In the comments I would say stick to the issues and don't bother criticizing any of the participants in the debate.

How should economists integrate their personal and professional lives?

Arnold Kling queries what I meant on that point in a recent talk.  I meant the following:

1. There is an entire class of economists — a large class at that — whose choice of problems to work on bears little relation to what they think are important issues in the real world.  I would stress, however, that it is difficult to find such economists (though there are some) at the top tier schools.  This is a bigger problem at lower tier and wanna-be institutions.

2. I commonly meet economists and other social scientists who will tell you about the implications of their latest research, yet if you ask them other questions they will respond in hushed tones of the most severe agnosticism.  For instance they will refuse to answer Robin Hanson's question about identifying large inefficiencies in the contemporary United States.

Now, if such agnosticism truly represents their actual views as human beings, that is a perfectly defensible stance.  Yet I find that many (most?) of these same people will hold very definite political views and act on them in their private lives.  They will support candidates, donate money, condemn colleagues who don't hold similar views, and so on.  In other words, they are not really agnostic on all those other issues, they just don't want their personal views subject to full analytic scrutiny.  They bifurcate the personal and the political.

This is one of my pet peeves.  It is defensible to be truly agnostic.  It is also defensible to believe that general principles of economic theory and empirics and ethics allow us to have "all things considered" policy views on matters we have not studied closely.  It is not defensible to hold such views but, under the cloak of a not-really-meant agnosticism, refuse to put them on the social science table, so to speak.

(I find that bloggers hardly ever suffer from this problem.  In many ways the core of blogging is a willingness to apply what you know to every problem you encounter, and see how good a job you can do of it in a more or less integrated fashion.)

3. Most intelligent people, in their ordinary lives, believe that other people, especially less intelligent ones, make stupid mistakes all the time, including in their decisive choices (not just in their voting).  Yet some of these intelligent people call themselves rational expectations theorists.  I don't get it. 

The Price of Magic Pills

Greg Mankiw's column today is one of his best.  Here are the key points:

Imagine that someone invented a pill even better than the one I take. Let’s call it the Dorian Gray pill, after the Oscar Wilde character. Every day that you take the Dorian Gray, you will not die, get sick, or even age. Absolutely guaranteed. The catch? A year’s supply costs $150,000.

Anyone who is able to afford this new treatment can live forever. Certainly, Bill Gates can afford it. Most likely, thousands of upper-income Americans would gladly shell out $150,000 a year for immortality.

Most Americans, however, would not be so lucky. Because the price of these new pills well exceeds average income, it would be impossible to provide them for everyone, even if all the economy’s resources were devoted to producing Dorian Gray tablets.

So here is the hard question: How should we, as a society, decide who gets the benefits of this medical breakthrough? Are we going to be health care egalitarians and try to prohibit Bill Gates from using his wealth to outlive Joe Sixpack? Or are we going to learn to live (and die) with vast differences in health outcomes? Is there a middle way?

From the comments

MR commentator Liberalarts offered up this insight:

To other professors of economics, I might add that it is a bit shocking
for past undergraduate students to explain their memories of your class
to you!

I would request that MR readers offer up examples, either from their time as teachers or, more aptly, from their time as students, of what they remember from a particular class.

NFL player bankruptcy

The ever-excellent Mark Steckbeck offers up a quotation from Yahoo:

78 percent number (i.e., 78% of NFL players go bankrupt within two
years of retirement) is buoyed by the fact that the average NFL career
lasts just three years. So, figure a player gets drafted in 2009, signs
for the minimum and lasts three years in the league: He will have
earned about $1.2 million in salary. Factor in taxes, cost of living
and the misguided belief that there will be more years and bigger
paydays down the road, and it becomes a lot easier to see how so many
players struggle with money after their careers end.

Eric Falkenstein’s *Finding Alpha*

The subtitle is The Search for Alpha When Risk and Return Break Down.  I definitely liked this book.  It's the best readable summary I know of why CAPM fails (see my comments here).  Market data do not, upon examination, show a close connection between risk and return, at least not once you start moving out on the risk spectrum beyond T-Bills and the like.  It's not just the famous Fama and French papers, it is worse than you think.  I also like the author's "relative status" theory for why many people enjoy risk; it reminds me of Reuven Brenner, a neglected economist to this day.

More controversially, Falkenstein believes the equity premium is zero or near zero.  I see it as positive but equilibration does not occur for at least two reasons.  First, people don't like the thought that they are losers, and second, their spouses can criticize their investment decisions when temporary nominal losses come and last for years.  In this sense my non-EFM view differs from his.

I recall someone in the blogosphere asking why this book does not overturn modern finance.  It is a very good book.  For it to "stick" it would need a clear empirical test of the relative status model of risk-taking vs. other models.  We don't yet have that and I am not sure we ever will.  There are too many conjectures consistent with Beta not much mattering for stock market returns and I am not sure the relative status model offers unique predictions within the realm of financial theory.  The relative status model offers plenty of testable, and often confirmed, predictions elsewhere, but once we drop EFM we're in a world where choice and risk are context-dependent and we still have to prove it is relative status-driven risk-taking which regulates equity returns.  That's very hard to do.

Here is one summary of the book.  Here is Eric Falkenstein's blog.