Welcome Bloggingheads.tv viewers
I can’t bear to watch myself on TV, so you’ll have to tell me how awkward I look. The format presents several challenges, you don’t see the other person, you have a number of topics to cover, and you want to get certain points across (but also seem conversational.) In addition, the audience is unseen (unlike a seminar) and thus it’s hard to know if the level of discussion is appropriate. Fortunately Mark Thoma is very friendly and easy to talk to, so despite our occasional policy differences it was a very pleasant discussion. Of course I later thought of a 100 points I should have mentioned, and thus below I will link to some posts that new visitors might want to look at if they are interested in a more coherent explanation of my views of the crisis.
For a view of what went wrong with monetary policy look here.
For my policy recommendations look here and here.
For some data supporting the reverse causality view look here and here.
For evidence that tight money causes low interest rates look here and here.
For my views on market efficiency look here.
For my views on forward-looking monetary policy look here.
For my views on the General Theory look here and here.
For my views on fiscal stimulus look here.
I also tend to do non-monetary posts on Sunday. Here is one on neoliberalism and cultural values.
I think that people have a natural level of success, or set point, based on their personal characteristics. Although it is hard to evaluate oneself, I suspect my economic intuition is above average and my poise and presentation skills are below average. The intuition works to my advantage in the blog format, but less so on TV. Of course luck also plays a role in success, and I was fortunate to get some very favorable reviews from people like Tyler Cowen, Will Wilkinson, and Greg Mankiw. Those reviews might have boosted me from below to above my set point. We’ll see if my TV appearance puts me back at my natural set point. (I recall that people used to talk about a “Peter principle,” but I haven’t heard that term recently.)
Here is the link.
Tags:
5. April 2009 at 16:12
Hey Scott,
Great BHTV appearance (you are far too harsh a self-critic). I wasn’t familiar with your blog beforehand, but consider it bookmarked now!
best,
Gil
5. April 2009 at 16:15
Thanks Gil, Even after 5 hours you are the first comment I have gotten. I couldn’t stand watching after two of the first three words were “um”. But I guess I relaxed a bit afterwards. So it’s good to know I wasn’t too bad after all.
5. April 2009 at 16:20
My sense is that Sundays tend to be slow for bloggingheads viewership, so you might have to wait for more feedback, but you came across as at ease with the medium to me.
5. April 2009 at 17:47
Professor Sumner,
It seems to me that the Taylor Rule could easily be modified to follow nominal GDP. Just drop the price term from the equation and then use nominal GDP instead of real GDP.
5. April 2009 at 19:57
I don’t really watch the video so I can’t attest to how awkward you look, or don’t look, but you sound just fine by bloggingheads standards at least; certainly you’d need a little work if you wanted to do sound bites on cable, but I can’t imagine why you would.
5. April 2009 at 21:16
A few notes –
I fail to understand this whole argument that tax cuts make a bad stimulus because the money will be hoarded.
The recession is caused by a drop in aggregate demand. The drop in aggregate demand is caused by a vaporization of paper wealth. When paper wealth disappears, and people’s balance sheets are ruined, they must cut expenditures to restore their desired expenditures to paper wealth ratio. People cut spending on luxuries and durables first, causing unemployment and business failures in these industries.
The best way to repair balance sheets and restore aggregate demand is to simply print money and throw it out of a helicopter. Declare a payroll tax holiday and fund it by printing money. If this is not enough, declare a holiday on all taxes. Or just start mailing checks. People saving the money instead of spending it is a feature, not a bug. The saving is necessary to repair balance sheets. Keep printing money until balance sheets and aggregate demand are restored ( when CPI starts to tick up, corporate profits start rising again, and the lay offs stop, then it is time to stop the printing presses).
Second note:
Targeting nominal GDP to increase at 5% a year is way too high. In order to avoid bubbles, the Fed must not allow the money supply to dilute at a higher rate than alternative stores of value dilute. For instance, if the money supply dilutes at 5% a year, and the gold supply dilutes at 2% a year, people will start trading their dollars for gold, as gold will be a much more effective store of value. Thus even a 5% a year dilution rate can provoke a currency crisis.
5. April 2009 at 23:59
Scott,
Great BHTV! I’m a religious viewer and I found this particular diavlog very helpful and instructive. I’m a graduate student of European history and have only recently begun to integrate my rudimentary understanding of Economics into the broader perspective. I found Adam Tooze’s Wages of Destruction very thought-provoking (regarding the Nazi war economy) and was wondering -if you know his work – how his arguments about German labor needs fit into broader arguments about pre-war and war-time economic history.
Please diavlog again, if you could. It was extremely helpful.
6. April 2009 at 06:43
I thought the interview was very very good. The only awkward thing was that you had to talk into a phone, but I’m kind of used to that on bloggingheads. Otherwise I thought it was a really well done appearance, and interesting discussion. I think it’s a pretty universal thing to think that your own appearances are painfully awkward, even when the appearance is not. It’s the same thing as how hearing your own voice recorded on on an answering machine sounds awkward, while it sounds totally normal to anyone else.
I’m definitely on the Thoma side of things, but it’s very interesting to hear the arguments of a real monetarist. In a way it seems like you’re the last one standing, and I can understand why you would be frustrated that monetarists didn’t seem to stand by their principles in this crisis, and have not really been offering the logical monetarist solutions.
Maybe the people on my side of things (Keynesian) have hastily written off monetary policy because these types of arguments weren’t really being made by monetarists over the past few months. I disagree on some fundamental issues (see Bruce Wilder’s comment at EV) but it is valuable to have somebody out there making the monetarist arguments in a clear and coherent way, and advocating good solutions based on those principles, like reserve penalties (which I now favor, thanks to your blog)
6. April 2009 at 06:48
Scott,
Having never seen a BHTV session before, I think you did a great job. Based on the comments here and on the BHTV site, it looks like others were also very happy with the exchange.
Wasn’t that 15 minutes of fame supposed to have worn off a long time ago?
6. April 2009 at 16:45
Richard A., Yes it could be modified exactly as you say. By the way, Taylor once recommended NGDP targets, and the logic of the Taylor rule (incorporating P and Y) is very similar to NGDP–in practice they are very close. My only complaint is that he favors a backward-looking version (unless I am mistaken.)
Asher, Thanks
Devin, Tax cuts (without more money) may not do much if they are saved. I agree that tax cuts combined with monetary injections can work, but so can monetary injections alone, and without the huge budget deficit and future tax increases.
Does your second point confuse NGDP growth and inflation? Maybe 5% is a bit too high, but if you have say 4.6% NGDP growth, and 2.6% real growth (the current long run estimate) you only get 2% inflation, or a 2% fall in money’s purchasing power. We could even go to 3% NGDP growth, the key is to pick some target, not swing from plus 6% to minus 7%.
Craig, Thanks. I don’t know much about the Nazi economic policy but I believe that unlike the U.S. and France (which raised wages by fiat) they held wages down and got a quicker recovery. They also had a massive fiscal stimulus, which boosted growth. Does this mesh with what the book you mention says? Let me add that (even apart from the war and their appalling crimes) the boost in GDP is not a good argument for fiscal expansion. Why? Because living standards fell as a huge portion of GDP was diverted into the military by 1940 (at least that’s what I read.) But again, I am getting all this second hand, so I may have the facts wrong.
Bob, Thanks, Let me clarify one thing. Your “monetarist” point is true in one respect, I do use their transmission mechanism. But unlike monetarists I don’t put much weight on the monetary aggregates, or the long and variable lags. Hence I was much more critical then they were. There actually aren’t many true monetarist left. Many of the best monetarist insights were incorporated into new Keynesianism, and the rest just withered away. But I still think the monetarists are ahead of the Keynesians on the transmission mechanism question.
7. April 2009 at 03:56
Scott,
In reverse order –
Does your second point confuse NGDP growth and inflation?
No I did not confuse the two. Here’s the problem with NGDP growing at 5% a year:
Let’s say that my CPI basket of goods is weighted by the price of transistors and the price of residential housing ( each weighted at 50%).
Let’s say the supply of transistors increases at 5% a year and the supply of housing increases at 1% a year. NGDP increases at 5% a year. All things being equal, the price of transistors is stable, while the price of housing rises 4% a year. Thus my CPI inflation is only 2.5%.
This sounds ok, right? Well, no. A rational person notices that the price of housing consistently rises every year. Said person realizes that they should dump all their savings and spend it on the most expensive McMansion possible, because a house is a better store of value than a dollar ( since housing dilutes at a lower rate). This increased demand for housing in turn drives up the price of housing, making it seem like an even more attractive investment.
Allowing the dollar to dilute at a greater rate than the housing supply increases is a recipe for blowing a real estate bubble.
Even worse, since in the real life both the CPI and NGDP do not include real estate prices, there is no signal that feedbacks and warns the Fed to tighten. In fact, none of the common alternative stores of value ( real estate, gold, and stocks being the top three) are included in NGDP. So CPI and NGDP could be fine, but in reality you are blowing huge asset bubbles. This is exactly what happened from 96-2008.
Eventually the prices of the assets get so high that new production ramps up and a flood of new supply comes onto the market ( ie pets.com, houses in the desert). At this point the bubble collapses. (or if the bubble is in gold, it might never collapse and you get a currency run instead) When the bubble collapses, paper net worth evaporates, balance sheets are in tatters, everyone is forced to cut back on expenditures, and aggregate demand plummets.
The way to prevent this entire cycle is that the Fed should never allow the money supply to grow faster than the supply of alternative investment goods ( stocks, real estate, and gold). Nor should the Fed allow demand for the dollar to fall. Thus growth in NGDP should really be under 2%.
Incidentally, I was just reading a collection of essays by Milton Friedman and he came to the same conclusion later in life. He had come to believe that targeting the price of consumer goods was a huge mistake. You needed to target the price of non-manufactured goods that have inelastic supplies ( oil, copper, farm land, and gold). If Greenspan and Bernanke had followed this maxim, the past decades would have been much smoother.
Tax cuts (without more money) may not do much if they are saved. I agree that tax cuts combined with monetary injections can work, but so can monetary injections alone, and without the huge budget deficit and future tax increases.
As I said before, the money should be printed. No future tax increases necessary. The economy is experiencing a dramatic monetary shock ( a massive increase in the demand for dollars) and that calls for a corresponding increase in the supply of dollars. People saving money is a feature, not a bug. Saving printed dollars is the the balance sheet repair that will get aggregate demand back up. If aggregate demand isn’t recovering, keep printing money until it does.
QE will not restart aggregate demand because it does not repair balance sheets. And without consumers having repaired balance sheets, banks cannot lend, because there are simply not enough credit worthy borrowers.
7. April 2009 at 17:07
Devin, Last point first; Bank lending has nothing to do with boosting AD. In a world with no banks, QE would still boost AD. It doesn’t do that by encouraging lending, it does that by debasing money. If you have more money, each dollar is worth less, lending or no lending. And having each dollar be worth less boosts AD.
Sorry, I don’t see any evidence that inflationary policies cause bubbles. The late 1960s and 1970s were more inflationary than the 1990s and 2000s, but there were no stock market or real estate bubbles. Indeed stocks did very poorly in the late 1960s and throughout the 1970s. There was no inflation in the 1920s, and a big stock bubble. Nor do I see any logical reason why inflation should cause bubbles. Bubbles are defined as irrational behavior. Why should inflation cause people to behave irrationally? And why would 4% inflation in home prices make you want to buy a second home? Why not just buy stocks, it’s less work and the historical rate of return is much higher.
Scott
8. April 2009 at 14:58
Finbarr,
you ignore the “fisher” effect.
inflation raises nominal interest rates.
While it is true that inflation means that people will conserve on currency holdings, most securities will have a higher nominal yield, compensating for the inflation.
Your error is to imagine an economy with three goods–homes, transistors, and zero interest currency. And further, that the choice is between using currency and one of the goods as a store of wealth. In Scott’s response, he suggested investing in equities. Well, what about debt? In fact, it makes no difference.
By the way, if it were true that people begin to demand houses because their prices are rising, and this makes those prices rise even faster, then (in your expample) nominal income will start to rise faster. And so, contractionary policy will be needed to keep nominal income on target. For the bubble to be maintained the price of your other good will have to fall.
Further, to avoid bubbles, it appears that you must have no price ever increase. While I suppose that is possible, with the good whose relative price increases the most has an unchanged nominal price and every other price falls less if its relative price is rising by less and more if its relative price is falling, this hardly seems desirable.
And why wouldn’t the demand for goods collapse if their price falls. Everyone will hold money and no one will buy a house because the prices of houses fall?
I suggest thinking about these things a bit more.
9. April 2009 at 17:41
Bill,
inflation raises nominal interest rates.
In practice, in our modern system, inflation enters the system via subsidized credit, so it does not raise interest rates. From 2000-2008, MZM increased by ~8% a year, while the interest rate on CD’s was around 3%. This is a huge difference, and a major reason the economy was so bubblicious.
In theory, if new money entered the system simply by the Government printing it, interest rates would rise. But they might not rise nearly enough to offset the inflation. The reason is that as people attempt to trade dollars for future dollars, that has a countervailing effect of driving the price of future dollars down. If the rate of inflation is high enough, it is entirely possible to have the interest rate be lower than the rate of inflation.
And further, that the choice is between using currency and one of the goods as a store of wealth. In Scott’s response, he suggested investing in equities. Well, what about debt? In fact, it makes no difference.
If the herd moves to equities then it blows a bubble in equities. If the herd moves to debt, it blows a bubble in debt.
Money is a unique good. It is a collectible, an intermediary good, it has no other purpose other than to be a store of value. All societies have a great demand for a store of value. What makes dollars or gold a good store of value is that the supply has hard limits ( By the laws of physics in the case of gold, by law in the case of dollars). Debt, housing, stocks, etc have no such limits, thus they do not make effective dollar substitutes in the long run.
Further, to avoid bubbles, it appears that you must have no price ever increase.
You just have to keep the supply of money fixed. In such a world, I suspect that bubbles would not exist. Goods that were constantly increasing in supply (transistors, clothing) would decrease in price. Goods that had increasing scarcity (rain forest timber, ivory) would rise in price over time. Since the only goods that decrease in supply are goods that are perishable, there is no chance of having a large bubble in these goods.
And why wouldn’t the demand for goods collapse if their price falls. Everyone will hold money and no one will buy a house because the prices of houses fall?
Why do people buy game consoles when the price always falls so drastically? Simple: because they want the utility of the XBox now.
The price of housing falls only until buying a house is a better deal than renting. And empirically, there was plenty of home building and home buying back when the world was on the classical gold standard.
Of course, there would indeed be some massive transition issues in going from an inflationary policy to a fixed money supply, but that’s a separate debate.
Modern macroeconomics teaches that deflation is always evil. But there are three possible reasons for price deflation: contraction of the money supply, increased demand for money, or increased supply of goods. The first two are every bit as catastrophic as macroeconomics teaches. The third is very healthy, it happens all the time in the tech industry, and is generally seen as a great thing. People get cheaper and better products.
I suggest thinking about these things a bit more.
I’ve actually thought about all of this a great deal.
9. April 2009 at 19:47
Scott-
Bank lending has nothing to do with boosting AD. In a world with no banks, QE would still boost AD.
You seem to have a very different concept of QE than both Ben Bernanke and Wikipedia.
What is your vision of the ideal QE regimen? Should the Fed print money to buy bank assets? Or should it just buy treasuries? Does it buy treasuries at market prices or at a premium? Or does it just print money and mail checks? Or throw it out of a helicopter? ( If you’ve already posted an answer to these questions I apologize, I’ve read through a bunch of your archived posts but I don’t think I’ve seen you describe your interpretation of QE).
Sorry, I don’t see any evidence that inflationary policies cause bubbles.
Monetary dilution is a necessary but not sufficient ingredient. Other ingredients include: tax incentives, government policies, supply rigidities, mass psychology, cultural memory, and marketing by Wall St. Also, in our modern system new money enters through credit creation, so assets exposed to credit creation are especially prone to bubbles. In the 20’s and the 90’s it was a lot easier to buy stocks with leverage than in the 70’s.
I don’t know precisely why there was no stock bubble in the 70’s, although I could certainly pose a number of plausible theories. I do know that there were a bunch of other bubbles – gold, real estate, oil, paintings, etc.
As for the 1920’s, while price inflation was flat, monetary inflation was not ( and my point is all about monetary inflation, if Ford can produce cars for 10% cheaper each year, that does not magically make loose money policy sound). While there is no Fed M2 or MZM stat from the time, there are stats on the growth of bank deposits, savings and loans deposits, savings and loans deposits. Overall, broad money grew at about 6.5% a year from 1922 to 1928 (source, page 91). And total mortgage debt increased by 200% ( I’m am conflating credit creation with broad money supply growth, but in a system of fractional reserve, the two are conflated). In short: the 1920’s was a period of very loose money.
While the specifics of bubbles depends on many factors, what can also be said is that the period of very low monetary inflation under the British classical gold standard ( 1860 to 1914) had far fewer bubbles than the periods of greatest monetary growth in the U.S. ( 1917 to 1928, and 1970 to 2008 ).
You can also look at it from the opposite direction. In a system of zero money supply growth, broad indexes like the S&P would be basically flat ( dilution and stock buybacks pretty much offset ). Given that there would be no price appreciation, it would be obvious to everyone that the only way to make money off stocks was through dividend yield. Thus, when dividend yields drop below the interest rate on BAA bonds, it is plainly obvious to everyone that stocks are a bad buy. Not even the greatest Fidelity ad can argue, “Don’t bother with dividends, because stocks always go up in long run”, because the statement would so plainly be false.
But when you have monetary inflation at a rate of ~8% a year, and a typical bond interest rate of 5% a year (as was the case from 2000-2008), then even a 0% dividend rate can be plausibly a good buy. If everyone has a 401K and allocates 5% of income into equities, and everyone keeps this ratio constant, than stocks will appreciate at 8% a year (all other things being equal). That makes stocks a much better investment than bonds or dollars in a vault, despite paying no dividends. But the problem is that now instead of basing your investment decisions based on predictable dividends, you’re basing investment decisions based on herd behavior. And the herd could easily change its asset allocation from equities to gold or equities to dollars, thus wiping out your investment.
Bubbles are defined as irrational behavior. Why should inflation cause people to behave irrationally?
No, bubbles are defined as disequilibrium. The disequilibrium may be rational by market actors in the context of a badly mismanaged currency.
Here is a great explanation of money, via the blog Interfluidity:
When the supply of dollars increases faster than the supply of stocks or gold, it breaks the Nash equilibrium. The rational actor must weigh the risk of buying into a bubble versus the risk of dilution. This creates a very unstable situation.
10. April 2009 at 04:10
Devin, You confuse the growth rate of money with inflation, the Fisher effects refers to price inflation, not monetary inflation. So it is not surprising that the money supply growth rate exceeds the nominal interest rate.
Money is not just a store of value, it is also a medium of exchange. And by the way, the gold supply also increases over time, so the money supply is not stable under a gold standard
I very much doubt that Bernanke would deny that QE can work in a world without banking. What do you think would happen in a simple society with just goods, services and cash as a medium of exchange, if lots of money was dumped from a helicopter?
QE could work if all the Fed did was to buy Treasury bonds at market prices. They don’t need anything special there. What they need is a penalty rate on excess reserves, and an explicit nominal growth trajectory for their target.
There was no real estate bubble in the 1970s nor was their an oil bubble. Bubbles involve price increases not supported by fundamentals. There were plenty of fundamentals in both those cases. And the real estate bubble never even popped, so that is a very odd choice on your part. 2007-08 was the first decline in RE prices since the Depression.
I don’t understand the last part of your argument at all. You spend a lot of time showing how you think inflation makes people behave irrationally in the stock markets, and then you deny bubbles have anything to do with irrationality. You say bubbles imply disequilibrium, but of course equilibrium is defined as the efficient markets price, the price with rational expectations. I have never seen a bubble theory that was not based in irrationality. Certainly that’s how almost everyone interprets it.
If your theory has any meaning at all, it would have implications for investing. If it has no predictive implications that differ from the Ratex EMH, then what use is it? If you read my EMH piece, you will see why I don’t think bubble models have any value. Perhaps if you told me how I could beat the market in the future by using your model, I could better evaluate it.
20. April 2009 at 20:11
Scott-
I drafted this replay a while ago, before I got caught up with work. We come from very different schools of economics. I hope I have been able to explain my ideas well enough, and at least interest you, if not convince you.
You confuse the growth rate of money with inflation, the Fisher effects refers to price inflation, not monetary inflation.
Wow, you’re right, so it does. In that case it is even more wrong. Imagine a VC backed startup manages to invent new algae biofuel that replaces oil at a fraction the cost. CPI drops by 6-7% a year for several years. Do interest rates drop to -2%? No. Heck, interest rates might go up as the revenues of oil companies plummets and they default on formerly AAA debt.
And either way, my original point stands. With enough monetary inflation, the return on investment on an inert object like gold will exceed the return on bonds.
Money is not just a store of value, it is also a medium of exchange.
Right, money is an intermediate good. You trade good X for money, then trade money for good Y at a different time.
And by the way, the gold supply also increases over time, so the money supply is not stable under a gold standard
Also true. In fact, a fiat currency that had a fixed supply would make an even better currency than gold ( well, if you could trust the government to keep the supply fixed). But keep in mind, even at the height of the greatest gold rush, the supply of gold still increased at a much lower rate than the dollar has over the past forty years.
What do you think would happen in a simple society with just goods, services and cash as a medium of exchange, if lots of money was dumped from a helicopter?
Aggregate demand would go up, the recession would end, helicopter pilot hoisted onto shoulders and paraded through the streets.
QE could work if all the Fed did was to buy Treasury bonds at market prices.
No, this would not work. What is a treasury bond? A treasury is simply a piece of paper, backed by the full faith and credit of the U.S. government saying, “this will be a dollar on date X”. The market price of the treasury is the face value adjusted for time preference. And what is a dollar? A piece of paper, fiat currency issued by the U.S. Government. So if the Fed replaces one piece of paper backed by the full faith and credit of the U.S., with another paper of the same net present value, the Fed has done nothing. The Fed only inflates if it overpays for the treasuries. But if the Fed overpays, then the inflation is not-neutral and not helicopter-like. It would be a give away, a transfer of wealth.
I realize that this take on Treasuries is the opposite of what everyone believes. I didn’t believe it myself on I got in a long debate at Winterspeak’s blog, and was convinced. I suggest reading “The Seven Innocent Frauds of Macroeconomics” by Warren Mosler. He’s made his bones trading treasuries on Wall St. and his arguments are very convincing.
If the government wants to do QE, it should do so in the fastest, most neutral way possible: mail out checks to every tax payer.
They don’t need anything special there. What they need is a penalty rate on excess reserves, and an explicit nominal growth trajectory for their target.
Reserves have not mattered for a long time. Most savings is held in zero percent reserve accounts ( money markets, savings accounts, and CD’s). The two big factors affecting lending are capital requirements, and more importantly, borrowers who can fit the credit rating models. See: http://www.winterspeak.com/2009/01/nytimes-1-chicago-0.html
Even if banks want to lend to avoid the penalty, they still need borrowers. And right now, consumer balance sheets are in shambles. Trying to stimulate aggregate demand via credit creation just gets us back to 2007. Really, the Fed should just print the money so that the overall debt to money stock ratio can be made sustainable, without a wave of bankruptcies.
There was no real estate bubble in the 1970s nor was their an oil bubble.
Real estate prices grew 50% in four years, and 200% for the decade, both rates exceeding the growth of median income. Prices did collapse later on in Massachusetts, where I live. But you’re right, they did not crash nationwide. But this is exactly why money supply growth is so insidious. Housing prices can rise against the fundamentals (the fundamentals being cost of renting and median income) for many, many years, because housing experiences additional demand as a store of value and inflation hedge, in addition to its demand based on direct utility. The 70’s run up proved that “prices always go up”. In general thanks, to monetary inflation, this is true. But how much can they go up? This is much harder to predict. In fact it is near impossible to predict since the price becomes based on herd psychology rather than fundamentals.
As for oil prices, do you really think OPEC was responsible for the oil price spike? I mean, I haven’t looked into it closely, but the correlation between the rise and fall of the oil price and the rise and fall of gold is suspiciously close. I recall hearing last June how oil prices were affected by the perfect storm of geopolitical instability in Iraq, Iran and Venezuela and were thus so high. This was, of course, hogwash. Nick Szabo called it at the time: http://unenumerated.blogspot.com/2008/04/hoarding-and-speculation-of-commodities.html The prices were being driven up by Wall St.’s infinite loan machine. When the machine shut off, the prices crashed back down.
You spend a lot of time showing how you think inflation makes people behave irrationally in the stock markets, and then you deny bubbles have anything to do with irrationality. You say bubbles imply disequilibrium, but of course equilibrium is defined as the efficient markets price, the price with rational expectations.
A good can be priced in a disequilibrium, even when all actors are rational and smart. Take the price of gold. What is the price of gold based on fundamentals? Is it over priced or under priced? I mean, it’s an inert substance, with awful tax treatment, it costs money to store it, and yet it has exceeded the return on treasuries for the past 20 years!
The gold price right now is in disequilbrium. That means it’s current price is not stable, it’s on the top of a hill, and it will roll down one way. But which way? If a few Persian Gulf countries decide to make it the reserve currency, if Americans tire of currency instability and start to invest in it, if China starts building its reserves, then the price will go up. As the price goes up, a meme develops ( “gold they’re not making any more of it ya know”, “all fiat currencies end in ruin” ). More people start buying, pushing the price up further. This can continue until you have a full fledged currency run and the price shoots up to $20,000 an ounce.
Or not. Perhaps the meme doesn’t take. Interest in gold starts to fade. The price drops. People who bought on margin must sell. The price undergoes a 1981-like collapse.
Either of these outcomes is possible. The current price of gold factors in both of these possibilities outcomes. A rational person has no sure way of knowing which way it will go. Thus even though gold is currently priced by people being rational, and there is no way to outsmart the market, the price is still in dis-equilibrium. A slight momentum shift could snowball and the price could swing dramatically either way.
There are only three types of goods in an economy:
1) goods providing direct utility ( a car, tv, chocolate )
2) collectibles ( a baseball card, diamonds, gold )
3) flows ( stocks, bonds )
Collectibles are valuable, not because the good provides direct utility, but because everyone else believes that it is valuable. Usually an economy establishes one collectible as its official intermediary good – that collectible is then called “money”. A “flow” is simply the right to an expected future flow of a collectible or good. The most common flow is a yield of money.
A stock market is in disequilibrium when people start trading stocks as collectibles rather than as flows. In other words, instead of buying a stock based on the hope of generating a return via dividends, they start buying a stock in order to sell it to someone else ( price appreciation).
Flows are relatively straight forward to price objectively. Collectibles are a much more dangerous game – the price is entirely dependent on herd behavior.
When the government dilutes the money supply, people start searching for a replacement collectible to serve as a store of value. People end up buying stocks not based on dividend yields, but in order to trade for later at a higher dollar price. People buy houses not based on direct utility or as an alternative to paying rent, but in order to sell for later at a higher price. These goods start trading as collectibles, and thus are subject to the whims of the herd.
I have never seen a bubble theory that was not based in irrationality.
Well now you have. And my theory has the neat feature of reconciling the fact of bubbles, with the fact that experts do not seem to be able to beat the market. EMH is kind of right, but EMH assumes that stocks are priced as flows, whereas in reality stocks are priced as collectibles. Collectibles are far different beasts than flow, and exhibit far different behavior.
Perhaps if you told me how I could beat the market in the future by using your model, I could better evaluate it.
An savvy investor can only beat the market by understanding herd psychology. This is no easy task. In fact, in the collectibles game, often the best strategy is to bet on the same thing everyone else is betting on. That’s why collectibles are valuable – everyone thinks they are valuable. The S&P 500 weightings formula can be thought of as a generally agreed upon appraisal method. The reason why managed funds cannot beat the returns of index funds is that you cannot do better in collectibles market by using your own appraisal method. If everyone values clear diamonds the most, you aren’t going to make more money by investing in yellow diamonds.
But my theory does have one implication that did save me a bunch of money – since inflation helps build the bubble, even a small amount of deflation can cause rapid price collapses. The fall in price will be much greater than the fall in dividends. Late last summer I was looking at numbers, and noticed that real estate, equities, oil, and gold had all been down for two months straight. The only thing those goods have in common is the currency they are priced in. So I said, “Holy deflation, Batman!” and sold half of the index funds that I owned. There is simply no sane reason to hold onto index funds paying a 2% dividend yield in the face of a deflation. There is no way you can win.
The ideal monetary policy would be to build a basket of goods that have a relatively fixed supply ( oil, gold, farmland, center city real estate, old masters paintings, shares of the S&P 500, an hour of labor). Then target a 0% percent inflation rate for this index. The pricing data for these goods are all instantaneous – it is much quicker and more efficient than NGDP targeting. And you would never have any bubbles or crashes. Nor would people ever see safe investments like CD’s lose money in real terms over the course of a decade ( like they did from 1998-2008). It would be perfect economic stability, and continuous growth.
22. April 2009 at 17:24
Devin, If you were right then inflation should have risen sharply in the early 1980s, instead it fell. The fed had a tight money policy but the Treasury borrowed a lot to finance the Reagan deficits. Tight money and expansionary fiscal. And inflation fell sharply. So maybe trading money for bonds does make a difference.
Housing “fundamentals” don’t impress me. the coastal markets have exceeded fundamentals for several decades. It means the market is driven by fundamentals beyond income.
Gold is high and oil is low, so I don’t see the connection you draw.
I didn’t say inflation causes stock market irrationality, or at least hope I didn’t.
I just want to go back to mid-2008 after the housing bubble had collapsed, not back to 2007.
22. April 2009 at 20:32
The fed had a tight money policy but the Treasury borrowed a lot to finance the Reagan deficits.
All this means is that the tightness of the Fed outweighed the inflationary impact of the deficit. The Fed can be arbitrarily tight if it increases the federal funds rate.
Housing “fundamentals” don’t impress me. the coastal markets have exceeded fundamentals for several decades.
Fundamentals was a bad word. Housing on the coast switched as trading based on direct utility (what I meant by “fundamentals”) to trading as a collectible.
Gold is high and oil is low, so I don’t see the connection you draw.
It was definitely hedge fund money pushing up the price of oil last year, not consumption demand. Gold has held up recently because the whole Bretton Woods II system is tottering and gold is not only an inflation hedge, but it’s also an “end of the financial world as we know it” hedge.
So maybe trading money for bonds does make a difference.
The federal funds rate makes a difference. When you were talking about OMO and debt monetization, you seemed to be talking about outside of the context of changing the Federal Funds rate.
23. April 2009 at 06:26
Devin, I already addressed the point of ff-rate and OMOs being excactly the same in a more recent post a few minutes ago–so you can look at that one and respond.
Oil speculators did not drive up prices last year, it was demand from developing countries. If speculators drove up prices you would have seen more oil hoarded. And hoarding didn’t increase. Otherwise speculation is just a bet, like if I bet you about whether oil would be higher next year. It has no effect on spot prices.
4. May 2009 at 20:07
If speculators drove up prices you would have seen more oil hoarded.
Hoarding oil can take the form of just leaving it in the ground. Read the Nick Szabo post I referenced before. He wrote a series of posts about speculation in the oil markets that was very convincing.
6. June 2009 at 13:10
Devin, Oil production rose between 2007 and 2008. So I doubt whether hoarding of oil in the ground was a major factor in raising oil prices.
6. June 2009 at 15:58
As we discussed previously, between 1-2m bpd in production were also missing. Now, I think there are technical reasons for this, not speculative hoarding, but the mere fact the production overall rose does contradict Devin’s claim.
8. June 2009 at 03:35
Jon, Agreed, but I would add a couple points:
1. The burden of proof is on those claiming that speculation drove up the price. When both price and output rise at the same time, economists normally assume that demand is the major factor driving up prices. Supply restriction could have also played a role, but that would require the sort of evidence that no commenter has provided.
2. If supply restrictions of 1-2 mbpd were enough to double oil prices, then an equal increase in demand from developing countries could do the same. Thus at the very least no one should come into the discussion with a preconceived notion that demand could not explain a price spike of that magnitude. We know that oil demand was soaring in China and other 3rd world countries. So I still see demand as the most plausible explanation. And there is certainly no convincing evidence of a price “bubble.”
8. June 2009 at 15:27
ssumner, Devin said: “All societies have a great _demand_ for a store of value” (emphasis added). Devin and I are saying that most of the commodity runup last year _did_ come from increased demand — but primarily demand _as a collectible_ (i.e. as an inflation hedge) rather than demand for industrial consumption.
I concur with Devin: if long-term inflation expectations were extremely low, the price of housing, stocks, commodities, etc. could be estimated from demand deriving solely from their cash flow plus consumption demand — there would be no collectible premium. But since asset prices come with a difficult to estimate and fluctuating inflation expectations premium, this makes it far harder to judge whether an asset is over- or under-priced, leading to greater over- and under-pricing, i.e. seemingly irrational asset booms and busts.
I do like the strategy suggested by Devin’s shorting of stocks when commodities fell, i.e. that of arbitraging between asset markets with different collectible premiums, albeit this assumes that one can estimate the price derived from just cash flow plus consumption demand, which I don’t think is as easy as it looks.
That said, I’d add (perhaps disagreeing with Devin) that in the large collapse in commodities since last summer, decreased expectations for future industrial consumption (due to rising expectations of a long-term worldwide recession) was a large factor alongside a change from irrationally high collectible valuation to irrationally low collectible valuation.
Gold and commodities prices have a good long-term correlation across business cycles — commodity prices due vary far more than gold due to changes in consumption expectations — so a subset of the collectible arbitraging strategy is to look at for example the oil/gold ratio. Last summer this ratio was far too high, reflecting irrationally high valuation of industrial commodities as collectible and recently it has been far too low, reflecting irrationally low valuation of commodities as collectibles, as well as lowered consumption expectations (the business cycle). In both cases one would have profited over the course of entire business cycle (and even in this case, luckily, over the short run) from betting against even more extreme deviations from the average historical ratio (or historical trend, if you believe oil is being depleted faster than gold, which is entirely plausible, even if “peak oil” is silly).
9. June 2009 at 05:52
Nick, I agree with part of your comments, but am confused about the commodity/collectible link. Gold and silver are collectibles, but I don’t see how other commodities are. Have I misinterpreted what you and Devin are saying?
10. June 2009 at 11:44
ssumner, look at Devin’s list as a list of demand curve components. Demand curves for housing and commodities have a utility (consumption) component. If a shopper for a house plans to live in it and rent out their basement, the demand curve for purchasing the house also has a cash flow component: the demand for the house includes both utility and flow components. Finally, any asset that provides any hedge against inflation has what we are calling a _collectible_ component. The collectible component reflects inflation expectations. Thus, with non-zero inflation expectations the demand curve for that house includes all three components: utility, flow, and collectible.
Commodities can hedge against long-term inflation and thus often have a high collectible component on top of their consumption component. Houses also often have a high collectible premium. Stocks also have a (smaller) collectible premium.
See my recent blog post on this subject for further explanation.