Z **Inactive** Hoisted from the Archives

Dogs vs. Cats, Treasury vs. State, Economists vs. Diplomats

Brad DeLong's Website: Dogs vs. Cats, Treasury vs. State, Economists vs. Diplomats: Once again today I had my nose rubbed in a fact of life...

When economists talk about international trade and finance, they talk--first and most importantly--about building institutions to allow for mutually-beneficial acts of economic exchange. They talk about diminishing barriers and increasing confidence. They talk about playing positive-sum games with people in other countries that increase wealth, trust, and confidence and that ultimately align interests: the larger is the surplus from international trade and finance, the bigger is that stake that everyone has in continuing the free-trade-and-finance game.

When diplomats talk about international trade and finance, they talk about them as carrots and sticks: we give people we want to reward access to our markets; we punish people who we want to punish by slapping on trade embargos. "Economic diplomacy" is like bombing, only less so.

And arguments that it is much more important to build large and profitable positive-sum games that align interests than to win zero- (or negative!) sum games that lead to the domination of one government's conception of its momentary interest over another's? They blow right past the diplomats, the State Department people as if they were just gentle breezes.

Now this matters a lot, for in the long run we all have an enormous mutual common interest in peace, tolerance, and prosperity. And we have virtually no interest in most of what governments choose to fight about. Who cares today whether the signs in Strasbourg say "Strasbourg" or "Strassburg"? Who today is willing to fight and die to make Vancouver part of the United States of America? Who cares today whether the eighteenth century saw members of the Bourbon or the Habsburg dynasty seated on the throne of Spain?

This has very powerful implications. For one thing, it means that next to nobody in the foreign relations community is thinking about a set of issues that is one of the key sets of geostrategic issues for America today. What set? Let me back up a century and a half.

Between 1850 and 1910--by accident--Great Britain built ties with the United States: economic ties, cultural ties, political ties of mutual deference where strategic issues were at stake. As a result, by 1910 Americans perceived Britain as their friend, and the British Empire as by and large a force for good in the world. This is in striking contrast to how Britain was perceived in 1850: the cruel corrupt ex-colonial power that had just starved a quarter of all Irishmen to death.

Now this mattered a lot.

This meant that when Britain got into trouble in the twentieth century--whether with Wilhelm II or Hitler or Stalin and his successors--it had wired aces as its hole cards in the poker game of seven-card stud that is international relations. The willingness of the United States to send Pershing and his army Over There, to risk war with and then to fight Hitler, and to move U.S. tanks from Ft. Hood, TX, to the Fulda Gap were all powerfully motivated by America's affinity with Britain, its geostrategic causes, and its security.(1)

How does this apply to the present? It is obvious. Alexis de Tocqueville could project before the Civil War that the U.S. and Russia were likely to become twentieth-century superpowers. We can project today that at least one of India and China--perhaps both--will become late-twenty first century superpowers. We have an interest in building ties of affinity now. It is very important for the late-twenty first century national security of the United States that, fifty years from now, schoolchildren in India and China be taught that America is their friend that did all it could to help them become rich. It is very important that they not be taught that America wishes that they were still barefoot and powerless, and has done all it can to keep them so.

The fact that these issues are not even on the radar screen of the international relations community is indeed terrifying...

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(1)The argument--that I have heard twice--that the U.S. fought World Wars I and II and the Cold War overwhelmingly out of keen-eyed realism, and not in part because of the affinity between the U.S. and Britain that had grown up since 1850, strikes me as prima facie ludicrous for the cases of World Wars I and II. Wilhelmine Germany posed no threat to the national security or the prosperity of the United States. The same goes for Hitler's Germany. D-Day was only possible because (1) 75% of the Wehrmacht was tied down by the Red Army on the Eastern Front and (2) England served as a huge aircraft carrier and logistics base. A D-Day in reverse with 1940s technology is inconceivable. The Atlantic Ocean is big. Only with the coming of the H-bomb and the ICBM does U.S. national security become dependent on what happens on other continents.

Roosevelt tried to sell Hitler's Nazism as a threat to America, but not in a convincing fashion. Wilson didn't even try to sell Wilhelmine Germany as a threat.

Hoisted from the Archives: Sailing into Harm's Way versus the Dangerously Eloquent Jeff Faux

Grasping Reality with Both Hands: Economist Brad DeLong's Semi-Daily Journal: In Which I Carry Yet More Water for the Commissars-Turned-Capitalists of Shanghai

Over at TPM Cafe, I respond to the eloquent and dangerous Jeff Faux yet again:

Sailing into Harm's Way versus the Dangerously Eloquent Jeff Faux | TPMCafe:

I had written:

Is there a way to interpret Jeff other than as a call to keep China a society of poor subsistence rice farmers as long as possible--keep them poor, barefoot, uneducated, and by no means allow them to work at any of the high-value manufacturing occupations we want to keep in the United States?

Jeff Faux writes back:

Feb | TPMCafe: Brad missed the point. There are rich people in poor countries and poor people in rich countries. China is not just a society of poor, barefoot, uneducated peasants. At the top, China is a place of immense wealth.... Why is it that it is the responsibility of $40,000 year American working families to sacrifice their future in order to raise up the living standards of poor Chinese, when commissars turned capitalists ride around Shanghai in a different Rolls every day?...

I think it's time to put myself seriously in harm's way here...

I reply:

There aren't many commissars-turned-capitalists.

Scratching on the back of my envelope, I find that at current exchange rates, China's GDP per worker--and there are 800 million workers--is $3,000 per year. (In 1990 it was $1,100 of today's dollars per year.) According to Piketty and Qian's guesses, the top 0.1% of China's workers get an average of $30,000 per year at current exchange rates. This elite of some 800,000 do live considerably better in their homes in Shanghai than Americans with $30,000 do--unskilled labor and the services it provides are really cheap in Shanghai because China is still really poor (perhaps at a level equivalent to $100,000 per year if you like being waited on and having a household staff; much less if you don't). Redistribute all the income of the 800,000 commissars-turned-capitalists back to the masses, and you boost median standards of living in China by 1% above current levels.

In 1877, it was the United States that was the rising superpower across the ocean to the west of the world's industrial and military leader. Today it is China. In 1917 and again in 1941 it was greatly to Britain's benefit that America regarded it as a friend and an ally rather than as a competitor and an enemy. And since 1945 it has been greatly to Britain's benefit that America has regarded it as a trading partner rather than an industrial competitor.

There is a good chance that China is now on the same path to world preeminence that America walked 130 years ago. Come 2047 and again in 2071 and in the years after 2075, America is going to need China. There is nothing more dangerous for America's future national security and nothing more destructive to America's future prosperity than for Chinese schoolchildren to be taught in 2047 and 2071 and 2075 that America tried to keep the Chinese as poor as possible for as long as possible.

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Speaking as a Water-Carrying Policy Intellectual...

Over at the coffeehouse that is TPM Cafe, I feel compelled to sail into harm's way vis-a-vis the eloquent and dangerous Jeff Faux:

A Question for Jeff Faux... | TPMCafe:

Jeff Faux is... confused, to put it politely. He opens:

Confronting Davos: The Class Politics of Global Governance | TPMCafe: it’s no surprise that a cross-border class politics has developed in the wake of the globalizing economy... a one-party system. Call it the Party of Davos, after the annual elite bash in the Swiss Alps that resembles the big-donor receptions at a political convention--corporate CEOs and world class investors, the people who carry their bags, and the politicians, pundits and policy intellectuals who carry their water...

Well, as one of the policy intellectuals who carries the water for the "corporate CEOS and world-class investors... people who carry their bags, and the politicians" I guess I should respond.

Jeff goes on:

[T]he economic challenge to Americans is not from China, per se, but from a business partnership between Chinese commissars who provide the cheap labor and American and other transnationals who provide the technology and financing--and whose lobbyists in Washington provided access to the US market.... [T]his reality is rarely if ever part of the mainstream discussion of globalization. It discomforts advertisers and campaign contributors. Better to define the issues with the abstract homilies of economics 101--“free-trade vs. protectionism.”...

[...]

Don’t think of your job, they tell anxious workers, think of the benefits of cheap prices.... [W]hatever numbers you want to believe, neither economic theory nor statistical calculation can determine whether the benefits of cheaper sneakers are worth the costs of lost jobs, disrupted lives and increased economic security. It is essentially a values question. In the context of the domestic economy, Progressives rightly reject the argument, even where true, that lower prices and greater employment generated by cheaper labor would justify the elimination of social protections and safety nets. Yet intimidated by the prospect of being labeled a “protectionist,” many support international trade regimes that are based on the same argument...

Let me respond with a question: Is there a way to interpret Jeff other than as a call to keep China a society of poor subsistence rice farmers as long as possible--keep them poor, barefoot, uneducated, and by no means allow them to work at any of the high-value manufacturing occupations we want to keep in the United States?

Hoisted from the Archives: National Review and Francisco Franco

Francisco Franco is still dead. Except in the archives of National Review, that is, where he is the glorious hero with a righteous cause who saved the day--an integral part of Western civilization--the man to whom Spain looks for leadership.

Yes, National Review praises military coups, the overthrow of democratic governments, the imperative need to side with neither Churchill nor Hitler, and that integral part of Western civilization that was Francisco Franco. You can sense William F. Buckley more than half-wishing he could have played his part in Franco's righteous fight against the grotesque democratic regime of Republican Spain--perhaps by piloting a Ju-87 in the Condor Legion?

October 26, 1957: General Franco is an authentic national hero... [with the] talents, the perseverance, and the sense of the righteousness of his cause, that were required to wrest Spain from the hands of the visionaries, ideologues, Marxists, and nihilists that were imposing... a regime so grotesque as to do violence to the Spanish soul, to deny, even, Spain's historical destiny. He saved the day.... The need was imperative... for a national policy [to]... make this concession to Churchill this morning, that one to Hitler this afternoon.... Franco reigns... supreme. He is not an oppressive dictator.... only as oppressive as is necessary to maintain total power...

March 9, 1957: Franco is a part, and an integral part, of Western civilization... [the] convergence of the multifarious political philosophical, religious, and cultural tendencies that have shaped Spanish history... the man to whom the Spanish people look--as the Chinese have looked to Chiang [Kaishek], for all his faults--for leadership.

Hoisted from the Archives: The Gordon Equation, Earnings Yields, and Stock Returns<

Grasping Reality with Both Hands: Economist Brad DeLong's Semi-Daily Journal: A Teaching Note: The Gordon Equation, Earnings Yields, and Stock Returns

J. Bradford DeLong, U.C. Berkeley and NBER
May 2007

At the level of the stock market as a whole, the ratio of cyclically-adjusted and normal earnings to stock prices--the permanent earnings yield--should be a good guide to the market's expectation of the real rate of return.

Think of it as a Modigliani-Miller result. Firms could pay out all their earnings in dividends and still keep their companies' productive potential unimpaired--that's what "earnings" means, after all. In that case, as long as the companies' productive potential is truly unimpaired the expected return is the earnings yield. When firms retain and reinvest earnings it is because managers see it as advantageous (to them or to shareholders) to do so. Thus with the appropriate caveats--as long as there are no big gaps between the required market and firms' internal rates of return, and as long as current accounting earnings do not grossly understate or overstate true Haig-Simons permanent earnings--the earnings yield on an index should be a good guide to the market's expectation of the long-run real rate of return on equities.

To fix this intuition, consider the Gordon equation in a steady-state context. The Gordon equation relates the long-run rate of return r on a company's stock--or a stock index--to the long-run dividend yield D/P and to the long-run rate of capital gain g:

r = D/P + g

In steady-state there is a constant dividend yield D/P and a constant share of earnings paid out as dividends:

D/E = θ

Assume also a simple generating process determining earnings. Assume a constant internal rate of return r+ρ on reinvested earnings. Earnings are then:

E = (r+ρ)K

where K is the comprehensively-defined productive capital stock assets of the firm (or index), and where the capital stock increases over time as retained earnings are used to purchase new plant and equipment or acquire already-existing productive assets:

dK/dt = E-D

In steady-state, the rate of capital gain g will be the same as the rate of growth of the capital stock:

g = (1/K)(dK/dt)

And then it is a simple matter of algebra:

(1/K)(dK/dt) = (1-θ)E/K = (1-θ)(r+ρ)

r = D/P + r - θr + ρ - θρ

θr = θE/P + ρ - θρ

r = E/P + (1/θ - 1)ρ

For ρ=0--when there is no difference between the market and the internal rate of return--then simply:

r = E/P

For θ=1--when there are no retained earnings--then simply:

r = E/P

When θ is less than one--when there are retained earnings--then earnings yields will understate returns to the extent that superior managerial knowledge of projects creates a positive gap ρ between internal and market rates of return; earnings yields will overstate returns to the extent that managerial entrenchment allows the dissipation of retained earnings on low-return projects--a negative gap ρ.

When firm managers classify investments as operating expenses to reduce tax liability, there will be a further positive wedge between r and the accounting earnings yield. Should firm managers overstate earnings to try to boost stock prices to increase the value of their options, this will drive a negative wedge between r and the accounting earnings yield.

And, of course, these are permanent earnings yields we are talking about: they must be properly adjusted for the state of the business cycle and for windfalls and non-recurring expenses.

But with these caveats--accounting earnings a good approximation to true Haig-Simons permanent earnings, managerial entrenchment offsetting superior managerial information to keep internal close to market rates of return, and so forth--the same logic that leads us to the Gordon equation conclusion that the dividend yield should be equal to the difference between the required rate of return and the dividend growth rate leads, if taken one step further, to the conclusion that the earnings yield should be the required rate of return.