Reagan, Taxes, Jobs: Morning in America
links for 2010-01-19

Six Economics Pieces Worth Reading: January 19, 2010

1) Mark Thoma sends us to Maxine Udall: Please, sir, may we have some justice?:

We have just witnessed highly compensated investment bankers asserting that they are the clueless victims of an unforeseeable, unpreventable hundred year financial crisis (except when it happens every five to seven years). Until last year, Maxine had always assumed that at least one reason for investment bankers' high compensation was that the market had chosen to reward them for competence and knowledge about high finance, things we lesser mortals couldn’t possibly grasp with our mundane, tiny little minds. Now we find out that they apparently hadn’t even grasped the basics that Maxine’s rather less well-paid businessman father drilled into her from a very early age. “Maxine,” he used to say. “The higher the returns, the higher the risk, and if the returns are high and sustained, you’re in a Ponzi scheme or a bubble. Never forget that.” And Maxine never has...

2) Free Exchange: More on bubble spotting:

SCOTT SUMNER has written a long post defending Eugene Fama and the efficient markets hypothesis. In a nutshell, he thinks that I'm gravely mistaken if I believe that bubbles can be spotted ahead of time, that The Economist's correct calls of the tech and housing bubbles were just a magnificent stroke of luck, and that if we're so bloody confident in our ability to predict bubbles why aren't we making billions running mutual funds? I feel like this is the sort of critique that sounds lovely so long as one remains comfortably in the realm of abstract intellectualism. The price-to-income ratio has risen above its long-term trend, but how can we know that it's a bubble? Fundamentals? Well, perhaps they've shifted. And if you're so confident, why aren't you ringing up your trader and telling him to short housing?

In The Economist's recent Briefing on bubbles, the author of the Briefing outlined a few key signs... high asset values relative to historical trends... price-to-income and price-to-rent ratios... well above trend levels.... At the very least, you ought to be able to tell a compelling story about why things have changed.... Secondly, the author warned that bubbles typically involve rapid private credit growth and market enthusiasm. If this were all a matter of making predictions based on big upward swings in a set of asset values, well, Mr Sumner might have a point. But it's a little strange, is it not, that writers at The Economist and elsewhere didn't just identify the bubble but correctly pointed out the specific dynamics that were creating this unsustainable state--a heedless expansion of the credit available to those willing to buy homes? It's one thing to be right about a guess that it may rain tomorrow. It's another to identify the approaching low pressure system and specify the moisture content of the airmass....

Markets are efficient in the sense that it's hard to make an easy buck off of them, particularly when they're rushing maniacally up the skin of an inflating bubble. But are they efficient in the sense that prices are right? Tens of thousands of empty homes say no. And despite the great extent to which markets depart from the theoretician's ideal, people did manage to put together models predicting the fall, bet on those models, and make a great deal of money off of those bets. And now we find ourselves in a situation where these people, having set up a model explaining what would happen which was subsequently verified by events, are being told that they suffer from cognitive illusion. That in fact, this testable hypothesis, which passed a test against real world events, is no good.

Well, ok. If Mr Sumner and Mr Fama continue to feel secure in their beliefs, then that's their business...

3) Matthew Yglesias: Efficient Markets Hypothesis Rhetoric:

Read Scott Sumner’s lengthy defense of Eugene Fama and the Efficient Markets Hypothesis makes me want to refine what I said already about Fama’s recent New Yorker interview. This goes back, I suppose, to Larry Summers’ old point about ketchup economics, but I think people are talking past each other over the term “efficient.” Let me quote Summers:

The differences I am discussing may be clarified by considering a field of economics which could but does not exist: ketchup economics. There are two groups of researchers concerned with ketchup economics. Some general economists study the market for ketchup as part of the broader economic system. The other group is comprised of ketchup economists located in Department of Ketchup where they receive much higher salaries.... General economists are concerned with the fundamental determinants of prices and quantities in the ketchup market. They attempt to examine various factors affecting the supply and demand for ketchup such as the cost of tomatoes, wages, the prices of ketchup substitutes and consumers incomes. They examine a number of different types of data in an effort to explain fluctuations in ketchup prices.... Ketchup economists reject out of hand much of this research on the ketchup market. They believe that the data used is based on almost meaningless accounting information and are quick to point out that concepts such as costs of production vary across firms and are not accurately measurable in any event. They believe that ketchup transactions prices are the only hard data worth studying. Nonetheless ketchup economists have an impressive research program, focusing on the scope for excess opportunities in the ketchup market. They have shown that two quart bottles of ketchup invariably sell for twice as much as one quart bottles of ketchup except for deviations traceable to transactions costs, and that one cannot get a bargain on ketchup by buying and combining ingredients once one takes account of transactions costs. Nor are there gains to be had from storing ketchup, or mixing together different quality ketchups.... Indeed, most ketchup economists regard the efficiency of the ketchup market as the best established fact in empirical economics.

To say that the ketchup market is “efficient” from the point of view of a participant in the ketchup market seeking an opportunity trade at a profit is just a totally different thing from saying that the fluctuations of the ketchup market constitute an efficient element of a larger economic system.... [Market] crashes have a lot of undesirable effects on people’s lives and that the speed and magnitude of the changes doesn’t seem grounded in any acts of God. It’s not as if an earthquake leveled the stock market or the productivity of the American workforce dramatically plummeted. It’s just not clear that predictability has anything to do with this. But if people just called the thesis that financial markets are unpredictable the “unpredictable markets hypothesis” then I doubt that people outside the Department of Ketchup would be very interested in arguing with them...

4) BEST NON-ECONOMICS THING I HAVE READ TODAY: Robert Farley: On How Neocons Feed Off One Another...:

The ideology of toughness extends beyond the borders of the United States; the Russian, Chinese, and Iranian versions of Chuckie Krauthammer are at this very moment insisting that the projection of power, resolve, and toughness will force the Americans to back down/give up/stop poking us/do something. The implications of handing foreign policy to people committed to the rhetoric of toughness should be obvious. A demonstration of "resolve" on the part of the United States is matched by a similar demonstration on the part of the Chinese; a weapon system intended as a "bargaining chip" spurs development of a corresponding system by the Russians; insistence on "regime change" in Iran empowers the people who have always argued that the United States intends to conquer Iran. And then we get things like this: "China said late Monday that it had successfully tested the nation’s first land-based missile defense system..."

[H]ow could you think that a Chinese ABM test would have an even vaguely positive effect on US behavior? Does anyone now believe that it is less likely that the US will transfer F-16s and Patriot missile systems to Taiwan? I appreciate that weapons need to be tested and domestic constituencies need to be appeased, but it seems clear that the Chinese intended this test as a warning to both the US and Taiwan. I suspect that the Chinese intended this message to say: "Please respect China's territorial integrity, and right to manage its sphere of influence..." I very much doubt that this is the message Americans will hear. More specifically, I doubt that the right people will hear this message in the way the Chinese want. Instead, those voices who have always insisted that the Chinese are an incorrigible threat, that they cannot be dealt with, and that they only understand the language of force will be enabled. To manage the next foreign policy dispute with China in a wise and measured fashion will become "appeasement of the aggressor." Voices in Beijing will be making precisely the same argument.

I suspect that international franchising of the Weekly Standard might be an excellent investment opportunity.

5) STUPIDEST THING I HAVE READ TODAY: Via Glenn Greenwald, Cass Sunstein:

What can government do about conspiracy theories?... (1) Government might ban conspiracy theorizing. (2) Government might impose some sort of tax.... (3) Government might itself engage in counterspeech, marshalling arguments to discredit conspiracy theories. (4) Government might formally hire credible private parties to engage in counterspeech. (5) Government might engage in informal communication with such parties, encouraging them to help. Each instrument... will have a place.... However, our main policy idea is that the government should engage in cognitive infiltration of the groups that produce conspiracy theories...