Both Nick and I agree that investors appear to be substituting out of private securities and into government securities (in particular, USD and US treasuries). We appear to differ on the underlying cause of this behavior.
Nick takes the bubble and its behavior as exogenous. There is a growing bubble in money/bonds, which is drawing resources away from private capital investment. In a comment on Nick's post, I suggested an alternative interpretation. I take expectations over the future return to capital as exogenous and interpret the bubble asset as a socially beneficial alternative store of value (in theory, such bubbles can mitigate the adverse consequences of a dynamic inefficiency).
The type of model I have in mind can be found here. In that model, money (bonds) and capital compete as a store of value in the wealth portfolios of individuals. Assuming risk neutrality and diminishing returns to capital investment, a no-arbitrage-condition equates the expected marginal product of capital to the expected real rate of return on money. I then define "good news" as information that leads to an upward revision in the forecast of capital return; "bad news" is defined conversely. I argued that a bad news event (or a series of bad news events) would cause rational downward revisions in the forecasted return to future capital, thereby depressing capital investment and stock prices, and causing a flow of resources into government money/bonds. There would be "surprise" declines in the price-level (reflecting the increase in demand for money). The resulting behavior looks like an exogenous increase in the demand for government securities, but this is the wrong interpretation.
In a subsequent discussion, Simon van Norden asked me to explain what evidence I had to support the notion that shocks to expectations (over future capital return) varied significantly and at high frequency. These are the type of impolite questions that I think need to be asked. I replied, rather lamely I think, that these expectations were difficult to measure (except perhaps, indirectly via asset prices). I think I even stooped to the time-honored tradition of citing the importance that our predecessors attached to the hypothesis (think Keynes, Pigou, Marshall, and so on, back in time). Simon suggested that I look at the Federal Reserve Bank of Philadelphia's Survey of Professional Forecasters. Thanks, Simon!
I am kind of leery of this data, as the forecasts of professional forecasters are not necessarily the same thing as the forecasts of businessmen in charge of making multimillion dollar investments. Moreover, the survey does not ask about forecasts over the return to capital...the closest measure is future real GDP growth. But what the heck...some data is better than no data.
And the data looks kind of interesting. In Figure 1, I plot the average (over all forecasters) expected growth rate over five periods: the current quarter, one quarter ahead, ..., up to four quarters ahead. (Click on the figure to enlarge). I do this for each quarter, beginning with 2007:4 and ending with 2010:2. The dashed line measures actual (revised) real GDP growth. Let me summarize some facts about this data that I find interesting.
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| FIGURE 1 |
FACT 1: Short-run forecasts are much more volatile than long-run forecasts.
Personally, I find the resiliency in the year-ahead forecasts rather remarkable. Even in the depths of the financial crisis, these professional forecasters were forecasting a return to normal rates of growth within a year or so. Do they run the same canned VAR models to come up with these forecasts? I wonder whether businessmen in charge of capital budgets were as optimistic as these professional forecasters in the fourth quarter of 2008?
FACT 2: The recent recession appears to be associated with a persistent (possibly permanent) decline in potential GDP.
An expected return to "potential" GDP would require year-ahead forecasts to exceed 2% per annum coming out of the recession. This does not appear to be the case; at least, not so far.
I wonder how Pigou and Keynes would have reacted to this data. If I understand their views correctly, it is precisely the long-horizon that is subject to the psychology of animal spirits. And because capital investment today runs largely off of long-horizon forecasts, this is what makes investment so volatile. This view (which is related to my own) does not seem to be supported by this data.
On the other hand, even changes in short-horizon forecasts can induce changes in asset prices. And to the extent that assets are used as collateral in lending, a decline in asset prices may depress investment spending through the familiar accelerator. (I have written a model, with my SFU colleague Fernando Martin, that is being extended in this manner).
It is also of some interest to explore some higher moments associated with these growth forecasts. In Figure 2, I plot the standard deviation of forecasts (across forecasters) in each quarter and at each horizon. I interpret this standard deviation as a measure of "uncertainty."
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| FIGURE 2 |
Figure 2 suggests that the uncertainty over long-horizon growth increased substantially since the beginning of the recession and continues to remain high. In a nutshell, these forecasters are expecting a return to 2% growth in the long-horizon, but there appears to be much more uncertainty among these forecasters about the prospect of such an event.
It is also curious to see how "uncertainty" over the short-horizon increases dramatically. I view this as some evidence against Nick's hypothesis and in favor of my own (extended to include higher moments, of course). The emerging bond bubble is the consequence of increasing uncertainty over short and long term capital returns; this same uncertainty is contributing to depressed capital expenditure.
In short, I think that Nick might have the direction of causality ass-backwards.
* I thank Constanza Liborio for gathering and plotting this data.
David,
ReplyDeleteInteresting post. Naturally, being a corporate finance researcher, I believe I have some insights here. Before getting into that, I think you might enjoy reading some of Bob Higgs' writings. His most recent on regime uncertainty, in which he talks about businessmen forecasts: http://www.independent.org/blog/index.php?p=7821
Now, let's think about how a business approaches an investment project. A project that carries requires significant resources often has two characteristics: partial (or complete) irreversibility and the ability to delay. Because of the irreversibility, the delaying option is valuable. We know from option pricing theory that increased uncertainty raises the value of the option. The delaying option is no different here. So right now it is more valuable to "wait and see" than to go ahead with a project.
In the mean time, businesses are accumulating hordes of cash. Something like $1.8 trillion, according to the latest from the WSJ. That cash needs to be held in cash and near-cash because it needs to be "shovel-ready" for when uncertainty damps down. Also, periods of high uncertainty will keep the businesses from investing in capital securities like stocks and corporate bonds, for obvious reasons.
So, where does the cash go? Lowest-risk securities that can be found. Cash and near-cash in the form of U.S. treasuries. And voila - bond bubble.
Btw, this doesn't even take into consideration the foreign companies, governments, and individuals who are dealing with regime uncertainty and need to park cash for a while.
Hi David: "(the mad, mad I say)" That got a good laugh! It has to be said with an English accent, right? But what movie (or whatever) is it from?
ReplyDeleteMy crude story of causality follows something vaguely similar to Scott Sumner's story. The falling expectations of *nominal* GDP are a sign of tight monetary policy. This is almost definitional for Scott, since he says that the job of the Fed is to keep expected NGDP growing at some smooth constant rate.
(We can quibble over whether we say that the Fed *caused* expected NGDP growth to fall, or whether it *allowed* expected NGDP growth to fall by failing to respond appropriately to events in financial markets, that increased the perceived risk of holding assets previously seen as safe, and caused a flight to money+bonds.)
And that tight monetary policy is what caused real GDP to fall.
(Some people reading this will immediately shout out "How can you possibly say monetary policy was tight, when nominal interest rates are 0%!!!?" And the answer, of course, is that low/high nominal interest rates are not a sign of current loose/tight monetary policy but of past tight/loose monetary policy.)
How to distinguish, empirically, between your view and mine/Scott's?
Dunno. Maybe that your view is a story about *real* GDP expectations, and mine/Scott's about *nominal* GDP expectations? If so, I think that what was happening on the TIPS spread might confirm our monetary story? Though it doesn't really contradict your story.
Good post.
Prof J: You are talking about "the option value of doing nothing", right? And that creates a demand for liquid assets, because you delay investing in the irreversible (which means illiquid) real assets.
ReplyDeleteDid a post on this a couple of months back.
I would say it is not strictly an increase in uncertainty that causes people to delay irreversible investments. It is increased uncertainty *that people expect to be resolved soon*. It is *expected future reduction* in uncertainty that stops investment.
God help us if they ever announced that cheap and reliable crystal balls will be available to buy next year. All irreversible investment would immediately collapse, as everyone waits for the crystal balls that will tell them where to invest. All us profs would be unemployed for a year, as all students waited till next year to decide what they should major in.
Right now, everyone's waiting to see what the Fed is gonna do.
Nick,
ReplyDeleteI would say you're absolutely right when you say it is uncertainty that people expect to be resolved soon. Soon is a bit of an ambiguous time frame, but suffice to say "within the next couple of years" or similar thing.
I disagree that everyone's waiting to see what the Fed will do. I think that's only one piece of the puzzle. Shoes will also continue to drop on health care, financial services, and tax regime issues.
Prof J: Thanks for the link to Higgs. I'm not sure why he says "mainstream" economists hold regime uncertainty with contempt. (I've modeled uncertain policy regimes myself). Apart from this, what he says makes sense to me.
ReplyDeleteNick: I cannot locate the source of that line, though it is obviously from a movie (perhaps more than one).
So, if I understand, your story is that a financial shock of some sort increased some measure of uncertainty. I think we more or less agree on this, except that you interpret the shock as a bursting bubble, and I interpret it as the rational response to new information relating to underlying fundamentals. Either way, there is a flight to government securities.
My interpretation is that this flight to safety is contributing to the bond bubble; and that the bond bubble may be welfare improving.
Your interpretation is that the bond bubble should be pricked by the Fed, so as to dissaude individuals from storing their wealth in bonds--thereby rediverting resources to investment, which has collapsed for no good reason.
If I have your argument just about right, I'd question the notion that investment spending has collapsed for no good reason. A case can be made, I think, that there was an overbuild, that expected returns did not materialize (nothing necessarily irrational about this), and that it is now time to reallocate resources to their best uses.
David,
ReplyDeleteI'd like to hear your thoughts on the new banking proposal being fielded in UK.
Thanks,
Prof J
David: It's both investment and (or and/or) consumption that's too low. It's individually rational for people to spend less, but not collectively rational. Standard Keynesian/monetarist coordination failure from a fall in AD. If everybody did what was individually irrational, and tried to get out of bonds+money, everyone would be better off.
ReplyDeleteProf J: Do you have a good summary of those proposals? (I've found some scattered references, but have otherwise not been paying attention).
ReplyDeleteNick: Your reply above can be interpreted in one of two ways. [1] You are stating a theorem; or [2] You are stating what you know to be true of reality.
If you meant [1], then yes, of course, I am familiar with this argument. If you meant [2], well, I'm not sure how you can be so sure.
The "coordination failure" argument requires that agents coordinate on depressed expectations (say, concerning the future return on capital expenditure). Take a look at the data on one-year-ahead growth forecasts. They do not look depressed to me. How can you reconcile this data with your hypothesis?
David,
ReplyDeleteHere is a link with a lengthy preamble by Stephan Kinsella. The actual proposal starts around the middle of the page, with a fairly unassuming (read: small) title so be careful when scrolling through. It's easy to miss. My understanding of the gist is that it's really more about laws regarding lending of deposits than a considered approach to FRB and banking crises.
http://blog.mises.org/13868/british-proposal-for-banking-reform-fractional-reserve-banking-versus-deposits-and-loans-2/
David: I was stating my belief. I'm not sure.
ReplyDeleteThere's "growth* forecasts and *level* forecasts. Even if growth forecasts look OK, going forward, the recession means the level forecasts will be lower than trend. If firms already have more capacity than they need to meet existing demand, it would take much higher than normal growth, over a longer period, to persuade them to invest. The Marginal Revenue Product of capital is zero if you can't sell the marginal unit of output.
Nick,
ReplyDeleteThe distinction between growth and level had occurred to me, and I am not surprised that you invoke it now.
I don't want to put words in your mouth, but what you seem to be saying is the following. The bursting real estate bubble led people to become overly (from a social perspective) pessimistic over short-horizon growth prospects (long horizon forecasts did not change very much). This led to portfolio substitution, bonds for capital, leading to a bond bubble and downward pressure on investment spending. People continue to be overly depressed over short-run growth prospects; moreover, their long-run growth prospects do not forecast the economy catching up to "potential" any time soon. There is an "effective demand failure." Policy needs to stimulate demand, to kickstart sales, and improve both short and long horizon expectations (which will then become a self-fulfilling prophesy).
Is this, more or less, your argument?
How do you know that the economy was not operating above "potential" prior to the crisis? This would seem to be consistent with what people now interpret as a "bubble" in asset prices. How do we know that the economy is not at or close to potential right now? (Is it the unemployment rate? What if all these people just drop out of the labor force? Would you continue to say we are below potential?)