Why Short Selling Matters

Arnold Kling (hat tip: Matthew Yglesias) argues that short-selling can’t “destroy a good company” because if the company is good, someone will always be willing to pay a good price for it and will be willing to buy it from the short-seller at that good price. But his analysis fails to account for uncertainty and imperfect information. We don’t really know which companies are “good.” Everyone has their own guess about how much a company is worth, but how much is it really worth? We won’t know until we see its results. Actually, we won’t even know then, because it will have more results in the future that we still won’t know about.

In general, since the market value of a company depends on an uncertain guess as to its true value, a good company can be destroyed simply by bad opinions, if people wrongly judge that it is a bad company. And, as I will explain, short-selling can exacerbate this problem in the case of a company that is in fact good but that, in terms of market opinions, is on the margin between being considered good and being considered bad. The “margin” idea applies when there is only one “marginal” short seller, but if there are many, they will effectively widen the margin, so that a clearly “good” company can turn into a clearly “bad” one.

For any given company, the market does not have one opinion, shared by everyone, about the value of its stock. Rather, everyone has a different opinion. People use different methods (including subjective ones, which differ from any one individual to another) to evaluate a stock. Those different methods lead to different conclusions about the stock’s value. One person may think a stock is worth $10; another may think it’s worth $9.99; another may think it’s worth $9.98; and so on down, and maybe, at the other extreme, there is someone who thinks it’s only worth $2.

So suppose the stock is trading at $10, and a large short-seller appears on the scene. The short-seller will satisfy the demand of the person who thinks the stock is worth $10, and then there will be no more demand at $10, and the stock will trade down to $9.99. Then the short-seller (who is, by my construction, “large”) will satisfy the demand of the person who thinks the stock is worth $9.99. Then the stock will trade down to $9.98, and the short-seller will satisfy the demand of the person who thinks it’s worth $9.98, and it will trade down to $9.97. And so on. If there are a lot of large short-sellers, they can bring the price down by quite a lot by, for example, satisfying the demand of everyone who thinks the stock is worth more than $7.

So let’s take that $10/$7 example, and let’s suppose that the definition of “good” requires the stock to be worth $8 or more (in a sense that will become more precise in later paragraphs). By sending the price down from $10 to $7, the short-sellers have effectively shifted the company’s “market reputation” from the “good” category into the “bad” category. No individual has actually changed their opinion, but because of the aggressiveness of the short-sellers (who obviously believe the company is quite a “bad” one), the “market” has changed its “collective opinion.”

Now let’s suppose that the company is (in actual fact rather than opinion) a “good” company but that it needs to raise more equity capital in order to stay good. (When you’re talking about a bank that is solvent but undercapitalized, this might be a reasonable description.) When it offers new shares, the company faces the same demand curve as the short-seller did, and since the price is now down to $7, the company will have to offer the shares at a lower price, say $6, for the offering to be fully subscribed, because it will satisfy the demand of everyone who believes the company is worth $7, $6.99, $6.98, and so on, down to $6.

OK, but suppose that the amount of capital raised at a $6 share price will not be enough to keep the company good. And let’s also suppose that it would have been enough if the offering price had been $9, which it would have been (approximately) if the short-sellers had not become involved. So the company still doesn’t have enough capital, and it needs to raise more. So it offers more shares. But again, the company faces a downward-sloping demand curve for its shares. Suppose it offers additional shares, which satisfy the demand of everyone who thinks they are worth more than $5, so the company offers these new shares at $5. But suppose that still is not enough to keep the company good. It has to offer more shares. But now that it has done two separate offerings, and it attempts a third, it probably won’t have the confidence of the market. Market participants will say, “If we pay $4 now, who is to say that the company won’t come back and offer shares at $3? We’ll wait for that.” And if they wait for $3, why not wait for $2? And if $2, why not $1? Of course at some point everyone is going to realize that the company is going to be unable to raise sufficient capital at any price.

In practice, potential buyers will have realized that much earlier. If they have a reasonable guess as to how much capital the company needs, and a reasonable guess as to what the demand curve for its stock looks like, then they will be able to come up with a reasonable guess as to whether the company can raise the necessary capital. Of course, there will be a variety of guesses, and opinions will differ. But at some point (as the declining stock value makes the problem clearer), only a few people (or none at all) will be of the opinion that the company can raise enough capital. At that point, the company is effectively ruined, the price goes down to near zero, and the short-sellers profit handsomely. If there are enough large short-sellers, not only can they destroy a good company, they can make a lot of money doing it.


UPDATE: Another way to argue that short-selling doesn't matter would be to argue that the person with the $10 opinion has an infinite amount of capital available, and therefore they will demand an unlimited number of shares at $10. Of course, it's rather silly to think that anyone has infinite capital. And for someone with limited capital, the more they pay for the shares, the more risk they are taking. So they will be willing to buy a certain number of shares at $10, but after that, the risk become too high, and the price has to go down to get them to buy more. Essentially, my argument above still applies, except that you can construct the demand curve from just one person's opinion. If there are many potential buyers, each of whom has limited capital and limited risk tolerance, but who have different opinions, the demand curve will still slope downward, and again my argument applies.

WSJ Factual Error

From the top story in today’s Wall Street Journal:

At one point during the day, investors were willing to pay more for one-month Treasurys than they could expect to get back when the bonds matured....That’s never happened before.

Actually it has happened before, not in the easily available data, but it has happened – in 1938 (and apparently several other times between 1935 and 1941).

My only source is a talk by Paul Samuelson, for which I cannot even point to a transcript, but I’m confident that primary sources will bear me out. I’m too lazy to go check old copies of The Wall Street Journal on microfilm, but take my word for it.

It’s actually pretty obvious if you look at the monthly data from the Fed. For example, in February 1941, the average yield on 3-month T-bills was 0.03 percent. Considering how the yield fluctuates from day to day and from hour to hour, it’s impossible to believe that it was not negative at certain points during that month. (Technically the Journal was referring to one-month bills, but it’s a safe assumption that, if 3-month bills were selling above maturity value, so were one-month bills for at least part of the time.)


UPDATE: Paul Krugman makes the same claim (hat tip: anonymous commenter)....and I continue to believe it is wrong. I'm not sure his claim is independent: he may have gotten his information from the Journal, or they may have gotten it from the same source, which I hope they will cite so we can follow it up and judge its reliability.

UPDATE2: Reuters and the AP, both citing Los Angeles-based Global Financial Data, report that the last time the 3-month T-bill was at or below zero was January 1940. (Could it merely have been "at" zero? It seems unlikely that the bid would have stopped at exactly zero.) Another AP report says that demand sent "the yield on the 3-month Treasury bill briefly into negative territory for the first time since 1940." Friedman and Jacobson, in A Monetary History of the United States, 1867-1960, say in a footnote that "yields on Treasury bills were occasionally negative in 1940." (Apparently my "obvious" conclusion about 1941 was not correct, buy my main point stands.)

How many people have lost their jobs?

According to Barack Obama, 600 thousand Americans have lost their jobs since January. Actually, he's wrong: something like 20 million Americans have lost their jobs since January. It's just that most of them found new jobs. Probably the new jobs generally weren't as good as the ones they lost. And almost certainly, more than 600 thousand of them were unable to find new jobs, because many of the new jobs created were filled by new entrants to the labor force or by people who were already unemployed when the year began.

Like almost everyone else I've ever heard, Senator Obama is making the mistake of using a net job loss figure with language that, if taken in its plain sense, clearly implies he is talking about gross job loss. And it seems to me that gross job loss is the appropriate concept: losing your job is a pretty serious bummer, even if you are able to find a new one after a few months.

There has been a lot of talk about Senator McCain and how he has been saying things that aren't true in order benefit himself politically. It turns out that Senator Obama is also (obviously unintentionally) saying things that aren't true, but in this case they benefit his opponent.

Moral Hazard for Corporations, part 2

I agree with Mark Kleiman's main points here, but this one, as my previous post would suggest, I think is a mistake:

Why shouldn't the government bail out a private company that isn't a regulated bank? Moral hazard. You don't want to protect AIG shareholders from the consequences of the bad bets made by the management, or you offer every big firm the chance to gamble on a "heads I win, tails you cover my losses" basis.

(Just to be clear, he isn't defending his own overall position with that statement; he's just discussing one consideration to be weighed.) As I argued in my previous post, whether or not any "bailout" is attempted, the shareholders are automatically bailed out by the limited liability that is part of the definition of a corporation. In a failure, their stock might become entirely worthless; in a bailout it just becomes almost worthless -- not an important distinction. Prudent stockholders have portfolios of stock, so it's not like a stockholder is someone who will personally be left with nothing in the case of a failure but still have a little bit to keep in the case of a bailout. Typical stockholders will just see changes in the values of their portfolios, and the difference between a 90% drop and a 100% drop in one stock will make only a tiny difference to the value of the portfolio.

Mark Kleiman goes on to discuss the role of moral hazard for creditors, and of course that is the real story. Since stockholders have limited liability, they always have an incentive to take excessive risks, unless the creditors prevent them from doing so (usually by threatening to withdraw credit). The real reason for avoiding bailouts is that the prospect of a bailout takes away the creditors' incentive to provide discipline. OK, I'm not going to repeat more of what I've said like three times already, and I'm not going to quibble with the subsequent wording of the post that I cited. It's worth reading for itself, although the argument is not too different from what I've been saying in recent posts.

Moral Hazard for Corporations

With all the talk about “moral hazard” lately, I have realized something: there is a basic flaw in the way the subject is typically discussed with respect to financial corporations. I’m not saying that the people discussing it are necessarily misunderstanding, but the terms in which it’s typically discussed will tend to lead the unwary into sloppy thinking or confusion.

Take, for example, the aphorism (regarding deposit insurance), “Heads stockholders win, tails taxpayers lose.” (This aphorism was recently used by, and may have been coined by, Paul Krugman. To be fair, if you read his whole entry, the language is more precise when he discusses the matter explicitly. But he also uses the misleading expression – which he did not coin – “FDIC put.”) This makes it sound as if deposit insurance were somehow protecting stockholders from the consequences of risky actions taken on their behalf. But what if there were no deposit insurance and the same risky actions were taken? What would happen to stockholders if those risks turned out badly? The stockholders would lose what they put into the corporation but no more – exactly the same as when there is deposit insurance. The moral hazard problem exists in general with stockholders, whether or not the assets are insured, because of the limited liability inherent in the corporate form of ownership. There is no “FDIC put” for stockholders; there is merely the “corporate put” that exists for all corporations.

When we talk about corporations whose assets are insured, either explicitly or implicitly, the special moral hazard problem is not with stockholders but with creditors. In the case of commercial banks, the creditors are known as depositors. The problem with deposit insurance is that it takes away the incentive that depositors would have to select and police their banks in such a way as to prevent excessive risk-taking. Overall, in the case of commercial banks, removing this incentive is a good thing, because depositors – with limited information and resources – aren’t able to do a very good job of policing and selecting banks. Their attempts to identify “bad banks” often result in “false positives” that precipitate bank runs. It makes much more sense to have regulators – who have more resources and better information – do the policing.

So I’ll repeat the point I’ve made several times before. When we talk about the implicit insurance that is (apparently not, as of yesterday) offered to investment banks and the like, the issue is not whether the stockholders are being protected – they’re always protected by the rules of corporate ownership – but whether the creditors are being protected. Are creditors being encouraged to make rash decisions about where to lend their money? Is the process of avoiding those rash decisions (as in the case of commercial banks) an inefficient one that could be done better by someone else (regulators, presumably)?

I have argued that, in the case of major investment banks, the moral hazard for creditors should not be a major concern. The comments have convinced me that I may have overstated my case, but I stand behind the policy recommendation. (Well, a “recommendation” after the fact is known as a “criticism,” but I would have recommended the same thing before the fact. The main reason I didn’t talk about it before the fact is that I expected officials to do what I would have recommended anyhow.) Large investment banks can, and perhaps should, be allowed to fail sometimes, but not when the country is already in the midst of an ongoing financial crisis and interest rates are low enough to limit the potential for using monetary policy to blunt the economic effects. Creditors should perhaps take the risk of losing their investment during generally good times, when the effect on the economy would not be potentially disastrous. I’ll reserve judgment as to whether creditors should be (implicitly or explicitly) insured (and I will certainly agree that such insurance should come with additional regulation), but I will not retract my opinion that the financial system as a whole should be insured. Sometimes implementing insurance for the system as a whole requires that individual institutions be bailed out.

Third Rant of the Day

When it rains, it pours. This one is really sort of a repeat of my first rant, but with more explanation and less sarcasm. Well, more explanation, anyhow.

Here’s Treasury Secretary Paulson at a press briefing this afternoon:

I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers.

When I first read this, I interpreted it to mean, “I never once considered the possibility that it was appropriate...,” and I was ready to write a somewhat more obnoxious rant about how Paulson was either a liar or irresponsible, and I hoped he was a liar. But a more careful parsing reveals that he is neither lying nor being irresponsible; he is just engaging in doubletalk. I don’t fault him for that, since it’s pretty much part of the treasury secretary’s job description. He never considered it to be the case that it was appropriate to put taxpayer money on the line.

Secretary Paulson is drawing his macho line in the sand and saying, “See, Mr. and Mrs. Average American, who faithfully pay your taxes, I’m protecting your money from the whining Wall Street plutocrats. So never think that just because I came from Wall Street, I will put Wall Street’s interests above those of Main Street. And never say that Republicans always help the rich.”

Which is fine if you believe that financial events have no impact on the nonfinancial economy. But most economists (and, I would guess, Secretary Paulson himself) don’t believe that. Let me assert – and see whether I get broad disagreement – that the failure of the 4th largest investment bank in the country can be expected to increase significantly the risks faced by participants in the nonfinancial economy. In particular, when the financial system is strained and interest rates on Treasury securities are already quite low, there is an increased risk that a weak economy will turn into a serious recession which the Fed will have little power to combat. If you depend on your job to earn a living, that’s a pretty serious risk.

So instead of putting “taxpayer money” on the line, Secretary Paulson is putting taxpayers on the line.

But then there is also the question of whether even “taxpayer money” is really less on the line than it would be if the Treasury had provided loan guarantees. I’ve addressed this question before in connection with the Fed’s Term Securities Lending Facility. Each individual taxpayer who benefits from public services depends on the taxes collected from all the other taxpayers to help pay for those services. If the other taxpayers start losing their jobs, tax receipts will go down, and this taxpayer will eventually have to pay more taxes, or give up more public services, to make up for that loss. If you risk the potential economic effects of a major investment bank failure, you are risking that taxpayers will have to pay higher taxes. That’s just the same as if you had provided loan guarantees, which risk that the loans will go sour and require an increase in taxes to make up the difference. In which case is the risk bigger? Not obvious to me, but if I had to guess, I would say that the investment bank failure risks taxpayer money more than would the loan guarantees. So I would say that Secretary Paulson’s stance on “taxpayer money” is either politically disingenuous or economically naïve.

Let’s consider the possibility that it is politically disingenuous and that his motivation is actually something different than protecting taxpayer money. I’m not suggesting anything sinister; I’m just suggesting that there is a (slightly) more reasonable, but harder to explain, argument for avoiding a bailout. As Secretary Paulson says elsewhere in the briefing:

Moral hazard is something I don't take lightly.

Rather than trying to define moral hazard, I’ll go with the definition used by the AP in the report about the briefing: “the belief that when the government steps in to rescue a private financial firm it encourages other firms to engage in risky behavior.”

But does it? When the government steps in to rescue a firm by facilitating its sale at a small fraction of the price that it fetched a year or two ago, does that really encourage other firms to engage in risky behavior? It’s kind of like when your health insurer requires only a $950 co-payment for a $1000 procedure. Does that give you an incentive to make excessive use of the health care system? If I were a financial firm contemplating engaging in risky behavior, I wouldn’t find the prospect of a fire-sale rescue to be very encouraging.

It’s really not the firm that would be bailed out, but the firm’s creditors. Were the creditors engaging in risky behavior that needs to be discouraged? There isn’t much I can say about that that I didn’t already say this morning. In general, I think that doing business with major investment banks is something that we should encourage. A financial system doesn’t work very well when everyone is afraid to do business with everyone else. Should counterparties really be expected to do extensive due diligence on the 4th largest investment bank in the country before they engage in credit swaps with it? It seems to me that would not be a very efficient use of resources. And in any case, it’s not clear that even extensive due diligence would have uncovered the depth of Lehman’s problems.

End of rant. Executive summary: They should have bailed out Lehman.

Careless, Disingenuous, or Just Ignorant?

Donald Luskin in the Washington Post:

Obama is flat-out wrong when he frets on his campaign Web site that "the personal savings rate is now the lowest it's been since the Great Depression." The latest rate, for the second quarter of 2008, is 2.6 percent -- higher than the 1.9 percent rate that prevailed in the last quarter of Bill Clinton's presidency.

That sounded a little strange to me, so I checked the national accounts. It's quite true that the savings rate is 2.6 percent in the second quarter of 2008, but the average of the last 4 quarters is less than 1 percent, and in most of the recent quarters it has been 0.5% or less -- which certainly qualifies as "the lowest...since the Great Depression."

Have US households suddenly seen the light and started saving again? A slightly closer look at the national accounts shows where that light shined from. The only thing unusual about the second quarter of 2008 was a sudden drop in "personal current taxes," which resulted in an increase in "disposable personal income," the denominator for the savings rate. Ah, yes, that's what had slipped my mind (and perhaps Mr. Luskin's as well) about the 2nd quarter. (If the reason for the drop in taxes isn't immediately apparent, you might want to check the headlines for January 24. But I'm guessing that rebate check didn't come as a surprise.)

Apparently Americans thought it might be better to save some of of the "stimulus" money for, say, the 3rd quarter or the 4th quarter...or even next year? So, yes, the savings rate did go up. That's one of the usual results of a fiscal stimulus. In fact, a fiscal stimulus is exactly how Franklin Roosevelt managed to get the savings rate back into positive territory during....what was it?...oh, yeah, the Great Depression.

Perhaps Mr. Luskin was in a hurry and didn't notice what the savings rate was in other recent quarters. Or perhaps he was deliberately using a true but misleading fact. Or perhaps he just didn't understand why the savings rate had suddenly risen. Based on past experience with Donald Luskin, I tend to go with the last explanation. I have no particular reason to question his diligence or his intellectual honesty, but his understanding of economics often seems weak, even when the points in question are fairly basic.

Apparently Mr. Luskin now hopes to have some political influence:

I'm an adviser to John McCain's campaign, though as far as I know, the senator has never taken one word of my advice.

If John McCain has indeed never taken any of Donald Luskin's advice, that speaks well for the senator's judgment.

Moral Hazard and Protecting the Taxpayer

What? You've been doing business with the 4th largest investment bank in the country? How imprudent of you! We can't allow such rashness to be rewarded. No, we must let the market punish you for your imprudence. Otherwise, it will encourage people to do such risky things in the future -- expecting the risks to fall on the taxpayer.

Yes, it is the taxpayer that we are trying to protect. The taxpayer cannot accept the consequences of your imprudent actions. Never mind that, given the possible economic impact, most people who pay taxes will face even greater risks than the they would if the government had facilitated a sale by guaranteeing some of Lehman's assets. The Treasury's obligation is not to the people who pay taxes. It is to the taxpayer!

Drilling makes us more dependent on foreign oil

Just thought I should point out that US oil reserves are not inexhaustible, and that most of the oil in the world is still elsewhere. If we continue to feed our addiction to oil-based energy by producing more in the US, that means, when our reserves are depleted, we will end up having to feed that addiction by buying more oil from abroad. On the other hand, if we shift to other forms of energy (which unfortunately include coal), we can hopefully break that addiction and really end our dependence on foreign oil.

My title is a bit of an exaggeration, I admit. Drilling doesn't necessarily make us more dependent on foreign oil, but it doesn't make us less dependent either, except in the short run. It shifts our dependence into the future. It makes us more dependent in the sense that we will remain dependent for a longer period of time (but be less so initially).

While I'm on the subject, a nice slogan for the Pigou Club, courtesy of Al Gore, via Battlepanda:

Tax what we burn, not what we earn.

Porn and Transportation are Substitutes

OK, I couldn't leave this one alone. Greg Mankiw points to some research showing that "many websites focused on adult or erotic material have experienced an upswing in sales in the recent weeks" since the stimulus checks were mailed out. I can buy the theory that many of their marginal customers are liquidity constrained, which I'm guessing is the way Greg sees it, but there's another issue here that hasn't been addressed. The stimulus checks are only one of a number of things that have happened over the past few months. You might also have noticed, for example, a dramatic increase in the price of gasoline, coming at a time when people were already adjusting to dramatic increases over the past 4 years. I think that particular change is an important part of the picture.

"Adult or erotic material" is a form of entertainment, or, if you will, recreation. But unlike various other forms of entertainment and recreation, it can be consumed at home. And I suspect that a lot of people think it's more fun than most other forms of entertainment and recreation that can be consumed at home. You can go out to a bar or a club or a ball game or a movie or a show or the beach or, well, a brothel, if you're in Nevada, or you can stay home and consume forms of entertainment that can be consumed at home. I can remember seeing a story recently (I don't remember where) about how brothels in Nevada are being hit hard by the economic slowdown. If you stay home, you don't have to use up gasoline, so the relative cost of at-home entertainment goes down when the price of gasoline goes up. Adult Web sites are probably not a Giffen good, so, if we could hold other income constant, we should expect that the demand for adult Web sites should go up when the price of gasoline goes up.

Granted, other income isn't constant. The rising price of gasoline affects a lot of other areas besides entertainment and recreation, so it represents a general decline in real income. And the economy is weak. So maybe the stimulus checks compensate for these declines in income. If the effect of the stimulus checks is to bring income up to the level that it was before the increase in gasoline prices, we should expect an increase in demand for adult Web sites. So the stimulus checks matter, but it isn't just the stimulus checks.

I should give credit where credit is due. The basic substance of this idea about gas prices and porn comes from this YouTube video:



Not coincidentally, the woman in the video (Isobel Wren, whom you may remember from an earlier post on this blog) has her own Web site "focused on adult or erotic material." And in the interest of smoothing the transition to a less energy-intensive economy, or maybe just to be naughty, I'll give you the link again. (Note that it is an adult Web site, so don't click the link unless you're over 18 and your boss isn't watching.)


UPDATE: I just noticed that this video is the same one that I linked to in the earlier post. Oh, well, now you get to watch it in embedded form.

Should we develop alternative fuels?

Until someone convinces me otherwise, I'm going to go with "no" -- at least if by "fuels" you mean carbon compounds that are used to release energy through combustion. Combustion of carbon compounds produces carbon dioxide, which aggravates global warming. If we're running out of oil, let's just run out, start driving less, flying less, doing less of things that produce greenhouse gases, and doing the remainder more efficiently. Or else let's find replacements that don't involve "fuels" in the sense I described: try electric cars that run on power from wind, solar power, hydroelectric power, nuclear power, etc..

From an environmental point of view, running out of oil is a good thing, an opportunity to slow down climate change, and are we now to try replacing that oil with other combustibles? When opportunity knocks, close the curtain and pretend you're not home?

If the government is going to subsidize anything, let it subsidize alternative sources and uses of electric power, or solar heating, or something like that. Why subsidize products that are going to aggravate our environmental problems?

Pigou and the Anthropophagi

Why does the salmon here cost more than the chicken? There ought to be a tax on chicken.

Why?

On chicken and meat and eggs and dairy products.

Why?

Because farm animals are bad for the environment.

How?

They contribute to global warming.

How?

They produce methane, which gets in the atmosphere and adds to the greenhouse effect.

People produce methane, too, you know.

That's why I think there should be a tax on people also. Cannibals need more vegetables in their diet anyhow.

Supply Response and Self-Unfulfilling Recession Prophecies

In a post last year, I argued that one reason economists have not successfully forecast recessions is that recession forecasts, or near-recession forecasts, prompt policymakers (usually the Fed) to act so as to prevent a recession. Only when the recession is unexpected (i.e. not forecast) will policymakers fail to act.

Spencer, an occasional blogger at Angry Bear and a frequent commenter on many different economics-oriented blogs, suggested (in a comment somewhere; I don’t remember where or when) another mechanism that operates through inventories. When manufacturers expect a recession, they reduce their inventories in anticipation, thus inducing themselves to increase production later, thereby preventing the recession they had expected. So again, a recession only occurs when it is unexpected, when manufacturers are caught with excess inventories because they hadn’t anticipated weaker demand.

Here I’m going to suggest a third mechanism whereby forecast recessions may tend to prevent themselves. The idea comes from this YouTube video, in which a model* discusses, among other things, her concerns about the weakening economy. Her response to those concerns: “I’m trying to book up as much work as I possibly can and get some savings cushions built up.”

This phenomenon may be specific to the modeling industry. Indeed, it may be specific to the particular model in the video. But I see no reason not to expect it to be more general. Intertemporally optimizing businesses, and self-employed individuals, in many service-producing industries (and for that matter, workers in all industries) may have a general incentive to shift their supply curves outward in response to the expectation of a future inward shift in demand curves. Thus the expectation of a recession would result in an immediate increase in economic activity.

I’m not sure what the full implications of this hypothesis are for the business cycle. It’s kind of the opposite of Spencer’s idea, in that here the expectation of a recession causes agents to produce more in the immediate time frame rather than less. I suspect, though, that manufacturers are better at planning at quarterly or longer horizons than are service-producing industries (and certainly individuals), so I suspect that the paring down of inventories happens well in advance of the expected recession, whereas the supply curve shift happens at about the time the recession is supposed to start. (The video example, one may note, took place in mid-April of this year, by which time many people believed that the US was already in a recession.) If the supply response is tardy enough, it could surely have the effect of preventing (or at least delaying) the recession to whose forecast it is responding.


*UPDATE: It occurs to me that I should identify the model, instead of just exploiting her as an example of a concept. Her name is Isobel Wren. She has a nice portfolio on One Model Place, and she also has her own Web site (Adults only. Not work safe.). She calls herself "the thinking man's nympho" and prides herself on being a nerd when she's not in front of the camera.

Bear Sterns

I started this post last Monday and then got distracted. Looking at it now, I think the fragment is worth preserving.

I’ve spent the past week being pissed off at all the people who were pissed off about the so-called “bailout” of Bear Stearns. In the light of this morning’s [Monday the 24th] news, I’m starting to half agree with them.

Earlier, I was going to write a post about what a lucky accident it was that the current Fed Chairman is also one of the world’s foremost experts on the problems of the early 1930’s. Now I’m beginning to wonder if it would have been better to have someone with a less well-matched academic background and more poker skills.

In retrospect, it appears that the $2/share price in the original version of the Bear deal was not a real price, just a piece of propaganda, intended to give the impression that it wasn't a bailout. But it's now clear that, whether or not one calls it a bailout, Bernanke offered a lot more in loan guarantees than was really required to get J.P. Morgan to do the deal. (The $1 billion deductible on the new version of the deal is not very convincing as a concession by Morgan, and in any case, it only makes it more obvious that the Fed's original offer was much higher than it needed to be, if Morgan is willing to take a hit both on the special financing and on the purchase price.)

I don't think that's exactly a moral hazard problem, but it's the same general idea. The next time the Fed wants somebody's help to keep the financial system afloat, that somebody will know to charge dearly for that help.


UPDATE: And another thing. What the hell were Ben's priorities? If he wanted to reassure the financial markets, he shouldn't have pushed for a price that made Bear Stearns appear to be in much worse shape than it actually was. (Did that just not occur to him? Did it not occur to Tim Geithner? Did it not occur to anybody at the Fed?) If he wanted to make the Fed look tough, he shouldn't have offered way better financing terms than were really needed to get the deal done. (As noted above, both the price and the financing terms got worse for Morgan subsequently, and they were still willing to play.) Did it not occur to him that being tough with winners was important for the Fed's reputation too, as well as being tough with losers? This was a major screw-up.

Where is “Sex” in the NAICS?

This business with Eliot Spitzer is bringing up issues in labor economics for me. In particular, how should we refer to Ms. Dupré’s occupation? Some people insist that she was a “sex worker.”

I have a number of problems with this terminology. For one thing, is there any other occupation where the title includes “worker” and the hourly billing rate can be in the quadruple digits? I mean, there are a few cinematic production workers who make that kind of pay – but they’re known invariably by other titles (actors, directors, etc.) – and a few sports workers – but they’re known as athletes – and quite a few finance workers – known as investment bankers, fund managers, and such – and quite a few…I guess I’d have to call them generic workers, since they can be in any industry…but they’re known as corporate executives – and a few legal service workers known as attorneys, and a few professional service workers known as consultants, and maybe a few health care workers known as doctors and surgeons, and so on.

Which brings me to my second, related point, which is that we don’t normally identify an occupation by the industry to which it belongs. The exceptions are sort of residual categories: we do call some people “health care workers” if we can’t think of anything better to call them, but most people in health care occupations (nurses, for example) would probably find it insulting to have their occupation identified as “health care worker.”

According to Wikipedia, a sex worker is someone (anyone, apparently) who works in the “sex industry.” I have a feeling that many people who work in the “sex industry” would be insulted to be called “sex workers” (rather like nurses, if you call them “health care workers”). I mean, really, doesn’t everyone know that the phrase “sex worker” is a euphemism for “prostitute”? (I know, technically, that’s not the case, but in real life, other “sex workers” seem to use the phrase for themselves only when they’re trying to make a show of their solidarity with prostitutes.)

But here’s the real problem: What the hell is the “sex industry”? And more to the point, what kind of industry is it?

• An information industry? (The adult video industry, as best I can tell, is part of NAICS 512110, “Video production,” an information industry.)
  
  
• A personal service industry? (Officially, Miss Dupré was probably working in NAICS 812990, the “Social escort services” industry, a personal service industry. As to what she was actually doing, it seems to me that prostitution is clearly a service, and it’s about as personal as services get.)
  
  
• A food service industry? (I know that doesn’t make much sense, but where do strip clubs fit in the NAICS? As best I can tell, they are part of NAICS 722410, “Night clubs, alcoholic beverage,” a food service industry.)
  
  
• An entertainment industry? (It’s really tough to find a NAICS code that would actually apply here, but aren’t strippers entertainers? Of course strippers also give lap dances, which are really more of a personal service than a form of entertainment. In fact, in that respect I have to question whether strippers are really more like prostitutes than entertainers.)
  
  
• An amusement and recreation industry? (That’s pretty much just a wild guess. But where the hell do brothels fall in the NAICS? There are legal brothels in Nevada, so I assume they must have a NAICS code.)

As far as I can tell, the whole concept of a “sex industry” makes a mockery of the way we normally classify industries. I don’t have a problem with changing the occupational title of prostitutes to something that has less of a stigmatizing history. But “sex worker” just doesn’t do it for me. I’m going to try “personal sexual service provider” (PSSP for short) and see if it catches on. Otherwise I’ll just call them hookers – a term which doesn’t seem to offend people even though its etymology is rather scurrilous.

What's going on?

In Paul Krugman’s latest column (hat tip: Mark Thoma), he compares the current financial crisis to the bank runs of 1930 and 1931:

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

That sounds like a pretty good description of what’s going on, but there’s something missing. Thinking about this as a regular person rather than an economist, I have to ask, “Who are these ‘people’ that are pulling their money out of the shadow banking system and putting it into treasury bills?” Because it sure isn’t me. I have my cash in a prime money market fund; I deliberately passed up the “treasury-only” option, and I see no reason to change my mind now. My fund hasn’t broken the buck. In fact, I haven’t heard of any money market fund that has broken the buck recently. (Possibly something escaped my attention, with all the news that’s come out lately, but even if there have been one or two cases, there haven’t been many, and they haven’t been big ones.)

I don’t know exactly what my fund manager is doing; I imagine they’ve probably increased the proportion of treasuries in their portfolio, and I guess, technically, it was “people” that made that decision, but it wasn’t any people that I know personally. If anything, I’d like my fund to skate closer to the edge. It would not drive me into bankruptcy if the share price went from $1.00 to $0.99. In fact, I probably wouldn’t even notice, except for the fact that I’d read about it in the newspaper, and the fund would probably send me all kinds of stuff in the mail about how something went terribly wrong and the employee has been fired and this will never ever happen again in a million years and they’re completely changing all their control procedures and they’re changing their name just to show that they aren’t really the ones who lost that one cent.

So I guess the point is, it’s not really “people,” in the sense of retail investors, who have lost confidence; it’s institutions. Maybe that’s why so many “people” have a hard time seeing what the big deal is and why the Fed needs to help “bail out” Bear Stearns. As for me, when I see the TED spread approaching 200 basis points and the treasury bill rate approaching zero, I know that something is very wrong and that the Fed has good reason to be taking drastic measures, but I’m still a little confused as to why all this is happening. I understand that the consequences of the failure of a major investment bank under these conditions would be disastrous, but I still have trouble seeing why J.P. Morgan needed $30 billion in non-recourse financing to convince it to buy Bear Stearns for a tiny fraction of what the market seemed to think it was worth.

Capital Flight is Good

Some people (Yves Smith and Tim Duy, to name two, but I’m sure there are many others that I haven’t gotten around to reading yet) are worried that concern about capital flight is going to have to be a constraint on the Fed’s ability to deal with this crisis. I disagree. I don’t think the Fed will or should be concerned about capital flight. In fact, I think capital flight is part of the solution, not part of the problem.

In general, capital flight is a problem if you care about quantities that are not denominated in your own currency. If all the quantities you care about are (or can be) denominated in your own currency, then you can just print as much currency as you need to replace the foreign capital. There are basically 4 situations where capital flight is a problem, which I will call the 4 Fs:

1. Full employment. If all your real domestic resources are being used, then the withdrawal of foreign capital will mean the withdrawal of real resources, which will reduce your growth potential. This was an issue for the US in the late 90s. But today the US is not at full employment. And if you still think it is, just wait a few months.
   
   
2. Fixed exchange rate. If you need to defend an exchange rate, the government will effectively have to supply exiting capital out of limited official reserves. This was a large part of the problem in the early 30s. But today the US does not have an obligation to defend its currency, nor does it have (about which see the rest of this post) and interest in maintaining its currency’s value.
   
   
3. Foreign currency-denominated debts. If you have to pay back foreign currency, you’ll be in trouble if capital flight weakens your own currency and thereby makes foreign currency harder for you to get. This has been a problem in various places, particularly Latin America, in the past, but it’s not an issue for the US today: almost all our debts are denominated in dollars.
   
   
4. (in)Flation. If your country is experiencing, or on the verge of experiencing, an unwelcome inflation, capital flight will exacerbate the problem by weakening your currency and thereby raising import prices. As of 8:29 AM on Friday, I still thought this was an issue for the US today. I no longer do.

For the US today, the real problem would be if foreigners insisted on continuing to purchase US assets. That would support the dollar, making it that much harder to sell US goods and services and contributing to the weakening of the economy, thereby exacerbating the positive feedback between a weak economy and a weak financial system.

As long as inflation was a major issue, there were limits to what the Fed could do to stabilize the domestic financial system. It could only take on mortgage securities, for example, up to the point where it used up all its assets. In that situation, an absence of foreign demand for US securities might be a big problem.

If, as now appears to be the case, the risk of deflation is a bigger issue than the risk of inflation, then there is no limit to what the Fed can do. If it runs out of assets, it just prints more money to buy assets with. If foreigners refuse to buy US assets, the Fed prints money for Americans to buy them. If Americans refuse to buy risky assets, then the Fed can trade its own assets for risky assets through programs like the TSLF. Or lend money directly against risky assets. If foreigners withdraw capital, the Fed can replace it with newly created money. (Actually, it won’t need to, because when the proceeds from the withdrawn capital are converted out of dollars, the counterparty to that conversion will have dollars to invest.)

If the dollar weakens, so much the better. $2/Euro. $3/Euro. In the words of Chico Marx, “I got plenty higher numbers.” It might be a problem for Europe, but not for the US (and for Europe it would be a self-inflicted wound, since there is plenty of room to expand the supply of euros if there were a will to do so).

There is no limit to the potential magnitude of the Fed’s actions, but there could conceivably be limits to the effectiveness of those actions even as the magnitude becomes infinitely large. That situation is exactly one where capital flight would be a good thing. If the Fed can’t manage to stimulate the economy sufficiently by printing money, the stimulus has to come from somewhere else. Increased demand for US exports, due to a weak dollar, due to capital flight, is one of the chief candidates.

Moral Hazard

[Hypothetical future investor]: I own a major stake in an investment bank, and I’m getting concerned about their risk management. Should I bring this up at the shareholders’ meeting?

[Hypothetical friend]: I don’t see why. What’s the worst that can happen? The bank will go sour, the Fed will arrange a bailout, and you’ll only lose 95 percent of the money you invested, 96 tops. What’s the big deal?

[Hypothetical future investor]: You’re right. Isn’t the [Hypothetical future Fed chairman] put great?

TSLF: Is the government taking a risk?

In one of the latest blogospheric analyses of the Fed’s plans to accept private-label mortgage backed securities as collateral, James Hamilton concludes that the government is taking on a definite risk (specifically, although the Fed is the agent, it is really the Treasury’s risk, since the Fed’s profits are received by the Treasury) but that the risk is not a very large one. I wonder, though, if it’s appropriate to view the risk characteristics of the specific transactions in isolation without considering how they influence the Treasury’s other risks.

Modern portfolio theory teaches us that an asset that looks risky in isolation can actually decrease the risk of a portfolio. For example, if you have a portfolio that consists entirely of government bonds, and you take out some of the bonds and replace them with stocks, you have replaced a safer asset with a riskier one, and yet your portfolio overall is now less risky. In that context it is the correlation (or rather, lack thereof) between asset returns that is the issue, but in the case of the government itself, a more important issue is how transactions in one set of assets affect the value of other assets and liabilities.

In particular, the government’s most important asset, in real economic terms, is the expectation of tax revenues. Tax revenues depend mostly on incomes. In particular, revenues depend not on potential incomes but on actual incomes, so any expected gap between the two reduces the value of the government’s most important asset. The government’s most important liabilities are the securities it issues, most of which are denominated in nominal dollars and most of which do not contain a call provision. A worst case scenario for the government is a Japanese-style deflationary depression, in which the value of the government’s liabilities rises in real terms, while the value of its most important asset is eroded by an ongoing output gap.

Deflation might not have seemed like an issue before Friday’s CPI report, but now the risk cannot be so easily dismissed. Most of the positive inflation in recent months appears to be the result of rapidly rising commodity prices, which are volatile and could easily reverse direction. Meanwhile, the US labor market is weak, and the financial system – what’s left of it – is fragile. If, by taking on certain (relatively small, in the grand scheme of things) financial risks, the government is able to materially reduce the risk of a financial collapse and thereby reduce the risk of a deflationary depression, there is probably a net decline in the government’s total risk.

To put it a little differently, as James Hamilton says, “you don’t get something for nothing,” but, it seems to me, if the something that you get is clearly worth more to you than the something that you gave up, you kind of do get something for nothing. Don’t you?

This inflaiton report scares me.

Quoting myself from the comments section of my last post:

...Japan had plenty of missed opportunities in the early to mid 90s to prevent the depression from getting out of hand. It was only when the inflation rate went to zero...that it really became intractable.

Speak of the devil, and he shall arrive appear. I'm pretty sure we'll get positive core inflation in March (and there's no question that we'll get positive headline inflation), but seeing zero even in one month (as in today's February CPI report), while commodity prices are rising at unprecedented rates, is pretty disturbing. Both the 12-month CPI inflation rate and the 3-month annualized rate are 2.3%, which is right in the middle of the normal range. This is disturbing because it seems to indicate that business don't even have enough pricing power to pass on part of the huge cost increases they are facing in energy and materials. What happens when commodity prices stop rising? I don't think I want to find out.