QE boosts equities by boosting fundamentals

Many people suggest that the recovery in equity prices since 2009-2010, seen around round the world but particularly in the American NasdaqS&P500 and DJIA, does not represent a general economic improvement. Instead, they believe that these numbers are simply being buoyed by new money pumped into the system. I don't think this argument holds, and I will attempt to explain why. First let's consider why we think people hold equities. Essentially, people hold equities because they expect a given real return for a given risk profile. In our simplest model, people hold portfolios of assets based on their risk tolerance, their subjective judgements over probabilities, and their preferences. Adding in banks, insurers, pension funds and so on makes the overall picture more realistic, but doesn't change our theory much. People pick financial intermediaries that hold the assets according to our preferences—the intermediaries add value through scale, or through providing a payments system and settling accounts.

Why might electronic money printing (which we call "quantitative easing" or QE) affect equity prices?

Well, firstly, we might not expect an effect from quantitative easing under one circumstance. QE increases the amount of narrow money we have—that is the number of notes, coins and bank reserves in the system. Generally we think broad money—which includes bank accounts people can debit or write checks on, and is much, much larger—is what interacts directly with the real economy. The ratio of broad money to narrow money is called the money multiplier, and usually a rise in narrow money leads to an even bigger rise in broad money—but this multiplier is not stable. It's at least possible (although not historically typical) that a rise in narrow money could be completely counteracted by a fall in the money multiplier.

But assuming this doesn't happen, there are three reasons why QE might boost equity prices. First would be because it increases inflation and the future price level. If prices rise, cash is worth less, so relative to a given nominal amount of cash, all things being equal a given equity is worth more. In other terms, the firms' nominal expected returns would rise.

The second reason is that in a depressed economy monetary easing like QE may boost real growth, which we would expect to raise any given company's expected real returns. It might also reduce the risk of very bad economic outcomes. Since equities are riskier than bonds, gilts and cash they pay a risk premium to those who hold them—a higher return (lower price) to compensate for this. If risky outcomes in general become less likely, these risk premia might narrow, making equities more desirable and expensive.

The third reason QE might raise stock prices is because it increases overall social wealth, and thus may lead to greater risk-tolerance overall, if people are willing to bear more risk as they get wealthier, and thus shift towards riskier assets like equities.

In each of these three, the jump in equity prices comes from fundamental factors. One could certainly drive up stocks by creating lots of inflation, but we can easily check if that's what's happening by looking at inflation. Any real/relative growth in equities would refute that explanation. In contrast, real growth, reduced risk and shifted preferences due to extra wealth are all legitimate reasons for higher equity prices.

Accounts of why QE buoys stocks without improving fundamentals (and hence part of the argument that stock indices are not good proxies for economic health) tend to rely on a narrative that QE "flows into equities". But as explained, people try to hold their wealth in the portfolio that fits closest to their preferences. If QE money did "flow into equities" then people would now be holding more of their wealth in stocks than they wanted to—they would rapidly rebalance their portfolio. Typically people needn't even do this themselves, because their pension fund will do so for them. QE has to improve the fundamental factors in order to boost equities.

The Negative Income Tax and Basic Income are pretty much the same thing

I’ve been talking about the Negative Income Tax lately, and equating it with the idea of a Basic Income. I think most of the policies’ respective advocates would deny that they’re the same policy. In this post I’m going to outline why that’s incorrect and I’m happy to say that they’re basically the same thing. For the uninitiated, a Negative Income Tax is a form of welfare that replaces most existing welfare schemes with a single payment that supplements the income of the unemployed and low-paid. The payment is withdrawn as your earnings increase, ideally at a gradual enough rate that increasing your earnings (and hence reducing leisure time) is always worthwhile.

An example: a £5,000 basic payment at a 50% marginal withdrawal rate (this means that for every additional pound earned, the worker will receive 50p less in NIT payments). Someone with an income of zero would receive an NIT payment of £5,000, or just under £100/week. If they took a job that paid £5,000/year, they would receive a top-up of £2,500/year; that paid £7,500, a top-up of £1,250/year. Once they reached £10,000/year, they would receive nothing in NIT.

This idea was supported by Milton Friedman, among others, and has a reasonably strong pedigree on the right. Even libertarians who object to income redistribution in principle usually concede that a Negative Income Tax is the least bad form of welfare, because it is administratively simple and perverts incentives less than most welfare schemes. It is particularly appealing to many liberals and libertarians because it is unpaternalistic.

A Basic Income, on the other hand, is usually conceived as a flat payment to everybody irrespective of circumstance. This leads to a very big problem: assuming it replaces most forms of welfare as an NIT does, a basic income high enough for unemployed workers to subsist on would simply not be affordable to pay to everyone. A policy that ideally would be designed to help the poor ends up being a very expensive subsidy to people who do not need extra money.

Advocates of the Basic Income recognize this, and their solution is typically to use the tax system to ‘claw back’ the payment from relatively high earners. So everyone gets the money, but it is withdrawn according to earnings.

In practice, that’s more or less the same as a Negative Income Tax – the only difference is whether the withdrawal takes place at the ‘front’ of the payment (as with the NIT), or the ‘end’ (as with the Basic Income). Strange as it may seem, the policies advocated by Milton Friedman and the Green Party are the same in all but the technical detail.

But even if there is a surprising amount of agreement in terms of the kind of welfare we’d like to see, the detail may be more difficult to agree on. How much should a ‘basic income’ be? When should it begin to be withdrawn, and at what rate?

Questions like this are, I think, likely to be where what breaks up this (unholy?) alliance. But maybe not. Traditional policies like the minimum wage probably do more harm than good, and, rightfully, the question of how to improve the lives of the low paid does not seem to be going away. It will take compromise, but in the Negative Income Tax / Basic Income, we may have an answer.

It's amazing what we can learn from nature really

The latest news on the climate change front is that those melting glaciers in Antarctica and Greenland actually, by melting, aid in reducing the effects of climate change. Which is an interesting little thing we can pick up from our observation of the natural world around us. The reason is that the water, as it gushes over the rock underlying the ice, picks up a certain amount of iron. And we also know that there are areas of the oceans which do not have enough iron to sustain life (much of the deep ocean is actually a "desert" in that is has next to no life at all). So, iron in meltwater meets iron deficient areas, plankton blooms and some of that sinks to the ocean floor to, in time, become the sort of rock that Beachy Head is made out of.

Huge amounts of dissolved iron currently being released into the oceans from melting ice sheets might cancel out some of the negative effects of global warming, it has been claimed. A UK team has discovered that summer meltwaters from ice sheets are rich in iron. This can cause an increase in growth of phytoplankton - which capture carbon, they say.

This has all long been known to be possible, this is just a confirmation that it happens, through natural factors, more than we previously thought it did. But this poses another little problem. Chatting around to various scientists it's easy enough to find out that research has been done into artificially boosting the amount of iron that can be dumped into the oceans to create these blooms. And that it would be, in the words of one "ludicrously cheap" and could sequester, for geological time scsales, some 1 billion tonnes of CO2 emissions each year. Or about twice current UK emissions.

Quite seriously all that would be needed is a few ships tossing some ferrous sulphate over the side, something that any number of industrial processes would be delighted to give you for free.

Which leaves us with our little question, or perhaps two of them. Given that, from the political rhetoric at least, climate change is the most pressing problem of our times, a threat to our entire species, why was the last research into artificial boost to ocean iron levels this done a decade ago? And further, why would it be illegal to simply go out and do this? Who wants to stop a cheap and viable solution to at least some part of climate change and why?

Some things about equality that Piketty should know

Dr Arthur Shenfield (1909-1990) was a distinguished scholar and a valued member of the ASI's Academic Board.  In 1981 he published "Myth & Reality in Economic Systems," based on a lecture series.  The essay "Morality and Capitalism" is very pertinent today, given the recent claim by Thomas Piketty that capitalism must lead to widening inequality.  It is worth reading Shenfield, not least for his pithy turns of phrase:

Thus it ill becomes socialists to assail the inequality of capitalism for, once achieved, socialism produces inequality more gross and obnoxious than anything observable in a developed capitalist country.  However, since there is some merit in a wide degree of a fairly equal condition insofar as it does not hinder desirable incentives of varieties of life styles, it is important to consider which kind of system is most likely to achieve it. The clear answer is capitalism.

Socialism ostensibly pursues equality but produces inequality.  Capitalism pursues liberty but in the process also reduces inequality.  We have already noted that in capitalism wealth comes to those who serve the masses.  Thus in capitalism the inequality of condition is little more than the difference between the Cadillac and the Chevrolet, the Parisian couturier's model and the excellent mass-produced copies of it, caviar and the equally nutritious cod's roe. In pre-capitalist societies it was the difference between the mansion and the hovel, between silks and rags, between exquisite luxury and frequent famine.

In socialist societies it is between the luxurious country villa and the miserable worker's flat, between the special shops carrying high-quality goods imported from capitalist countries reserved for the Party elite and the endless queueing for the shoddy products of socialist industry imposed on the masses.

Richard Murphy's excellent argument for a lower overall tax burden

We here at the ASI have to be very selective in our mentions of Richard Murphy, the crusading tax campaigner. His normal output is such a target rich environment that we could spend entire working lives correcting his errors and misapprehensions. But there are times when he manages to, through some form of serendipty perhaps, get things right and it's worth our pointing to those happy events when they occur. So it is with his recent observation that, given that the collection of taxes is a burden upon both business and the citizenry then therefore we should work to lower that tax burden:

If, through its neglect, the government forces all the UK’s honest smaller businesses to compete with businesses that HMRC and Companies House are failing to regulate then it inevitably follows that the government are giving an unfair economic advantage to the cheats who do not pay their tax. No wonder as a result that the High Street is being decimated, bar the occasional fly-by-night pop up shop. And no wonder young people cannot find the jobs and apprenticeships they need with local employers when those honest enough to invest in jobs for those young people are likely to be competing against rogue traders who do not charge VAT on their sales and pays cash in hand wages.

As he points out that collection of taxation leads to the decimation of the High Street, to the young, the future of the nation, being wasted on the scrapheap of untrained unemployment and no doubt to many other horrors as yet unmentioned. The solution therefore is clearly to reduce that economic birden of those taxes. As we here at the ASI have been saying for some decades now: reducing the burden of taxation is a desirable thing in and of itself of course, but also because it will make the nation richer.

No doubt Murphy's next missive will include the evidence that he's got this point: for no one could, as he has pointed out, note that tax is a burden without then arguing that the burden should be reduced.

Could they?

Five intriguing papers I discovered this week II

As the second in a series, here are summaries of five interesting journal articles I read in the last week. All of these ones are new, although that may not always be the case. 1. "Very Long-Run Discount Rates" by Stefano Giglio, Matteo Maggiori and Johannes Stroebel

Giglio et al. use the difference between the prices of leasehold and freehold properties in the UK and Singapore to compute long-run discount rates. They find that over 100 years, the discount rate is 2.6%—whereas properties with 700-year or longer leases trade at par with freeholds. They point out that this 2.6% discount rate may have implications for climate change policy; the famous and influential Stern Review recommended using a 0% discount rate, which may justify much more extensive anti-CO2 measures now. Some slides explaining their findings are available here.

2. "Is the stock market just a side show? Evidence from a structural reform" by Murillo Campello, Rafael P. Ribas, and Albert Wang

Campello et al. look at a 2005 reform that, in a staggered 16-month basis and after a trial, allowed $400bn worth of Chinese equity, previously untradable, to be bought and sold. Using "wrinkles" in the roll out that provide quasi-experimental tests, they find that firm profitability, productivity, investment and value all improved substantially. "Policies that ease restrictions on [capital] markets may have positive effects" runs the final line of their conclusion—quelle surprise!

3. "Social security programs and retirement around the world: Disability insurance programs and retirement" by Courtney Coile, Kevin S. Milligan and David A. Wise

These three authors add to the burgeoning literature proving that those on the edge of retirement respond to incentives just like anyone else. This shouldn't really be a surprise, but the heavy flow of publications adding evidence in this direction suggests that maybe there was once a bizarre consensus in the other direction. Coile et al. show that delaying eligibility to pensions, increasing the stringency of disability insurance programs, and other welfare reforms for older people have "very large" effects on how much labour they decide to supply. Not exactly shocking, but certainly important in ageing societies.

4. "What Happens When Employers are Free to Discriminate? Evidence from the English Barclays Premier Fantasy Football League" by Alex Bryson and Arnaud Chevalier

In this nifty and quirky paper the authors try and isolate "taste-based" racial discrimination, by looking if fantasy football players pick footballers differently based on their race, controlling for "productivity" (i.e. their expected points tally). They find no evidence of taste-based discrimination here, suggesting that much of the apparent discrimination found in other studies (e.g. studies of fake CVs where different ethnicities see different acceptance rates even when they have similar qualifications and experience) could be statistical. That is, since employers cannot directly observe productivity (unlike in fantasy football), and since different ethnicities have different productivity distributions, certain ethnicities are on average less valuable to employers. Of course, it might be that people exercise taste-based discrimination as well when they have to interact regularly with the group/race/ethnicity in question—fantasy football is much more at arms length.

5. "The Role of Publicly Provided Electricity in Economic Development: The Experience of the Tennessee Valley Authority, 1929–1955" by Carl Kitchens (ungated)

The most fun kind of research to read is one that confirms a niggling view you've had for a while, but one that nevertheless overturns a happy consensus. The Tennessee Valley Authority is a classic example of "enlightened" central planning, targeting a hard-up area with massive coordinated infrastructural investment and widely believed to have delivered substantial benefits. But if these dams and systems were really such good investments wouldn't private companies have got around all the barriers to such an investment already? There are some cases where I suppose that sort of basic argument doesn't hold, but it's a pretty good first approach to any area, and it turns out the TVA is one of them. Kitchens newly-published paper finds "that the development of the TVA during its first 30 years did not cause manufacturing, retail sales per capita or electrification to grow any faster in areas receiving TVA electricity than in other areas in the Southeast."

Ignore the doomsayers: The recovery is real

Some commentators claim that the UK’s current economic recovery is illusory. They say that the recovery is based on an artificial boom fuelled by loose money and will eventually come crashing down to earth. I think it is very likely that this view is wrong, for at least two reasons. One, the UK does not have loose money that would fuel a credit boom. Two, the best tool we have for telling if the recovery is ‘real’ or not is the market. And the market is telling us that it sees things as looking good.

The idea that we have loose money is extremely common. It is based on the assumption that a Bank of England base rate of 0.5%, historically very low, must mean that money is loose. This is what Milton Friedman referred to as the ‘interest rate fallacy’. It is a fallacy because it fails to ask the key question: ‘compared to what?’

That ‘what’ is, or ought to be, the ‘neutral rate of interest’ – the interest rate where, in David Beckworth’s words, “monetary policy is neither too simulative nor too contractionary and is pushing the economy toward its full potential.” The tightness of money is determined by the central bank rate relative to the neutral rate. If the neutral rate of interest is lower than the base rate, then money is tight.

Is the neutral rate of interest in the UK currently above or below 0.5%? It's hard to say. Milton Friedman pointed out that usually low rates were a sign of tight, not easy money. This is because low rates almost always coincide with very low inflation, nominal GDP growth and money growth—which Friedman pointed out were much better ways of assessing the stance of policy.

It’s possible to infer from things like NGDP growth (well-below trend until recently) that money has been unusually tight. NGDP growth seems to be returning to the trend rate, if not the trend level, that it was before the crisis. People calling ‘easy money’ may disagree, but if they are simply pointing to low interest rates without trying to compare them to the neutral rate, they’re not proving anything at all.

But even if it’s not down to easy money, maybe the recovery really does sit upon a throne of lies that will inevitably collapse. How could we tell?

Since the world is very, very complex, it is unlikely that one individual expert or panel of experts will be able to possess all the information they would need to make reliable predictions about the future.

Where possible, we should prefer the ‘wisdom of crowds’. And we have something that can do so very effectively: the market. And the market seems pretty optimistic: the FTSE 100 is growing strongly; firms are taking on new staff; gilt yields are extremely low.

Second-guessing the market is particularly unusual for people on the right of the political spectrum. As Josh Barro put it recently, “A conservative is somebody who thinks every market is efficient — except the Treasury bond market.” (A point worth remembering next time you read about the UK's "looming debt crisis".)

Of course markets can get things wrong. There is a high degree of uncertainty involved in all predictions like this. But, given a choice between the aggregated judgement of millions of market participants, all bringing their local knowledge to bear, and the judgment of a few experts, I’ll go with the market.

In summary, there’s no reason to think that either we have excessively loose money or that the recovery is illusory. Note that mine is an entirely negative argument – I am not claiming that money is too tight, or just right, nor am I claiming that markets are correct. I'm saying that, given the information we have available to us, we should resist the urge to doomsay. In short: don't worry, be happy.

Gary Becker was right, part six: The family

Becker introduced the family into economic thinking and economic calculation into family life.  He spotted that a family is a miniature economic system like a small factory.  The basic goods it produces are things such as meals, residence, and entertainment.  The costs of these goods are compounded not only of the costs of their input, but include the time spent on producing them.  Since the family interacts with the wider economy including the place of work, there will be trade-offs between the two.

As real wages at work increase, it becomes relatively less attractive to spend time producing some of the family goods.  Some of these will be outsourced, buying in what was once done at home in order to free time for more valuable activity.  Examples include buying home-delivered pizzas or paying tailors to repair garments that used to be mended at home.  Sometimes people turn to outside institutions such as nurseries and schools to take over some of the activity that was once performed within the household.

Sometimes domestic production will become more capital intensive as work wages rise, with people buying labour-saving machines such as vacuum cleaners, washing machines and dishwashers.  The rise in the value of time at work has made domestic time relatively less efficient without them.  In place of the traditional dichotomy between work and leisure, Becker looked at the switch from more to less time-intensive production of home goods.

Becker noted some of the consequences of the large-scale entry of women into the workforce.  The wages they could earn at work made them less ready to spend as much time on domestic activity such as child rearing and childcare.  This provides an economic interpretation of the widely-observed decline in the fertility of societies as their economies develop.  Becker also thought it lay behind rising divorce rates in advanced societies.

Becker made a major contribution to our understanding of how families allocate time and assign tasks to the various members, so much so that we now routinely attempt to estimate the likely social and domestic impact of ongoing economic developments.

Err, yes, yes, this is the point

There's a very strange comment in the British Medical Journal. One that makes me worry for the ability of some of these doctoring types to quite grasp the point and purpose of the world we live in. They're talking about e-cigarettes, vaping, all that sort of thing, as an alternative to actually lighting up the cancer sticks directly:

However, Gerard Hastings and Marisa de Andrade have a different take on the issue. They dispute e-cigarettes’ effectiveness in smoking cessation, urge caution, and suggest that NICE’s revised guidance may give these untested products implicit approval. They present long term use of nicotine products marketed by big tobacco as commercial exploitation of smokers attempting to quit. Calling for a broader view of smoking than nicotine dependency, they say, “When the only obstacle to progress on preventing the harms of smoking is the user’s dependence, e-cigarettes offer the beguiling prospect of addicted smokers migrating painlessly to safer mechanisms of nicotine delivery.” But without evidence that e-cigarettes work, they conclude, “The tobacco multinationals have leapt enthusiastically into this market; all now have major e-cigarette interests. This is not a consumer movement but the full onslaught of corporate capital in hot pursuit of a profitable opportunity.”

Err, yes, yes, that's the point and purpose of the system. This capitalist/free market hybrid that we have. If consumers decide they quite like something, perhaps it's getting a regular hit of nicotine without hacking one's lungs out 30 years later, then the point and purpose of the free market part is that the consumers get to choose among possible suppliers of those products. And the successful producers get to make a profit out of supplying those things that the consumers would quite like to have. Because, you know, over the past few millennia we've worked out that this is the best manner of encouraging people to produce the things that consumers would quite like to have.

So, a bit of invention, some innovation, sparks off a bit of consumer desire and suddenly potential producers are rushing to market, salivating at the prospect of the hot and cold running Ferrari's that the profits of their efforts will being them.

This isn't an aberration in the system, this isn't something to be decried, this is the whole damn point of it all in the first place.

I'm sure that someone once told me that you've got to be bright to be even accepted into medical training. Is this no longer true?

What's a neutral monetary policy?

The Federal Reserve Bank of Richmond alerted me to a newish paper from one of my favourite economists, Robert Hetzel, entitled "The Monetarist-Keynesian Debate and the Phillips Curve: Lessons from the Great Inflation"—needless to say it's highly interesting and informative. One bit in particular prompted me to write this screed on neutrality in central banking and monetary policy.

In the Keynesian tradition, cyclical fluctuations arise from real shocks in the form of discrete shifts in the degree of investor optimism and pessimism about the future large enough to overwhelm the stabilising properties of the price system and, by extension, to overwhelm the monetary stimulus evidenced by cyclically low interest rates.

In the quantity theory [monetarist] tradition, cyclical fluctations rise from central bank behaviour that frustrates the working of the price system through monetary shocks that require changes in individual relative prices to reach, on average, a new price level in a way uncoordinated by a common set of expectations.

In the real-business-cycle [new classical] tradition, cyclical fluctuations arise from productivity shocks passed on to the real economy through a well-functioning price system devoid of monetary non-neutralities and nominal price stickiness.

From each of these perspectives, we can derive some sort of definition of monetary/central bank neutrality, as well as an idea of what policy the central bank should operate. It strikes me that only one view is plausible, but before I make the case for that view, I will make the case for a particular theory of "meta-neutrality", i.e. a way that we should think about neutrality, whatever our perspective. I think this is something that everyone should be able to agree on, but I think that once we've agreed on it one view becomes inescapable.

Nothing is neutral with respect to everything. In one of my favourite ever essays, Scott Alexander makes a very similar point about "safe spaces" (nothing can be a safe space for everything—safe spaces for, e.g. a safe space for a disadvantaged group cannot also be a safe space for no-holds-barred rational discussion). In the same way, a monetary policy that is neutral with respect to real interest rates might conceivably have to achieve this by non-neutrality with respect to say, exchange rates. So the interesting question is what economic variables monetary policy must be neutral with respect to for us to call it "neutral" with no qualifiers.

But what we really want to be neutral to is the microeconomic working of the price system and markets generally, which is a bit more complex than any particular macroeconomic variable we could point to. One way around the question is by thinking about what might be non-neutral to the workings of the price system. One answer is: menu and shoe-leather costs, typically associated with high inflation, but more accurately linked to high aggregate demand (nominal GDP) growth.

Both impose restrictions on price adjustment, especially if they are unexpected and hence not "priced in".Menu costs will stop firms re-pricing things as often as would be optimal, impeding price adjustment, whileshoe-leather costs (from the high nominal interest rates associated with high inflation and high NGDP growth) will stop people from holding as much cash as they otherwise would, distorting their consumption decisions.

On the other side, unexpectedly low NGDP growth, combined with "money illusion" in borrowers ("sticky debts") and workers ("sticky wages"), could cause other microeconomic problems—markets won't clear until people's information, expectations and plans have adjusted, i.e. until people realise that the fall in prices/wages is not a relative price adjustment but a fall in overall prices/NGDP.

Overall this suggests we should call a policy neutral without qualifiers not when it is perfectly neutral (which is impossible) but when it is the "neutrality maximising policy". In the words of David Beckworth "neither too stimulative nor too contractionary and is pushing the economy toward its full potential" or in the words of Alan Greenspan one that "would keep the economy at its production potential over time".

That is, one that balances the distortionary costs of high (particularly unexpectedly high) NGDP growth with the costs of low (particularly unexpectedly low) NGDP growth. Empirically, menu cost and shoe leather problems have never been large in the USA and UK when NGDP is ticking along at about 5%. By contrast, NGDP growth less than 2.5% is almost always consonant with stagnation, while NGDP growth of less than zero always means a recession—much bigger costs. This suggests policy, far from being unprecedentedly easy in the lacklustre post-recession recovery, was if anything on the tight side of neutral.

Two crucial final points:

1. Identifying the conditions that we'd want to see in the macroeconomy for a (relatively) undistorted microeconomy does not mean endorsing a particular monetary arrangement or regime. Whether we have a central bank or not, we'd want stable NGDP growth.

2. This 5% level is contingent on society-wide expectations. If long-term expectations held by borrowers, lenders, firms, consumers and workers were for 0% NGDP growth (e.g. the 19th Century), then 0% NGDP growth would be more likely to be the neutrality-maximising monetary policy.