Our journey will continue, however, and I’ve also started a sister blog, windy katabasis, that is more tech oriented.

For those wondering, an anabasis is a journey from the interior to the coast, but the context is Greek (made famous by Xenophon), and for that sea-faring culture, the implicit meaning is a journey from a low place to a high place, from chaos to order. That is how I think about macro-economics: the vicissitudes of personal decision-making are basically unknown and unknowable. Yes, there are some faith based models of utility optimization, but that is just handwaving, as there is no empirically or theoretically sound mechanism to convert the homunculus of “utility” into a coherent theory of individual consumer, worker, or firm behavior.  We care greatly about

• being treated fairly
• being around others who are treated fairly
• not needing to worry about the future
• not needing to optimize our consumption, but being able to expend mental resources on more enjoyable pursuits
• professional fulfillment
• living up to the expectations of our peers
• smoothing consumption

…. it is not just a question of the marginal rate of substitution between a bag of rice and an hour of leisure. The decision as to which of these we focus on and which we ignore is religious — what goes into the utility function, and what costs do we impose an actors for optimizing (optimizing is not “free”, and most people prefer to not optimize — they would spend a lot of money to avoid optimizing).

From the depths of these ad hoc choices at the micro level, we try to form a coherent macro model. It seems the way forward is to trust the macro and tweak the micro underneath.

We know that there is such a thing as “aggregate demand”, we know there is such a thing as a risk premium — we have much more evidence of this than we do for something as ill-defined and problematic as risk aversion.

In this reign, I’m impressed by the recent excellent posts by J.W. Mason and S.R.W. Go read them here:

• Negative Un-natural Rates of Interest + follow up model
• Capitalists want an exit

What they have in common is a refreshing inclusion of social/cultural institutions, that at least at the aggregate level,  constrain solutions to the optimization problem. In Waldman’s case, he is explicitly resurrecting the capitalist/labor cohort model, and Mason points out that capitalists do not actually want to be involved in the nasty business of running firms or allocating capital. History shows that this is correct. I.e. modern capitalism arose not because of economic freedom, but because of the opportunity to obtain economic rents.

In a closed or traditional economy, the existing rents are prescribed by social institutions, so you cannot compete to obtain them. You have to be born into the right class, become a member of the right temple, or have the king bestow a grant to you. But in a truly competitive economy, there is no profit in doing so. The reason why we never see such competitive economies is because no one ever bothers to drive economic rents to such a low level — there is no mechanism to force that much competition if investors don’t believe the cost of optimizing is a worthwhile endeavor — and remember, we are talking about very wealthy people here who are not concerned about consumption smoothing at all. They are purely in it for the chase, for aggrandizing power, for the enjoyment of creating new markets, or for the admiration of their peers/mates.

If suppliers of capital feel that they are entitled to 6% returns, even if their own rate of inter temporal substitution is 1%, they will still demand 6% returns and will re-price capital to meet those requirements, as consumption smoothing is not a binding constraint for them.

If the overnight rate is very low, then instead of having the rate of profit fall to the low level, you see a split between earnings and total return, with one high, reflecting earnings, and the other low, reflecting the influence of CB policy on the total return.   The result is that demand for labor is still low, even if the total return for holding stocks is negative and risk-free bond yields are zero. Shareholders keep re-pricing stocks downward according to their own discount rate, and the sum of declining share prices and constant earnings matches the declining interest rate environment as set by the central bank, even though the rate at which earnings are discounted remains high. Obviously labor demand is not going to increase in such an environment.

The Fair Price

In a new study, researchers had 15-month old babies watch movies of a person distributing crackers or milk to two others, either evenly or unevenly. Babies look at things longer when they’re surprised, so measuring looking time can be used to gain insight into what babies expect to happen. In the study, the infants looked longer when the person in the video distributed the foods unevenly, suggesting surprise, and perhaps even an early perception of fairness.

But the team also say they established a link between fairness and altruism. In a second part of the experiment, the babies chose between two toys, and were then asked to share one of the toys with an experimenter. About a third of the babies were “selfish sharers”: they shared the toy they hadn’t chosen. Another third were “altruistic sharers”: they shared their chosen toy. (The rest chose not to share. They may have been inhibited by the unfamiliarity of the experimenter, or maybe they just weren’t that into sharing.)

What’s interesting about the second half of the study was that by and large it was the babies who had previously been surprised by the unfair cracker and milk distribution who tended to share the preferred toy with the experimenter (the altruistic sharers). The babies who shared the rejected toy hadn’t expressed much surprise over unequal distribution. This led the researchers to suggest that there’s a fundamental link between altruism and a sense of equity.

Hat tip Bruce Schneier.

For the wealthy, the motivation of what they expect to get outstrips the motivation of maximizing consumption because they already have sufficient wealth so that they do not need to optimize their consumption; they can focus on the higher levels of Mazlow’s hierarchy and derive utility from that.

The birth of economic growth comes from the sweet spot — the opportunity to obtain rents via competition, with limits in place that do not allow those rents to be driven to a level below that deemed appropriate, so that there are always enough rents to encourage you to keep innovating.

The earliest capitalists were basically lenders who could demand monopolies and concessions in exchange for supplying funds to competing city states. Funds were only supplied if the monopolies were sufficiently lucrative.  This was possible because of trade — trade allowed for exploitation and for breaking the social barriers to selling goods for a “fair” price to your own community; you could screw someone over far away with trade whereas when conducting trade with your neighbor, you were answerable to the community, to the king, and to the priest. They all had a notion on what was a fair price. But this also provided an incentive for city-states to compete with each other. Competition therefore freed itself somewhat from social constraints.

The outcome of this arrangement was the spread of mercantilism and monopolies, together with industrial advancement that was funded by surplus profits. Each city state may have had a monopoly, but the city states themselves competed with each other. When barriers to entry were too low,  research and development — as well as living standards, began to stagnate. Suppliers of capital want rents, and when there are insufficient rents, the capital is not supplied and it goes away. Financial capital leads and real capital  follows. Money not lent is money not created. It disappears as the existing loans being repaid outstrip the new loans being taken out, and the tangible stock of capital declines as well, also disappearing due to being scrapped and/or depreciated as further investment does not occur. Society as a whole becomes less able to produce.

There has never been an example of an industrial economy that was not predicated on a steady flow of economic rents via some form of semi-permeable political and/or social barriers to competition that remain intact over sufficiently long time horizons to justify the initial investment. Ultimately you need a tricky balance, and this balance shifts with the social institutions and the general culture. It is very refreshing to see these concerns brought front and center.

I’ve never bought the wages = MRP story, for many reasons.

First, productivity is a function of the firm or industry, whereas wages are determined by the occupation. And most occupations are complementary.

From the BLS FAQ:

Why don’t we measure productivity for particular groups, such as white-collar workers?

BLS productivity measures are based on aggregate national measures of outputs and inputs. These data sources do not provide the information BLS would need to construct occupational measures. There are also conceptual obstacles to disaggregating these national measures. For example, the output of a factory may require both white-collar and blue-collar inputs, and it is therefore unclear how to allocate the output to the two groups separately.

Imagine a tech firm that has a QA department, an engineering department, technical writers, marketing staff, system administrators, accountants, lawyers, customer support, sales staff, sales engineers, human resources, and executives.

That is a simple firm.

Now the firm’s revenues increase (or decrease). How to allocate this change in revenue among the different occupations?

The notion that some form of MRS can determine relative wages is a bit odd. It suggests that the firm would engage in a series of experiments — say laying off some engineers and hiring more lawyers, to see which adds more to revenue in order to efficiently determine the wages paid to each occupation.

There is a reason why firms don’t do this. First, assume the firm has 100 occupations, so it engages in 100 100! = 9.33262154 × 10¹⁵⁷ layoff/hire shifts and then monitors its own revenue. Next,  the firm would need to determine whether, after a staffing change, the change in revenue was attributable to market forces, to the laid off individual being genuinely more or less productive, or to the occupation as a whole being more or less productive.  Therefore to separate signal from noise, it would need to gather a lot of data, and to keep gathering this data as the market or the firm’s own product line up changed. But there are costs (e.g. hiring and firing costs) that make such a wage determination exercise prohibitive.

Therefore the first obstacle is that gathering data about the MRP of occupations is too expensive.

The second obstacle is that it takes time, whereas the MRP of workers is state-contingent. When the firm decides to layoff some human resources staff and hire more technical writers, the effects of this decision are revealed over long time periods. And of course the market conditions will be different then, so you need to repeat this experiment over the whole business cycle. But firms, at one stage of development, need more engineers than sales staff, whereas at another stage of development they need more sales staff than engineers.

By the time you’ve gathered all the data you need, your data is obsolete.

More or less, firms understand which employees are high performing and which business functions are critical. But that general understanding does not translate into a specific “MRP” number that is stamped on someone’s forehead. There are problems of attribution. Business units fight over credit for performance, and it pays to know how to cover your ass or how to take credit. These skills wouldn’t be valuable if there wasn’t deep ambiguity about who contributed to the bottom line and who didn’t.

One could argue, even if firms do not engage in useful experimentation, that mere competition among firms will ensure that firms that accurately judge the MRP of workers will survive whereas firms that do not will fail. This is a type of evolutionary argument. But there is no “right” way to survive, and the organisms that exist are not perfectly optimized in all respects. Moreover, evolution requires millions of years, whereas firms and occupations are constantly changing, as is relative compensation of occupations.

Firms need to only be as efficient as their peers, and there are many different solutions to the competition problem, just as there are many different configurations of compensation that are “good enough” for firms to survive. In Germany, executives don’t earn huge salaries relative to their employees, whereas in the U.S. they do. Both are good enough to allow firms to survive. Which pseudo-equilibrium is selected depends on custom, culture, power relations, and reservation wages.

Update:

Added BLS quote and link to Shapley Value.

Jean Claude Trichet responds to calls to cut the discount rate:

We are doing exactly what we judge appropriate to deliver price stability and to continue to anchor solidly inflation expectations.

Is it contradictory to [...] economic growth and job creation? We trust that it is not contradictory.

Let’s make the thought experiment that we lose the solid anchoring of inflation expectations.

Then we would have all our nominal market and long interest rates augmenting because they would incorporate the additional inflation that the market would anticipate in the future. Our own population will be frightened to see that they cannot count on a currency which maintains its value. And, more generally, confidence would disappear in a large number of constituents of economic agents.

So, to the extent that we are fully in line with our definition — close to 2, less than 2, we trust that we also contribute to the appropriate prosperity of the European Union.

Market Model

Trichet argues that central banks are incapable of setting a nominal interest rate as the market will add an inflation premium.

This is a bizarre belief.  If the expected time path of short rate is, say, 1% over a 1 year horizon, and inflation expectations are 3%, then Trichet believes that nominal interest rates will be 4%, not 1%.  He believes that nominal interest rates are set by investor preferences, and not by arbitrage with the discount rate.

What could be the possible model behind this view? If we are generous, then we might argue that Trichet meant to say the following:

“If the ECB starts acting randomly, then investors will not be able to predict future short rates, and they might assume [why?] that future short rates will be higher than we intend, causing longer term nominal rates to also rise. Therefore it is in the best interest of the economy that the ECB follows a policy rule, and this policy rule currently tells us not to cut rates, because we believe that if we do, it will cause inflation to exceed its target amount.”

But the first reason why Trichet did not say that, was that he would be forced to defend the policy in the light of high unemployment and low economic growth. In his defense, it would be revealed that he does not believe that there is such a thing as an output gap due to insufficient investment demand. If he did believe this, then the policy should call for cutting the short rate when there is insufficient investment. The increase in investment would increase output and (eventually) inflation, at which point the policy rate would be raised again.

Trichet does not believe in this Wicksellian dynamic.

Hence the statement ”we trust that we also contribute to the appropriate prosperity of the European Union.” What he believes is some form of continuous full market clearing, which makes one wonder why he is involved in central banking to begin with.

Targets and Priorities

So, to the extent that we are fully in line with our definition — close to 2, less than 2, we trust that we also contribute to the appropriate prosperity of the European Union.

Note the “less than 2″. The second reason why Trichet did not make the more sensible statement that his reaction function does not call for rate cuts is that he would need to defend a reaction function that targets not a single rate of inflation, but an entire half-line.

If inflation rates less than 2 are also inline with the definition of price stability, whereas mass unemployment and low economic growth is in line with the “appropriate” prosperity of the eurozone, then we begin to understand ECB behavior a little better.

Our own population will be frightened to see that they cannot count on a currency which maintains its value.

Yes, the population is not frightened by decreased job security, high unemployment, cuts in pensions, and mass layoffs. They are instead frightened about the currency not being stable.

Perhaps Trichet, when he says “our own population” has a special definition, similar to his definitions of “price stability” and “appropriate prosperity”:

confidence would disappear in a large number of constituents of economic agents.

So this is what it all boils to — bond holders would be uncomfortable, they would be frightened by a decrease in the value of their currency. The incoherent economic model and shifting policy targets now make sense.

Debt: The First 5,000 Years.

To whet your appetite, here is some of the dialogue:

Graeber:  It goes back to Adam Smith, there is a fascinating story that we all learn, where money is supposed to come from:

Originally there is barter: “I’ll give you 20 chickens for that cow” . You say, “I don’t really need chickens right now”, “Maybe firewood?” ..And eventually you find what they need or you have to invent money. We all learn this.

In fact — being an anthropologist this is a professional pet-peeve — because we’ve been looking for 150 years if there is any place in the world where they do that and if there was, we would have found it by now.

There isn’t. It’s not true.

They do lots of other things, but they never do [barter]. [...]

So the question is why?

I think because money is credit. Credit is a social relation, and early economists had a problem with credit.

Henwood: They also had a trouble with social relations

Graeber:  Exactly, they had a problem with credit because credit is a social relation.

In order to constitute economics as a domain unto itself you have to posit that there is a sphere of human activity where people are just thinking about the stuff. But in normal human life we are never just thinking about the stuff; so you have to create a sphere, which is what the early economists were doing.[...]

Adam Smith and people like that came from a class where they thought that you really *should* be able to walk into the butcher or baker, plunk down your cash, take your stuff, walk out and never see the guy again, not even knowing his name — which was not the way it worked at the time.

There’s a great line in Adam Smith where he says “It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest.”

The crazy thing is that it wasn’t true at the time. All transactions were on credit. People were asking favors from butchers and bakers all the time.

[...]

So why does Adam Smith tell this story? Because If you think about it, it doesn’t make any sense. Here’s this guy, here’s his neighbor. He wants this cow, and offers some chickens, the neighbor says no. Well — these guys are neighbors in a small neolithic community, presumably.  But the economists are assuming that they will only interact with each other on the spot trade. Something for something right now and we walk away.

What sense does that make?

These guys are neighbors. If you don’t want his chickens, he’s going to have something. In fact, that’s what really happens. You walk up and you say “Hey, nice cow!”, and the guy says “oh, you like it? Hey it’s yours, don’t even think about giving anything back.”

Now you owe him one.

And he’s going to come later and say, “You know, my son is really interested in your daughter.” Or, “nice shoes”.

What you actually have is a rough informal credit system.

But again, that involves things like “my son is in love with your daughter”, which falls outside the domain of economics, so what they actually did is they made up this little story where everyone is just swapping stuff on the spot, and money comes in as a way of facilitating that.

Update: See also

• See also the interview in NakedCapitalism — and be sure to read the comments, as David Graeber participates extensively.
• Graeber posts a response to criticism at the Online Bible School.
• A Graeber essay on debt and money posted at longnow.org
• Graeber interview with RT (youtube).
• Graeber interview with Anarchist News.
• Writer’s Voice interview (audio)

The Haymarket square massacre and subsequent show trials occurred in the U.S., and labor organizations throughout the world celebrated May Day in solidarity with their U.S. labor counterparts, who quickly moved to distance themselves from those movements that were aware of, and emphasized, class conflict. After the massacre of union members at the Pullman Strike, U.S. labor organizations began celebrating their own labor day, in September — almost the antipodal opposite of May Day. 

The U.S. has always been afraid of acknowledging  the underlying battle between labor and capital. A frank assessment would put this conflict front and center, and would attempt to mediate some form of grand bargain — something for which the U.S. is exceptionally skilled.  But we get the bargain in backrooms, while the publicly pretending that no bargain has been made, and no bargain is necessary. This creates a terrible schizophrenia and political dysfunction, and hobbles macro-economics to the point of irrelevancy.

Here is Roosevelt in 1936:

Tomorrow is Labor Day. Labor Day in this country has never been a class holiday. It has always been a national holiday. It has never had more significance as a national holiday than it has now. In other countries the relationship of employer and employee has more or less been accepted as a class relationship not readily to be broken through. In this country we insist, as an essential of the Ameri- can way of life, that the employer-employee relationship should be one between free men and equals. We refuse to regard those who work with hand or brain as different from or inferior to those who live from their property. We insist that labor is entitled to as much respect as property. But our workers with hand and brain deserve more than respect for their labor. They deserve practical protection in the opportunity to use their labor at a return adequate to support them at a decent and constantly rising standard of living, and to accumulate a margin of security against the inevitable vicissitudes of life.

Note how Roosevelt, arguing in favor of extending labor protections, nevertheless felt constrained to frame his argument within the confines of the  ”America has no class distinctions” shibboleth:

“It is those short-sighted ones, not labor, who threaten this country with that class dissension which in other countries has led to dictatorship and the establishment of fear and hatred as the dominant emotions in human life.”

Roosevelt understood the fundamental point that labor requires income security, an increasing standard of living, and strong bargaining rights. Moreover, this does not happen “automatically” as a result of voluntary exchange. It’s quite a trick to argue for such a thing while denying the existence of a struggle between capital and labor.   Crucial information is missing. We can’t study the dynamics of labor and capital without acknowledging that these dynamics exist. We cannot make peace without acknowledging that a war is fought, and we cannot understand the mess we are in:

From the early 1930s through the late 1960s, the incomes of the masses and the rich grew more or less in tandem. Then, tragically, growth at the high end began seriously to lag the broader population. While the incomes of the bottom 90% (by the Piketty–Saez measure) fell by 2% from 1968 to 1978, those of the top 0.01% were down by 38%. This was clearly a social emergency.

..productivity growth began to sag, while total compensation (including fringe benefits) continued to grow. [...]

The whole state of affairs was clearly unsustainable. And so, as this newsletter has pointed out several times in analyzing the prehistory of our current crisis, the American elite mobilized [...] Paul Volcker took the helm at the Federal Reserve and created the deepest recession since the 1930s [...], scaring the hell out of the working class. And then Ronald Reagan moved into the White House, fired the air traffic controllers (declaring open season on organized labor), squeezing domestic spending, and cutting taxes on corporations and rich individuals. A massive upward transfer of income began.

[...]To sustain purchasing power, people turned to borrowing [...]

The basic argument can be seen in the data. The following image is taken from a BLS study on the productivity-compensation gap – something that no president or presidential candidate will mention.

Compensation was rising above productivity in the first half of the post-war era; after the Volcker intervention, productivity took off whereas compensation stagnated.  There is no plausible theory of wages being equal to the marginal revenue product of labor that can be consistent with this data. It was government policy that drove wages above productivity in the first period, and government policy drove them below productivity in the second period.

To put things into perspective, between 1980 and 2011, output per hour worked increased by a factor of 1.8, but median real earnings were unchanged (they actually declined somewhat) and median household income increased by a factor of 1.13.  The latter due to more women joining the labor force, bolstering total household income.

Women in labor force vs. hours worked/total size of labor force

Consumer expectations of median income growth (taken from the University of Michigan surveys), census bureau measurements of median income growth, and BLS measurements of median wages all show the stagnation, even as real GDP continued to grow.

But if consumers were aware of this income stagnation, why did they continue to purchase output at the current prices?

First, women’s participation allowed total the income of the majority of households to increase somewhat, and second the majority was effectively selling portions of their assets to the top 1%. This was justified because they believed that their remaining assets were appreciating in value sufficiently to maintain their target wealth levels.

To be clear, we are talking about housing, as most households hold an insignificant portion of bonds or equities. As women’s participation began to level out in the early 1990s, mortgage equity withdrawals began to increase, peaking at around 9% of disposable household income. Consumer credit and auto credit also increased, but the dominant source of demand was equity withdrawal.

When the house bubble burst there was no additional source of demand left. In order to increase demand now, the government must either supply it via deficit spending, or real compensation needs to approximately double in order to restore the balance between pay and productivity.  The problem with only using deficit spending is that the underlying wage issues are not addressed — so there is no end to the deficit spending.

Without a class-based interpretation, you will be looking for what accident went wrong in 2008 that we can fix to get “back on track”. A sudden rush of regulatory uncertainty! A liquidity crisis! A shortage of safe bonds! But a class-based interpretation of this crisis is that we are at the end-game of a 30 year period of unsustainable wage deterioration, and the specific triggers of the financial crisis were not the underlying cause. The underlying cause was  a three decade period of market failure in which one imbalance was hidden by another and then another. If the former interpretation is correct, then the provisioning of liquidity or more safe bonds will allow employment to get back to normal. If the latter interpretation is correct, then these interventions wont work. Employment will continue to stagnate and output will continue to be constrained by the level of deficit spending stimulus.

Only a long period of grinding deflation, combined with nominal wage rigidity, or a short period of massive redistribution and substantially higher median wages will allow the economy to continue to grow at its historical rate. Note that we do not require a higher total wage bill, but higher median wages, and lower superstar wages.

We need a new grand bargain, but unfortunately we are not allowed to talk about this bargain, economists do not want to model class conflicts, and the politicians do not want to discuss 30 years of wage stagnation.

It is a silent labor day.

Upside Down V

This first thing to note is the “V” shape in the capital-output ratio, from the mid-60s until the present day, with the peak occurring around 1982. The following Fred graph measures the tangible assets of non-farm non-financial businesses as a proportion of GDP.

Non-Financial Business Tangible Assets/GDP

Tangible assets consist of equipment and software together with real estate, with real estate the more volatile component (primarily due to valuation swings):

Non-Financial Business Real Estate Assets/GDP

Whereas the trend in equipment and software, which are not subject to the same valuation swings, is more clear, particularly when we normalize by potential GDP:

Non-Financial Business Equipment and Software/Potential GDP

Meanwhile, the gap between gross and net output is widening. I.e. a greater share of gross output consists of capital consumption:

Consumption of Fixed Capital/GDP

A different story emerges if we look at the financial assets of non-financial businesses, normalized by GDP:

Financial Assets of Non-financial businesses

Note that this data comes from Z.1, and presumably includes goodwill, purchased patents and copyrights, etc, but I couldn’t find confirmation for this digging around the Fed’s website (and for some reason they can’t put the handbook online!). If anyone can verify, please let me know.

Addenda

As an alternate measure, we can use the BEA Fixed Asset Stock tables. I used the quantity index of private equipment and software, and compared this to potential real GDP.  Note that we are using two different indexes with different bases, but we can still compare the growth rate of one with the growth rate of the other. This series ends in 2009 and is only available annually.

Also note that computing quantity indexes is difficult for software and technology components: just because MS office has 10 times more features does not mean that 10 times the quantity has been supplied over the previous version, or that firms purchasing MS Office for their workers are making 10 times the capital investment that they were making when they purchased the previous version. You can imagine a pareto distribution of feature-use, with the most obscure features used very rarely by a handful of customers, etc. Similarly, if processors are 1o times faster than 5 years ago, this does not mean that 10 times as many processors were supplied, nor does it mean that this component of the capital stock has increased ten-fold. IMO this is why the BLS has some whacky price deflators for semiconductors and software in comparison to more plausible price deflators for things like capital equipment.

Amid all the grim economic data and a chorus of warnings of a fresh recession, one group on Wall Street has remained remarkably optimistic despite the dangers that may lie ahead — the research analysts who track individual companies.

Typically bullish in the best of times, this group has barely budged on its expectations for earnings in the second half of 2011, even as the economists and strategists at the big brokerage firms have steadily ratcheted down their forecasts for overall economic growth.

Google buys Motorola Mobility for $12 Billion,  HP shut down its WebOS hardware operation (shortly after purchasing Palm) and looks to sell off its entire PC hardware division (after purchasing Compaq), while at the same time purchasing Autonomy for the (insane) price of $10 Billion. Autonomy sells structured data search services — its clients are large firms. Autonomy is in the high margin monopolistic “space”, whereas PCs are in the commodity space.

The cited reason for HP wanting to divest itself of its (profitable) consumer hardware division is falling margins.

HP doesn’t want to be in the low margin business — it wants to be in the high margin business, and it would rather sell off or liquidate capital rather than accept lower margins. It is not enough merely to be profitable. HP wants a high operating margin, and high earnings growth rates.

The market responded by shaving 20% off the price of HP stock.

In other words, if firms do not get the margins that they believe are expected of them, they shrink.

The buzz is that Samsung (a Japanese  Korean firm) is the front-runner to become HP’s hardware partner.

IBM also got out of the PC hardware business — due to falling margins — selling its PC manufacturing assets to Lenovo — a Chinese firm. Again, in China interest rates are extremely low, at least for politically favored entities.

It seems that every firm in the U.S., if it comes to believe that it cannot obtain 20% earnings growth, liquidates.

It can sell of its capital to nations in which firms have low funding costs.

In the U.S. capital is expensive, while in other countries it is cheap, and the U.S. is systematically divesting itself of all but the most profitable firms even as other nations expand investment.

And yet this is happening in a low IR environment.

My only explanation — what my gut tells me — is that dynamic effects have caused the rental rates demanded of capital to remain high even though risk-free borrowing rates are low. By dynamic effects, I mean that as interest rates fall, share prices rise, and investors who see the total gain, come to expect the large gains, which must ultimately be realized as high earnings and/or high earnings growth rates. Paradoxically, a long period of cutting borrowing costs can lead to a high cost of capital, if the past gains become embedded into “sticky” expectations of future gains.

This doesn’t bode well for domestic investment or employment.

UPDATE: Fixed some typos, added details of Autonomy and some handwaving re: dynamic effects.

UPDATE 2: Changed Asian slur — calling a Korean Company Japanese, and thus removed reference to low CoC in Japan — thanks Max!

On a monthly basis,

Define:

equity return = change in capital value over the month + (annual) dividend yield/12

The risk-free return = 3 month Treasury yield/12 — a proxy for the 1 month bill, for which I don’t have a long enough time series.

The excess real gain is the difference between the equity return and the risk-free return, adjusted for the month-on-month change in CPI.

Then take the 10 year (trailing) average of the excess gain, compared with the 10 year trailing average of the standard deviation of the excess gain:

The first thing to note is that the excess gain averages about 7% (annualized). More interestingly, as the standard deviation falls, the excess gain increases, and as the standard deviation increases, the excess gain falls.

Theory would say that the excess gain is compensation for volatility, so that a higher standard deviation would lead to a higher excess gain.

But as standard deviation declines, households bid up equities causing the real gain to increase, not decrease. In an timeless model, this adjustment would happen instantly, so the gains going forward would be lower. But say we are in a sticky expectations model, in which the adjustment happens gradually.  This type of friction reverses the conclusion of the model — now falling standard deviations are associated with increasing equity returns, and vice-versa.

This is another example of the (excellent) point Nick Rowe made about robustness of models. If adding a small friction reverses the conclusion of the model, then you cannot take the frictionless model seriously. If, in our world, investors only gradually come to expect falling volatility, then the equity premium becomes contravariant with volatility.

In that case, the system might have a locally self-destabilizing property, in the sense that periods of falling volatility lead to periods of increasing return on equities, which become transformed into increasing cost of equity, which ultimately results in an excessively high cost of equity, which when not met, leads to falling capital values and increasing volatility. The only friction needed is sticky expectations.

Update: fixed “covariant” to “contravariant”

At this rate, we would need to deliver 10% of GDP as corporate dividends before unemployment falls back to 5%.