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Reed College Public Policy Lecture

J. Bradford DeLong

Professor of Economics, U.C. Berkeley Research Associate, NBER

November 7, 2009 DRAFT

This is what is going on outside the window:

The Employment-to-Population Ratio Is in Free Fall

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America’s employment-to-population ratio—the fraction of those sixteen and over who say that they have jobs when the Current Population Survey knocks on their doors—is in free fall. Yesterday we learned that the seasonally-adjusted employment-to-population ratio hit 58.5%, down from 63.4% at its most recent 2007 business-cycle peak an down from its all-time high of more than 64% during the dot-com boom of a decade ago. That the economy’s employment-to-population ratio is suddenly lurching down should not come as a great surprise. It does this every decade or so. What does come as a surprise is the magnitude of this particular downward lurch. And that is my subject for today—why so large a downward lurch now, how we can understand it, what we are doing about it, what we should be doing about it, and what is likely to happen next as all you seniors out there worry about trying to enter the worst job market in America since 1939, as all you juniors out there worry that things might get even worse, and as President Diver worries about how he is going to cope with the rapid rise in the demand for financial aid from admitted candidates whose parents have lost their jobs or their 401ks. I am going to talk about by introducing you to a bunch of different people. Let me mention of them here:

• First, from today, Chicago School economist Narayana Kocherlakota, newly installed as President of the Federal Reserve Bank of Minneapolis, to explain to you why the past generation’s work in technical market-oriented Chicago economics is of no use in explaining what was going on.

• Second and third, from 1825, English novelist E.M. Forster’s

great-aunt Marianne, and her brother Henry Thornton, who were present at the English financial crisis of 1825—the cause of the first industrial depression and the first opportunity for governments to try to take a stand and take action to stem or curb or moderate such a depression.

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• Fourth, from my graduate school days in the early 1980s, my old teacher Charlie Kindleberger, whose book Manias, Panics, and Crashes is still both the best history and the best theoretical account of why the sober-sided bankers of the world sometimes act like herds of panicked cattle.

• Fifth and sixth, from the era of the Great Depression, Yale

economist Irving Fisher and Cambridge (England) economist John Hicks, to explain why financiers behaving like herds of panicked cattle is of so much concern to the rest of us.

• Seventh, the extremely smart, capable, and arrogant Alan

Greenspan, who did not worry as we got into this mess because he believed his Federal Reserve could handle any shock that Wall Street threw at it.

• Eighth, the extremely smart, capable, and not-arrogant Robert

Rubin, whose organization Citigroup and its peers delivered a shock to the economy that the financial system could not handle.

• And ninth through twelfth, Ben Bernanke, Henry Paulson, Tim

Geithner, and Barack Obama, who struggled and are still struggling to eat what has been set before them on their blind date with desitiny.

So let me begin. Narayana Kocherlakota and the Chicago School Economists believe that markets are good things. Back in the eighteenth century a number of people—Richard Cantillon, Bernard de Mandeville, and Davey Hume come first to mind—ending in Adam Smith collectively game up with a truly game-changing insight affecting a lot of questions of governance and pubic policy. We human beings—we East African Plains Apes—are built to keep our groups

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together by exchanging things. We have a natural propensity to truck, barter, and exchange, and if we collectively impose the right rules—private property, contract law, Pigouvian taxes, fair distribution of wealth—then the networks of exchange that we will spontaneously build up will constitute a remarkably effective collective social mechanism for calculating what we should make it, how it should be made, and how it should be distributed. Its not Saint Luke’s “each contribute according to their ability” and “each take as they have need,” but it is a big step. Economists coming out of the Viner-Simons-Knight-Stigler-Coase-Friedman Chicago School intellectual tradition that dominates America believe that markets are even better things than some of the rest of us, and for the past generation they have dominated technical economic research into business cycles by trying to build better and useful dynamic stochastic general equilibrium models of the economy that will help us understand episodes like the current collapse of employment—and help us figure out what to do about them. But, as the extremely sharp Narayana Kocherlakota pointed out just before he was chosen to be one of the nineteen members of America’s decision-making central-banking committee, they have not made much progress. In fact, the past generation’s work in technical economic theory is of no help at all. Models of the economy built on Chicago-School foundations, you see, possess an immense stability. In order to get them to undergo any large change-of-state like the one we are going through, you need to hit them with an enormous shock. In the current crop of models there are three shocks that can do the job:

• A Great Forgetting—a sudden large fall in the level of productive technological knowledge.

• A Great Vacation—a large and sudden shift in workers’ desire to work.

• A Great Rusting—a large and sudden increase in the rate at which capital equipment depreciates.

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Other shocks simply don’t do the job in the market-friendly DSGE models. And so, as Narayana Kocherlakota says and as I agree:

Why do we have business cycles? Why do asset prices move around so much?... [M]acroeconomics has little to offer by way of answer to these questions...

Modern models attribute economic downturns to various causes:

[M]ost models in macroeconomics rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities)...

As I said, a great forgetting of technological and organizational knowledge, a great vacation as workers develop a sudden extra taste for leisure, or a great rusting as the speed with which oxygen in the air corrodes speeds up and so reduces the value of large things made out of metal. And yet these:

sources of disturbances in macroeconomic models are (to my taste) patently unrealistic.... None of these disturbances seem compelling, to put it mildly...

And nobody really believes them:

Macroeconomists use them only as convenient short-cuts to generate the requisite levels of volatility in endogenous variables...

That is, the models currently being published in the technical journals are useful in thinking about comovements—why and how certain variables move together in business cycles. They are not useful for figuring out why a big downturn now, or how big the downturn will be, or what we should have done, should be doing, or should do about it. For that we have to turn away from modern economic theory back to economic history and the history of economic thought—to what has

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happened in the past when we have found the economy wedged in similar situations, and to what models frameworks economists in the past set forth that they found useful in thinking about policy issues even though their models and frameworks do not meet today’s methodological canons of technical rigor. So let’s get into the WABAC machine and head back to 1825 in London, back to the first industrial business cycle and the very first attempt to stem an industrial business cycle by government action. English Novelist E.M. Forsterʼs Great Aunt Marianne English novelist E.M. Forster’s favorite great-aunt was Marianne Thornton; he was her favorite great-nephew. She left him a legacy that provided the cushion he needed to make his life as a fiction writer; he was grateful, and to express that gratitude wrote a biography of her based heavily on her letters. For our purposes Marianne Thornton was an interesting subject because of her brother Henry and because the Thornton family was one of the leading banking families in England around 1800. As Forster wrote:1

[Although the] Bank… had… in 1815 it had passed out of Thornton control…. Henry [Thornton, Marianne’s brother,] longed to join it… in 1825 he became an active partner... in Pole, Thornton, and Co. It was said to be yielding £40,000 a year…

which was as large a share of the British economy then as $400M would be today. Young Henry—in his twenties—had no previous banking experience, yet he became one of five partners—at this point you should be dividing $400 million a year by five—in what

…was regarded as one of the most stable and most extensive banking houses in London…. The active partner was Peter Free.... On the

1 E. M. Forster (1956), Marianne Thornton: A Domestic Biography, 1797-1887 (New York: Harvest), p. 109 ff.

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surface all was now serene. Young Henry must have stepped aboard the family ship with confidence and pride...

Now let me turn the microphone over to Marianne Thornton, in her letters—return address given only as “Battersea Rise”—to her newly-married friend Hannah More:

Battersea Rise, 7th December 1825 PRIVATE AND CONFIDENTIAL Dearest Mrs. H.M., There is just now a great pressure in the mercantile world, in the consequence of the breaking of so many of these scheming stock company bubbles…

Can you say “irrational exuberance”? …and Free had been inexcusably imprudent in not keeping more cash in the House…

Can you say “excessively leveraged”?

but relying on that credit in them which had never been shaken, and which would enable them to borrow whenever they pleased...

Can you say “able to adjust his portfolio by trading at or very close to recent market prices whenever they pleased”?

[Free, however,] was not however particularly uneasy till last Thursday and Friday…. On Saturday however—that dreadful Saturday I shall never forget—the run increased to a frightful degree, everybody came in to take out their balance, no one brought any in; one old steady customer, who had usually £30,000 there, drew it out without, as is usual, giving any warning…

Think “nine months’ normal earnings of the bank with not five minutes’ notice”:

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and in order to pay it the House was left literally empty.... Such a moment of peril completely turned [managing partner] Free's head; he insisted on proclaiming themselves bankrupts at once, and raved and self-accused himself…. Old Scott cried like a child of five years old, but could suggest nothing. Pole and Down were both out of town. Henry saw it all lay upon him.... [H]e found that during the next hour they would have to pay thirty-three thousand [pounds], and they should receive only twelve thousand. This was certain destruction, and he walked out, resolved to try one last resource…

Picture this guy: in his twenties, six months working in the banking industry, wandering the streets of London’s financial district, with nothing to offer in collateral, at 4 PM on a Saturday afternoon, looking to borrow cash. He finds another banker:

John Smith [who] had been... particularly kind to Henry…. John Smith asked if he could give his word of honour... that the House was solvent. Henry said he could…. John Smith declared… he would apply to the Bank of England for them. Henry had little hope from this, for the Bank had never been known to do such a thing in the annals of Banking.… [T]he next morning at 8 o'clock [AM Sunday]]…. [A]ll the Bank of England directors who were in town.... John Smith began by saying that the failure of this House [of Pole, Thornton] would occasion so much ruin that he should really regard it as a national misfortune…

Can you say “too big to fail”? And here something happened that neither John Smith, nor Henry, nor Marianne Thornton could have counted on. Lord Liverpool—Robert Banks Jenkinson, Second Earl of Liverpool, First Lord of the Treasury (that is, Prime Minister to His Majesty George V Hanover)—had already taken a hand. Lord Liverpool had gone to the Governor of the Bank of England, Cornelius Buller, and asked him to do something about the situation: otherwise, Lord Liverpool feared, there would be great misery in the cities of Manchester and Birmingham and London as people in manufacturing industry rendered unemployed by the financial crisis and their families starved on the streets. And, Lord Liverpool feared, perhaps he would wind up with his head on a pike: it was only a generation since the French Revolution, after all, and Arthur Wellesley, Duke of

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Wellington, was called the “Iron Duke” not because of his strength of will or character but because of the iron shutters installed to cover the windows of Apsley House to keep them from being broken by rock-throwing mobs. Robert Banks Jenkinson had been warning about “bubbles” for quite a while. He believed that allowing the financial system to crash would have very bad consequences for employment in manufacturing. For the first time, you see, you had a large manufacturing sector—people who could not just go back to the farm if their employers could not borrow. And the financial crisis rolling forward was creating a situation in which no business could borrow to expand or even to fund its day-to-day operations on terms that made such profitable. Hence after Henry Thornton made his presentation, Governor Cornelius Buller:

then turned to Henry and said, 'I think you give your word the House is solvent?' Henry said he could… he had brought the books.... 'Well then', said the Governor and the Deputy Governor of the Bank, 'you shall have four hundred thousand pounds by eight tomorrow morning, which will I think float you'. Henry said he could scarcely believe what he had heard.… He was off again in the dark on Monday morning to the Bank of England, where he found the Governor and Deputy Governor who for the sake of secrecy had no clerks there, and they began counting out the Bills for him. 'I hope this won't overset you my young man', said one of them, 'to see the Governor and Deputy Governor of the Bank [of England] acting as your two clerks. He went back to the banking house £400,000 richer than he left it on Saturday. For the first hour there was a little run, but the rumours that the Bank of England had taken them under its wing soon spread, and people brought back money as fast as they had taken it out on Saturday...

1825 is the first time this happened. The first time that the financial system was large enough and integrated enough with the nascent industrial economy for a financial crisis to threaten to produce large-scale unemployment. It was the first time that as a result the crisis called forth aggressive public action to support and sustain market prices and market liquidity—by two guys in the Bank of England counting out banknotes and sending them out in a cart down Threadneedle Street (in violation of

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the Bank of England’s charter, I must say); by TARP and TALF and ARRA and a host of other alphabet-soup vehicles today. Henry Thornton lied about the solvency of Pole, Thornton and company: the Bank of England got some but not all of its money back. His cool behavior in the crisis, however, meant that the crash of Pole, Thornton did not mean the end of his banking career. Nathan Meyer Rothschild, then the richest man in the world, and others were impressed and willing to fund and back his projects thereafter.

Did It Work?

Did it work? Did the Bank of England’s intervention help the British economy’s manufacturing sector avoid a deep depression? We believe so: British cotton use in 1826 was only 12% below its 1825 level, and 1827 saw a 30% rise, after which British manufacturing resumed its growth in the Industrial Revolution.

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Charlie Kindleberger If you will recall, I said that Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said that modern Chicago-oriented macroeconomists have relatively little that is useful to say about large financial crisis-caused recessions like the one we are in. My old teacher Charlie Kindleberger, author of the wonderful Manias, Panics, and Crashes, would by contrast declare that he had a great deal to say. If you were to ask him why the world is currently in the grips of a financial crisis and a deep recessionary downturn, he would say that there is no mystery, that the 2007-2010 downturn is the latest episode in a long history of similar episodes of bubble—crash—crisis—recession. Such episodes have irregularly but frequently occurred in industrial economies at least back to the British canal bubble of the early 1820s; the subsequent 1825-6 failure of Pole, Thornton, and company; and the resulting first industrial recession that followed in Britain. We have seen this process at work in many other historical episodes as well: 1848, 1873, 1929, and 1987 come immediately to mind. The process starts when for some reason asset prices get way out of whack and rise to unsustainable levels. Sometimes the culprit is lousy internal controls in financial firms that over-reward subordinates for taking risk; sometimes it is government guarantees; sometimes it is the selection of the market as a long run of good fortune leaves the financial market dominated by cockeyed unrealistic overoptimists. These produce a substantial runup in financial asset prices. But the runup is unsustainable—in its late stages at least, people are holding assets at high prices for no reason other than they expect someone else to buy those assets for an even higher price in the future. Thus the crash comes. When the crash comes the risk tolerance of the market collapses. Everybody knows that there are immense unrealized losses in financial

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assets. Nobody is sure that they know where those unrealized losses are. To buy or even to hold risky assets in such a situation is a recipe for financial disaster. That nobody is sure where the losses lie, and thus as a result that every single private-sector investment has become risky, is absolutely key to the process. Four times as much money was lost in 1999 and 2000 by enthusiastic investors overwhelmed by irrational exuberance investing in the companies of the dot-com bubble as was lost making mortgages that will not be repaid on houses newly built in the desert between Los Angeles and Albuquerque. But the venture capitalists of 2000 had raised their money by offering investors shares in their funds, so when the crash came nobody feared that there would be a chain of bankruptcies. By contrast, the Bear Stearnses and the Lehman Brothers and the WaMus and the Citigroups had bet on subprime mortgages with money that they had borrowed—and so not only did the market’s appetite for holding risky assets fall but a great many assets that had been thought to be of minimal risk turned out to be of substantial risk indeed. Thus the dot-com crash of 2000 generated no fears of a collapse of the financial system. The much smaller subprime crash of 2007 did. Thus the crash is followed by a flight to safety as investors all at once try to shift their portfolios out of risky assets like stocks, junk bonds, and CDOs (the prices of which fall) into secure Treasury securities (the prices of which rise). The prices of private bonds fall. By contrast, the prices of safe bonds—government bonds, Treasury securities—rise as a result of the great financial “flight to safety.” It is certainly true that this panic is by economists’ canons “irrational.” There is a lot of money to be made by buying when everyone else is panicked and selling. There are, however, three problems with doing so: First, if you are investing not your own but your customers’ or borrowed money, you have to identify the bottom: buying before the bottom is a much quicker road to total bankruptcy as your customers or your creditors

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demand that you repay even though you know very well that if only you an hang on until the market recovers from panic you will make a fortune. Second, we are herd animals: East African Plains Apes who like to do things in groups: “Let’s all go to the waterhole!” “Let’s go eat Mgongo nuts!” Stubborn individualists who insisted on going to eat Mgongo nuts when everyone else in the pack headed for the waterhole ran into hungry leopards and did not contribute their genes to our current population. If everyone else is panicking, then you are unlikely to be able to avoid panicking as well. Third, finance is boring unless you are by nature a gambler. And if you are a gambler than you have to pay to that propensity the appropriate toll. You will gamble on anything—on whether Lindys sells more cheesecake or strudel, or on whether when you tap a sealed deck of cards fresh from the factory the jack of hearts will jump up and squirt cider in your ear. Even if you have a good fundamental long-run position that you should lock up and leave alone until its securities reach maturity, the kind of people who can do that are not the kinds of people who take jobs on Wall Street. Financial markets have had manias, panics, and crashes caused not by outside shocks or forces but by their own spontaneous psychological-economic dynamics for at least three centuries now. Deal with it. But why is this any more the concern of the rest of us than Brad and Angelina or the fate of the contestants on “I Survived a Japanese Game Show”? The fortunes and misfortunes of the rich and celebrated are interesting and diverting, yes. But Hollywood stars are much more buff and have funnier people writing their lines than do Lloyd Blankfein or Tim Geithner. It matters because finance is at the center of our economy. We have a market economy. This means that we have a price mechanism at its core: prices serve as semaphore flags: they send us signals as to what we ought to be doing in our work lives—what firms and occupations should grow, and what ones should shrink. A financial panic deranges the price

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mechanism: all of a sudden the prices that the financial sector is sending to the real economy are signaling the real economy to shut down. And while we believe in a market economy we do not believe that the market should be allowed to set prices when the prices it sets tell businesses that they should create mass unemployment—like now. Something needs to be done to correct or compensate for this derangement. Irving Fisher and John Hicks Why a financial crisis exercises such a deranging effect on the macroeconomic functioning of the price mechanism is a question that was settled about seventy years ago by what was then cutting-edge technically-sophisticated economic theory. So sharpen your pencils. There is, in practically all economies since the predecessors of Croesus of Lydia came up with the idea of coins perhaps 2700 years ago, a special commodity called “money”: things that are valued not because you can eat them or be pleased by looking at them or use them to keep your scalp free from lice or to keep yourself reasonably dry through a Portland winter but valued only because other people will value them in turn. Money in your pocket is useless. Money is useful only when you spend it. Money in your pocket should be held in some other form that is either directly useful to you or at least earns you some interest. So the more money—cash, checking account balances, PayPal balances, reserve deposits at the Federal Reserve—you have, the more you are going to want to spend. You aren’t going to want to spend it all today: you might well find something tomorrow that you would like to buy more than the things you see today. But under normal circumstances the speed at which people spend their money—the “velocity” or money, as Yale’s Irving Fisher called it—will be at some normal level. Thus if you know how much cash money in all of its paper and electronic forms there is the economy and if you know the institutional setup and technology of banking that tells you how long checks take to clear, et cetera, then you know how much spending there will be—and combine how much spending there is with what the level of prices is and you can calculate

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what inflation-adjusted sales—aggregate demand—will be, and thus production, and thus employment, This is the quantity theory of money.

The Quantity Theory of Money

Now consider what happens when the interest rates on Treasury bills aren’t normal. Treasury bills are very close to cash money in lots of ways. The government prints dollar bills, the government prints Treasury bills, holding both is thus subject to the same set of risks. And when you are deciding whether to hold your wealth in bills or cash you don’t have to worry at that margin about other sources of risk—markets for private securities dry up and become illiquid, companies default, companies are reorganized in ways that leave you with title to an empty debt-burdened shell, and so forth. So the interest rate on Treasury bills is a very good measure of the “opportunity cost” of holding cash. Each dollar bill in my pocket or in my checking account could be in a money market account invested in Treasuries instead—and there is would (most of the time) be earning interest.

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This means that when interest rates on T-bills are not normal but are high then it is expensive to hold cash money: you are losing a lot of interest for each dollar in your pocket. They are burning holes in it. So you have an incentive to rearrange your spending plans: hold each dollar in cash for a shorter time before you spend it. Aggregate up all the decisions as to how to change their spending plans people make when T-bill interest rates go up and their cash starts burning holes in their pockets, and you will see that rising T-bill rates go along with higher spending conditional on the quantity of money in the economy.

The Liquidity Trap

Now consider the reverse: what happens when T-bill interest rates are very low—like now. Now there is no incentive to economize on your cash holdings. You could move your cash into T-bills, but what’s the point: T-bills aren’t paying any interest. You could move your cash into other private investments, but they are very risky right now—and your tolerance for risk is very low. This is the “liquidity trap”: whenever interest rates are

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very, very low, the normal relationship between the quantity of money and the level of spending breaks. The level of spending could be any of a whole bunch of things—as in the liquidity trap diagram. And guess where the economy is right now. This is why we care: when financial panic reaches a stage in which T-bill interest rates are pushed down to zero, then we run the risk of a big depression if one consequence of that is a collapse of the normal relationship between the amount of cash in the economy and the level of the flow of spending. That’s what we fear. That’s what we have. The shrp reduction in interest rates on safe short-term assets generates a steep fall in the velocity of money: households and businesses everywhere hoard and do not spend their cash. And this fall in monetary velocity reduces spending and demand, and brings on recession, excess capacity, and high unemployment. The Federal Reserve, under Alan Greenspan, had adopted a policy pose I call “Greenspanism”: lighten the regulatory hand of the government on financial institutions, let them innovate, there will be episodes of irrational exuberance and those rich people who become irrationally exuberant will in the end lose lots of money, but the Federal Reserve has the power and the skill to keep financial turmoil limited and, especially, to keep financial turmoil from spilling over to the non-financial economy in the form of substantial output declines, large amounts of idle production capacity, and mass unemployment. As of 2003 the Greenspanist bet appeared a good one. The early 1980s had seen the opening of securities options trading in Chicago. O’Brien, Rubenstein, and my Berkeley colleague Hayne Leland had convinced a lot of mutual funds to buy their “portfolio insurance” dynamic options trading strategy (and a lot of others were following similar strategies on their own), and the stock market drops by a quarter in one day. But the Federal Reserve steps in. And you cannot see the 1987 crash as generating even a ripple in capacity utilization or unemployment.

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Similarly, 1990 saw S&Ls that appeared to have bad business judgment poorly regulated—in part because they were good at using congress to block their regulators—crash. The Treasury loses $150 billion, investors in S&Ls lose everything, the rest of us get a bunch of extra shopping malls (albeit half-empty ones) to shop in, and the Federal Reserve steps in and we see only a ripple in capacity utilization and unemployment. 1998 saw Michel Camdessus and Stanley Fischer at the IMF announce that nuclear-armed ex-superpowers like Russia are not, in fact, too big to fail and the partners of Long Term Capital Management deeply, deeply regret their decision to return two-thirds of their capital to their ex-investors and their creditors regret their decision to lend people with $3 billion $100 billion with no collateral or oversight whatsoever—and the Federal Reserve steps in and you cannot see the 1998 crash as generating even a ripple in capacity utilization or unemployment. 2000 sees the bursting of the mother of all irrational exuberance bubbles. The stock market reaches its all-time peak a month after high McCain advisor Kevin Hassett and George W. Bush library director James Glassman double down their “Dow 36000” bet and promise substantial donations to charity if their stock market targets have not been reached by January 2010 (note: already stretching their three-to-five year horizon to a decade). As investors realize that internet technologies are wonderful but that making money off of them is hard—that practically all of the value is flowing to consumers through market competition—the market crashes. And the Federal Reserve steps in, and we see only a ripple in capacity utilization and unemployment. Treasury Assistant Secretary and then Federal Reserve Chair William McChesney Martin said, famously, that the purpose of the Federal Reserve was to take away the punchbowl before the party got going. His successor’s successor’s successor’s successor Alan Greenspan begged to differ: the Federal Reserve, Alan Greenspan thought, should—as long as there was no threat of an inflationary spiral in consumer prices—be willing to spike the punchbowl with the grain alcohol of 1% federal funds rates, because it can serve as a designated driver to make sure that everyone gets home.

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Four years ago I was a reluctant but convinced Greenspanist: one of those hooting at Raghuram Rajan at the Federal Reserve’s Jackson Hole conference when he argued that financial innovation and sophistication had exposed us to aggregate risks we did not understand and that global central banks might not be able to manage. (The only person I recall speaking up in support of Raghuram was Armenio Fraga.) Today—can you say “agonizing reappraisal”? “V”s versus “L”s I believe that we can all agree that Greenspanism is wrong.

We Can All Agree Now that Greenspanism Is Wrong

And I believe we none of us expect a rapid return to normal levels of unemployment, of capacity utilization, and of the employment-to-population ratio. Very few people expect a V-shaped recession as far as unemployment is concerned. We today generally forecast 3-4% per year real GDP growth starting sometime around last May, but we also generally forecast an unemployment rate that stays near 10% for the next eighteen months. When Christy Romer and Jared Bernstein ran the forecast

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numbers for the incoming Obama administration ten months ago they—trying to stay close to the middle of the private-sector forecast pack—projected that with the policies they hoped to enact the unemployment rate would be near 7% by the end of 2010. They got congress to pass more-or-less what they asked for. Yet we today see ourselves as much more likely to see 10% unemployment than 7% unemployment as of the end of 2010. The reason for the slow recovery is, I think, clear. Recessions arise when asset prices crash, and when as a result businesses find it unprofitable to raise capital to expand capacity or even to continue operations at the previous scale. The substantial post-World War II recessions before 1990 were all produced by Federal Reserve decisions to raise interest rates to fight inflation, decisions that produce correlated falls in all asset prices from Treasuries to equities and real estate and beyond. And when those policies are reversed—when the Federal Reserve decides it has done enough or gone to far and reverses its high interest rate policies—all asset prices rise together in a correlated fashion, non-financial businesses find they can raise capital on more-or-less normal terms again, and we have a “V.”

“V”s versus “L”s

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That hasn’t happened since the start of the 1990s. Since the start of the 1990s, recessions have typically seen a negative correlation between returns on U.S. Treasury bonds—in the first, short-term, and in the second and third episodes, all—and returns on other asset classes. The configuration of asset prices wheels as the prime mover is not inflation-fighting on the part of the central bank but instead a fall in risk tolerance on the part of the private market. And risk tolerance does not spring back to normal immediately after the recession trough is reached. And so asset prices do not recover as rapidly as they do when the prime impetus behind the recovery is the Federal Reserve lowering interest rates. And so we get an L more than a V. That’s what we got in the Great Depression. That’s what Japan got in the 1990s. That’s what we got to some extent in the early 1990s and to a greater extent in the early 2000s. And it looks like that is what we are getting now. So why does the risk tolerance of the private market collapse? Robert Lucas Again Let me go back to the very sharp Professor Robert Lucas again, this time not to his AEA presidential speech but rather to an interview he gave Tom Keene of Bloomberg seven months ago.

LUCAS: Our economy’s got a remarkable ability to return to its long term growth trend. And for most of the depressions we’ve had or recessions, the return has been quick. Two or three, four years...

Lucas says that it is highly likely that the U.S. economy will be back to normal in three or four years, with a normal level of unemployment, a normal share of profits in national income—and a normal level of dividends and capital gains. This presumably means that stock prices will also be back to a normal multiple of long-run earnings, which means a year-2015 S&P of 1500 or so, compared to its March 2009 level of 700. But Lucas also tells Tom Keene:

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LUCAS: [T]here is no question that fear is what this liquidity crisis is. I mean the reason I got into money [with my portfolio] is that I got afraid to leave my pension fund in other securities. So I’m sitting there with a portfolio full of zero-yield stuff just because I’m afraid to do anything else. I think there are millions of people like me… KEENE: What will be the signal for Robert Lucas to go back into the markets?… LUCAS: I don’t know. Robert Rubin made a joke about that in the first session today. Nobody knows...

Investing in the S&P 500 for a six-year horizon is risky, certainly, but the expected return is high: 15% per year, if you believe Lucas’s forecast. And holding your money in cash is not all that safe either: the scenarios I can envision in which the S&P 500 is at a real value in 2015 corresponding to the value that 700 buys today are scenarios in which inflation has eaten away much of the value of cash. So what is Lucas doing holding his portfolio in cash? Has risk suddenly increased to an extraordinary extent to force the equity share of his portfolio down from 70% to 0% in spite of the huge jump in expected six-year returns? Risk has increased, but to that extent? Has his horizon shortened? No, he hasn’t boosted his consumption level. What is happening is that he, and millions of the other upper-middle class people like him who together deploy a majority of the net financial wealth of America, is behaving as if his tolerance for risk suddenly and utterly collapsed. Why? Because he is panicked. And he is not thinking that the economic-forecasting part of his brain his things to tell his dig-a-hole-and-hide part of his brain, like: “Your horizon is not one week but six years.” My guess is that the salience of the 2000 and now 2007-2009 market crashes—the ones in which the structure of asset prices wheel, as the prices of U.S. Treasuries (and the dollar) rise while the prices of all other assets fall, and fall the more the more risky they are perceived to be—in the minds of America’s upper middle class will be high for a generation. And so their risk tolerance will be low. It will be much more like the years before the 1920s, when industrial, utility, and even railroad equities were

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seen as very risky investments in markets rife with insider trading and fraud that were not for normal people, or the years from 1945 to 1995 or so in which the memory of the Great Depression, somewhat reinforced by the oil shocks of the 1970s, limited the risk tolerance of middle America. What will such a structure of asset prices be like? Robert Shiller and John Campbell Let’s start with what Harvard’s John Campbell and Yale’s Robert Shiller call the Graham ratio, after Warren Buffett’s guru Benjamin Graham, who said somewhere that a ten-year moving average of past earnings is a very good rough guide to what the permanent level of earnings is.

The Graham Ratio, 1880-2009

And Benjamin Graham also said that the first question you should always ask to assess asset values is to compare them to the long-run cash flows you can expect—which, for equities, are reasonably well-captured by

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permanent earnings. The figure shows this Graham ratio for the S&P Composite index, linked back in the past to the Cowles Commission index for the years from 1870 up to just after World War I as the best proxy for a major market index back then that we have. Looking at this Graham ratio teaches three things: that major movements in it are reversed, that reversals are movements in prices not earnings, and that the average level is quite low relative to analogous measures for other assets.

If You Are Very, Very Patient…

• If your horizon is long enough—twenty years, say, major movements are highly likely to be reversed. Whether the twenty-year fall from 1900-1920 from 20 to 5, the runup in the 1920s from 5 to 32, the collapse in the Great Depression, the runup from 1950

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to 1965, the collapse from 1965 to 1980, or the runup from 1980 to 2000.

• When the Graham ratio strongly reverts toward its previous mean,

it will not do so by having earnings fall (if the Graham ratio starts out low), or by having earnings rise steeply (if the Graham ratio starts out high). Instead, permanent earnings, generation after generation, in the United States grow—and outside the United States grow too save in countries that suffer hyperinflation, revolution, or massive destruction in war.

• The average level of equity prices relative to the potential available

cash flows earned by these equities is on average low. In fact, it is so low on average that diversified investments in equities only fail to outperform safe assets—whatever they are—when price-to-lagged-average-earnings at the aggregate are above twenty-five or so.

Back at the end of the 1970s when Shiller began running these regressions they were at the edge of statistical significance: the standard sneer at a conference was that Robert Shiller has run fifty regressions on aggregate returns and found one that is significant at the 5% level. Now we have thirty years more of data than when Bob Shiller was a young, green assistant professor desperate to get tenure. And rather than being significant at the 5% level they are now significant at the 0.5% level. Patience is, however, very very important for this. You have to have a horizon long enough to outlast the large movements in risk tolerance of America’s upper middle class in order for every equity and risk-bearing strategy to benefit from this long-run pressure toward mean-reversion. Shorter-term portfolios gain an edge from mean reversion, yes, but those that profit most are those that predict moves in fundamentals and moves in market-wide risk tolerance. Nevertheless, patience is highly likely to win out in the end. My view is that you cannot expect the professionals to fill up the risk-bearing gap

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when the people with portfolios of $1 to $10 million as a group turn them into cash, and won’t be enticed out now matter how high expected returns get—indeed, whose demand curves slope the wrong way so that the lower asset prices drop to produce higher long-run returns, the more scared they become. The true professionals are, after all, highly enough leveraged as it is: Goldman Sachs has been one step from blowing up three times in the past century—at the start of the 1930s with the collapse of the Goldman Sachs Trading Company, in 1970 when they and their clients were caught in the Penn Central bankruptcy, and in 2008 when their hedging of subprime risk had exposed them to lots of AIG risk that they did not understand and had not hedged.

If You Are Patient, But Not Very, Very Patient…

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And a ten-year horizon is not long enough. People have lost money in inflation-adjusted terms investing in a diversified portfolio of the U.S. stock market over ten years—even when prices have not been obviously out-of-whack relative to permanent earnings. The Bottom Line Ten or fifteen years ago, academic economists speculated about the long-run flattening of the CAPM line and the forthcoming reduction in the equity return premium. Investors in the 1950s had feared a return of the Great Depression—but the success of macroeconomics that Lucas trumpeted (and that I agreed with) in 2003 made that extremely unlikely. Investors in the 1970s feared a breakout into high inflation that might end in confiscatory taxation—remember windfall profits taxes?—on profits that were not really there, were simply artifacts of how IRS reporting interacted with inflation. But the end of the 1970s saw the Federal Reserve granted a baton to do whatever was necessary to control consumer price inflation. Economists in the 1990s weren’t—with a few exceptions—forecasting Dow 36,000 in three to five years. But they were implicitly forecasting that Graham ratios today would typically be much closer to 30 (and thus that real long-term average returns on value-weighted diversified U.S. equities would be a number like 3.3% per year) to the post-World War II average or today’s value of 17, and thus that real long-term average returns on value-weighted diversified U.S. equities would be much more like 6% per year. Now I think we have to draw a different lesson. To the extent—and I think it is a substantial extent—that the financial turmoil and the 401k impairment of the past decade has returned America’s upper middle class to an attitude toward equities much more like that of the 1900s or 1950s or 1970s than today, we can look at asset markets in which all kinds of risk are amply rewarded. But this risk is, we now know, risky. Three times in the past century economists and policymakers have confidently predicted that they had the

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business and financial cycles licked: in the 1920s (when Yale’s Irving Fisher said that modern monetary management plus the success of the war on drugs—Prohibition—had pushed equity prices to a permanently high plateau), in the 1960s (when the Department of Commerce changed the title of its Business Cycle Digest to the Business Conditions Digest), and in the 2000s (with all the papers on the Great Moderation reaching its apex in the Greenspan retirement year of 2005). Economists and policymakers are, if anything, even more prone to irrational exuberance than investors. Don’t believe that bearing risk is not going to be highly, highly rewarded over the course of the rest of your careers. It will be highly valued—unless the salience of the memory of 2000 and 2007-2009 is magically erased from popular culture and the brains of America’s and the world’s upper-middle class. And it won’t be magically erased. And, after all, what else are you going to do? It’s not as though inflation-hedged government bonds will even pay your expenses:

TIPS Yields

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But, also, don’t believe economists and policymakers the next time they say that the business cycle is licked, that there is a “Great Moderation” in progress: fool me once, shame on you; fool me four times… shame on me. November 6, 2009: 7,700 words