But Keynes Is Saved by Walras’s Law

Tyler Cowen writes:

Keynes’s General Theory, chapter six: in part ii the bombshell comes, unannounced. Keynes decides that he will declare savings to be a “mere residual.” Consumption and investment alone will determine income and savings is defined as whatever is left over to make the national income equations balance. At the time this was considered by many to be an enormous sleight of hand. The Austrian and Swedish traditions focused on the question of whether planned savings was going to equal planned investment and what happens if not. Keynes has just banished such questions to the woodshed and he has done so by a terminological maneuver.

Whether or not you think that the Austrian and Swedish traditions lead anywhere fruitful, Keynes is on shaky ground here. He is using definitions to favor one causal account of macro over another. That’s not right. You can still make a plausible argument that Keynes is right on empirical grounds that planned savings is not an important force for understanding business cycles. But so far no such empirical argument has been clinched…

I think it is much more than a terminological maneuver. Walras’s law tells us that if one market is out of supply-demand balance, there must be another related market (or markets) that is also out of balance. If planned saving is in excess of planned investment, then planned consumption spending must be less than planned production of consumer goods. You can then follow the inventory adjustment chain–say that as inventories pile up producers cut back on the making of consumption goods. You then try to follow through on what is happening in the money market and you are led to the conclusion that ex ante savings must be destroyed by a process of deleveraging and deflation and… you wind up in the swamp. But you can be rescued from the swamp by recalling Walras’s law, and recognizing that if you just follow the process by which equilibrium is restored in the goods market you will then discover that that process has also restored equilibrium in the flow-of-funds through financial markets.

Keynes’s “terminological maneuver” would not have succeeded if it were not for the fact that Keynes’s theory worked at a level that Wicksell’s or Myrdal’s or Ohlin’s never could.

Dani Rodrik writes:

Self-discovery in practice

It is remarkable to see something in theory work so well in practice. Ricardo Hausmann and I wrote a paper several years ago called “Economic Development as Self-Discovery,” where the idea was that entrepreneurship in a developing country consists of discovering the underlying cost structure–what can and cannot be produced profitably. Initial investors in a new line of economic activity face a great amount of uncertainty, since foreign technology always needs some local adaptation. Plus, their cost discovery soon becomes public knowledge–everyone can observe whether their projects are successful or not–so the social value they generate exceeds their private costs. If they succeed, much of the gains are socialized through entry and emulation, whereas if they fail, they bear the full costs.

Some of the what I have been seeing in Ethiopia is a picture perfect illustration of this process at work. Most notable in this respect is the flower industry, which was started by some courageous entrepreneurs who had observed the success of the industry in nearby Kenya and wondered if it could be made to work in Ethiopia as well. Even though much of the technology is standard, local soil conditions make a lot of difference to the economics of growing flowers, and a whole range of other services–from daily cargo flights to high-quality cardboard packaging–has to be in place before the operation can succeed. To its credit, the Ethiopian government understood the need to subsidize these pioneer firms, through cheap land and tax holidays, and the industry took off. Exports have reached $100 million from zero in just a few years. There are now around 90 flower farms in the country, with latecomers the beneficiary of the tinkering that early investors have undertaken.

A somewhat similar story in an earlier stage of development is playing out in textiles. The largest investment here to date is being undertaken by a foreign firm–a Turkish one as it turns out. Once finished, the operation will be fully integrated from spinning to finished garments and will employ 10,000 workers. All the output will be exported. The Turkish investor is a bit of a risk-lover, by his own admission. He told me that there are many firms in Turkey waiting to see how he will do. If he succeeds, you can be sure a good many will follow in his footsteps.

These are the discovery efforts that have been going on. One must presume that there are many more that could be taking place, but which are not, because it is difficult for pioneers to capture a large enough part of the social surplus they generate, even with the subsidy programs in place.

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McCullough, B.D. (2002). Proceedings of the 2001 Joint Statistical Meeting [CD-ROM]: Does Microsoft fix errors in Excel? Alexandria, VA: American Statistical Association.

McCullough, B.D. (1999). Assessing the reliability of statistical software: Part II. The American Statistician, 53(2), 149-159.

McCullough, B.D. (1998). Assessing the reliability of statistical software: Part I. The American Statistician, 52(4), 358-366.

McCullough, B.D. & Wilson, B. (2005). On the accuracy of statistical procedures in Microsoft Excel 2003. Computational Statistics and Data Analysis, 49(4), 1244-1252.

McCullough, B.D. & Wilson, B. (2002). On the accuracy of statistical procedures in Microsoft Excel 2000 and Excel XP. Computational Statistics and Data Analysis, 40(4),
713-721.

McCullough, B.D. & Wilson, B. (1999). On the accuracy of statistical procedures in Microsoft Excel 97. Computational Statistics and Data Analysis, 31(1), 27-37.

Also, see Errors, Faults and Fixes for Excel Statistical Functions and Routines.

Quant. Shop Offers Heady Long/Short Hedge Fund

December 17, 2008 | Source: FINalternatives

Santa Monica, Calif-based MarketPsy has launched a quantitative hedge fund that incorporates psychology into its trading strategy. So far, the firm’s Long-Short Fund has outperformed its discretionary counterparts, returning 6.03% since inception in September.

MarketPsy’s fund, which focuses on U.S. mid- to large-cap names, profits from what it calls psychology-driven movements in equities prices.

“Our investment strategy is based on the fact that innate psychological biases distort investors’ perceptions of stock value,” said Richard Peterson, managing director. “We find misvalued stocks by examining investors’ and executives’ language in SEC filings, executive conference calls and stock message boards. We have performed extensive software development, trade back testing, and portfolio simulation. Our long-short strategy is based on our discoveries of the psychological factors that predict stock price movement.”

In September, Peterson said the fund’s performance lagged because investors were not emotionally overreacting to the crises surrounding Fannie Mae, Freddie Mac and AIG, the bankruptcy of Lehman Brothers, and the credit freeze. The fund lost 6.7% that month.

However, the firm says investors began to overreact to news reports and media the following month, resulting in a 9% gain. In November, the firm’s short positions in solar stocks performed well after the U.S. presidential election, consistent with the classic “buy on the rumor and sell on the news” price pattern, said Peterson.

“We also performed well in November due to strategic long positions in financial stocks during the bailout of Citigroup.”

The fund charges a 1% management fee and a 10% performance fee with a $100,000 minimum investment requirement. It has a one-year lockup period.

There is a publicly available geocoding dataset of all U.S. ZIP codes. The data file was originally released as a part of the 2000 census on the Gazetteer website. The data fields are:

• ZIP code
• State (abbreviation)
• Latitude
• Longitude
• City
• State (full name)

Data may not be up-to-date, but it’s free…

Soviet Defectors by Vladislav Krasnov (Available on Google Books)

An excerpt:

Many times, I’ve tried to put together a brief narrative of the causes of World War I, and I invariably find (after the fact) that I’ve left something out. So here’s the latest (and, one would hope, final) attempt…

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There were at least three causes that in confluence led to World War I. Let’s take them one at a time and put them together a little later.

1. Germany unable to feed itself

In his book The Economic Consequences of the Peace (1919), J.M. Keynes cited contemporary estimates suggesting that immediately before the war, Germany had a population of 67 million, while producing enough food to feed about 40 million. Austria was in a qualitatively similar position. This state of affairs was largely caused by the legacy of feudal land ownership, whereby the aristocracy controlled vast amounts of land and extracted substantial rents from them.

2. The gold standard

Under the gold standard, a nation can expand its money supply only as far as its gold stock allows. To expand its gold stock, a nation must have a trade surplus. So expanding the money supply under the gold standard is only possible if a nation has a trade surplus.

Expanding money supply is the quickest way of ending recessions and thus keeping the population gainfully employed and reasonably happy. But under the gold standard, it is only possible if a nation has a trade surplus, so governments, instead of abandoning the gold standard (which was considered the holy cow of economic policy back then), started working on ensuring that their nations always have a trade surplus.

3. The continuing rule of the military aristocracy

All major European countries (with possible exception of Britain) were de-facto ruled by the military aristocracy, educated, if at all, in humanities and the art of war, not in economics (which, having begun in earnest with Marshall’s Principles published in 1890, was barely out of diapers in 1913). Three things were the direct result of this, (1) the ruling class, unable to comprehend the evils of the gold standard, upheld it, (2) the ruling class, being a military elite, actively sought military solutions to economic problems, and (3) the ruling class extracted substantial rents from its vast land holdings, making domestic agriculture prohibitively expensive compared to that of U.S., Canada, Australia, or Argentina.

Put all three together, and what do you get?

To keep the growing urban population employed, you need to expand money supply, which, under the gold standard, is only possible if your country has a trade surplus. To ensure that you have a trade surplus, you begin pressuring other countries into opening their markets for your exports while keeping imports off your domestic market using tariffs or non-tariff barriers. The pressure tactics gradually escalate from diplomacy to the threat or war, until Europe is completely polarized, with all major countries joining one of the two blocs that eventually went to war with each other. Germany, which desperately needs to export manufactures in order to pay for food, is especially aggressive in its attempts to secure export markets for its manufactures. So Europe becomes a powder keg that sits there waiting for a random spark to ignite its explosion. That spark was the assassination of Franz Ferdinand, the heir to the Austrian throne, by a group of Serbian conspirators. Had it not happened, another “cause” (having as little to do with the real causes as the assassination of Franz Ferdinand did) would have been found in a pretty short order…

Nathan Myhrvold, the former chief technology officer of Microsoft, now running Intellectual Ventures (which describes itself as “the invention company”), guest-blogs on Freakonomics. Here’s an excerpt:

The infrastructure is all new, from the airport to the expressway leading into the city (or you can take an ultra-high-speed maglev train and be there in 12 minutes). The downtown section of Shanghai is called Pudong, and it is full of gleaming new skyscrapers. The other side of the river has the Bund, the center of Shanghai’s 19th-century economic boom. It too is replete with interesting architecture, albeit smaller and older. Amusingly, none of this architecture is Chinese. The closest thing I found to ancient Chinese culture was a fast food-chain called Kung Fu. Maybe that is the point of the place; Shanghai has long prospered by embracing and adopting the foreign.

Pudong is clearly a work in progress — cranes hover over building sites everywhere. Most places that have tall buildings do so because they first had shorter buildings. The only reason to build high is that you’ve already exhausted the possibilities for building low. The economic value of density forces buildings up, because out is not an option.

The only places in the world that violate this rule are “instant” downtown areas that connive to jump the queue and go straight to the super-tall stage, for some artificial reason, rather than follow land-density economics. The Century City section of Los Angeles is one example, but the real classic example for this sort of instant development is the Las Vegas Strip. Vegas builds high, not because of economic pressure for building density, but for its own sake.

Shanghai has no casinos, but Pudong is the office-tower equivalent of the Strip. Giant skyscrapers erupt from the river bank in myriad forms, one more architecturally extravagant than the next. Like Vegas, they sport outsized gimmicks: the Aurora building transforms into a giant video billboard at night, the Pearl Orient tower is a science-fiction fantasy, and the Shanghai World Financial Center (SWFC) — the second-tallest building in the world — has a 105th-floor observation lounge with a glass floor looking down onto a giant hole in the building. It is spectacular.

I was curious what all of this splendor and view cost, so looked up the rent: the SWFC is charging $76 per square foot per year. By comparison, my company pays $25 for a second- or third-tier building in Bellevue, Wash. The good buildings in Bellevue are $40; downtown Seattle commands $45 to $50 (although I understand there may be some space coming available in the Washington Mutual building rather soon). At the other extreme, the warehouse space we rent in Kent, an outlying industrial suburb of Seattle, is a whopping $3.60, which is fortunate for me because rocket engines and dinosaurs take up space.

Our Singapore office costs us $73: about the same as SWFC, but for a much less impressive building. Our Tokyo office is the worst at $96, and it is definitely second-tier. I don’t have an office in midtown Manhattan, but my broker tells me that those average about $88 per square foot per year. So the coolest, newest office space in Shanghai at the SWFC is about the same price as mid-range Singapore, and a bit cheaper than midtown.

We have no plans to open a office in Shanghai. Plus we’re cheap, so we’d never pick that building (our office in Palo Alto is upstairs from a nail salon). However, I find it interesting that despite our frugal approach, we already pay 26 percent higher than SWFC in at least one place. Of course, all this proves is a rediscovery of the old real estate maxim: location, location, location.

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Steven Levitt writes:

Back in the old days, banks didn’t package and resell the mortgages they wrote. So when a homeowner got into trouble, they could go down and talk with the bank about working out some solution other than foreclosure. For instance, the bank could allow the borrower to pay back the loan over 30 years instead of 15 years, reducing the monthly payment.

Not really… Even in the old days (unless we’re talking really old days), the homeowner would not talk to the lender. Instead, they would talk to the servicer in charge of their loan (in the really old days, servicers were units of lender banks, but eventually, independent servicing companies sprang out all over the place). Here’s how Fannie Mae explains what servicers do and how they are compensated:

We do not perform the day-to-day servicing of the mortgage loans that are held in our mortgage portfolio or that back our Fannie Mae MBS… Typically, lenders who sell single-family mortgage loans to us initially service the mortgage loans they sell to us. There is an active market in which lenders sell servicing rights and obligations to other servicers.

Mortgage servicers typically collect and remit principal and interest payments, administer escrow accounts, monitor and report delinquencies, evaluate transfers of ownership interests, respond to requests for partial releases of security, and handle proceeds from casualty and condemnation losses. For problem loans, servicing includes negotiating workouts, engaging in loss mitigation and, if necessary, inspecting and preserving properties and processing foreclosures and bankruptcies. We have the right to remove servicing responsibilities from any servicer under criteria established in our contractual arrangements with servicers. We compensate servicers primarily by permitting them to retain a specified portion of each interest payment on a serviced mortgage loan, called a “servicing fee.” Servicers also generally retain prepayment premiums, assumption fees, late payment charges and other similar charges, to the extent they are collected from borrowers, as additional servicing compensation. We also compensate servicers for negotiating workouts on problem loans.

So from the borrower’s standpoint, not much has changed because of securitization; the borrower still deals mostly, of not exclusively, with the servicer.

I have four questions:

OK, let’s take them one at a time, keeping in mind that there are servicers…

1) With mortgage-backed securities, is it really the case that a given mortgage is stripped into multiple pieces held by different entities?

Not exactly. First, mortgages are assembled into a pool, which is structured as a separate legal entity with mortgages as its assets. Then, this pool can be stripped, with strips becoming the pool’s liabilities; the alternative is a simple pass-through structure. The company that puts the pool together (such as Fannie Mae) is the sole equity holder.

2) If mortgages really are stripped into pieces, how does foreclosure work? If many different firms hold a piece of the mortgage, who initiates foreclosure? Who pays the costs of foreclosure? It would seem to me that many of the same obstacles to working out a refinancing deal would be present for foreclosing as well.

Foreclosure works just as it used to before securitization. “Many firms holding pieces of the mortgage” are creditors and thus have no say in the foreclosure matters. The out-of-pocket costs of foreclosures are paid by the pool (meaning that in the end they accrue to the company that created the pool); the decision to initiate foreclosure is also made by the pool (meaning, essentially, by the company that has created the pool).

3) If mortgages are not stripped into pieces, are there firms out there trying to scoop up failing mortgages at rock-bottom prices and getting on the phone with the homeowners to try to negotiate deals to avoid foreclosure? If mortgages are not stripped into pieces, I don’t understand why it is so hard to value these mortgage-backed securities.

Where would those firms “trying to scoop up failing mortgages at rock-bottom prices” come from? By now, whoever wanted to invest in mortgages, already has more than they know what to do with; that’s why we have a credit crunch on hand… As to difficulties in valuation, they come not so much from stripping, but from uncertainties surrounding mortgages; the borrower can default (and the amount to be recovered from selling the foreclosed home is highly uncertain, as house prices change over time) or refinance. Neither of these eventualities is in control of the lender, so valuation ultimately depends on assumptions the lender makes about probabilities and timing of default and/or refinancing, as well as about the likely value of the home in the event of default.

4) If indeed mortgages are stripped into pieces, weren’t people worried about the complications that would result when these mortgages were divided into pieces?

Yes and no. Complications should be weighted against opportunities they afford. Mortgage securitization offered an easy and cost-effective way to invest in mortgages for mutual funds and insurance companies…

Paul Krugman writes:

Bernanke’s problem, and ours. This picture shows the target Fed funds rate, the usual tool of monetary policy; the 10-year Treasury rate; and two rates that actually matter to the private sector, the mortgage rate and the rate on Baa-rated corporate bonds. The Fed has had no success in reducing mortgage rates, and corporate borrowing costs have gone up, not down. Add in falling expectations of inflation, and in real terms monetary policy has gotten tighter, not easier.

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