Bloomberg has an intriguing April 29 article on Treasury Floaters According to Bloomberg, the Treasury may announce on May 2 that it will issue floaters. It quotes Cam Harvey, who testified that floaters as being a great idea in 1993, as disapproving. Knowing Cam, I suspect he had a more sophisticated view in mind.
Issuing floaters and converting a lot of debt to floating-rate debt is a great idea, if done right, even if the maturity structure of government debt should be much longer now. Let me explain.
Floating-rate debt is like an adjustable-rate mortgage. If you buy a $100 floating rate bond and short-term rates are 5%, you get $5. If next year short term rates rise to 10%, you get $10. And so forth.
The alternative to floating-rate debt is our current practice of rolling over short-term debt. The government issues one-year bills, then next year issues new bills to pay off the old ones. The big danger for our – or any – government is that markets refuse to roll over its debt. Greece didn’t get in trouble because it couldn’t borrow new money to pay its bills for a month; it got into trouble because it couldn’t borrow new money to pay off the old money. The US has to roll over about half our $15 trillion debt every two years, so we face a similar danger. You may say, interest rates are low now, who needs to worry about that? I would answer, Greek interest rates were low in 2006 as well. You need fire insurance even if a fire seems remote.
From a frictionless finance point of view, however, floating-rate debt is the same thing as rolling over short term debt. If the one year rate is 5% in the first year and 10% in the second year, the payments from government to bondholders are exactly the same. Similarly, rather than get a floating-rate mortgage, you could get a one-year loan, then borrow again next year to pay off this year’s loan and so on.
So, if you like floating-rate debt, you must have some market friction in mind. It certainly feels safer for bondholders to have long-term bonds with adjustable coupons rather than explicitly trying to sell new debt every year to pay off the old debt. It isn’t, really, however. In the circumstance that markets refuse to lend new one-year debt, the short-term interest rate would rise arbitrarily high; people would all be trying to sell the long-term “floating rate” bonds, and you have exactly the same crisis.
So where does the feeling that floating-rate debt is safer come from? I suspect part of it is a little behavioral, and perhaps sensibly. Many holders of government bonds may act passively around an interest rate reset, where they would actively have to make the decision how many new bonds to buy after their old bonds retire. It’s easier to have a bank run if everybody has to go to the bank every day, than if most people sit at home and watch interest rates change. On the other hand, most Treasury bills are held by large sophisticated institutions. Maybe the idea that we can get them not to pay attention by essentially making a roll over the default option is optimistic.
I think the real reason is a bit deeper. To really evaluate floating rate bonds, we need to know how the interest rate is set. Will it be an index, based on some other market? Or will it be some auction mechanism? Can rates rise arbitrarily high, or is there some cap on how far rates can rise? The devil is in the details here! Rolling over one-year bonds is the ultimate auction mechanism. Both sides really know they’re getting the market rate on bonds.
Another way to put the issue: will the market value of floating-rate debt always be exactly $100? True floating-rate debt has an interest rate set by auction every day, and the principal value is exactly $100. In that way it really is functionally the same as rolling over debt every day, but avoids a lot of needless churn.
I suspect the answer is no. As with auction-rate securities that fell apart in the financial crisis, I suspect there will be some cap on the floating rate, or that it will be set relative to some index. In a crisis, the market value will fall below $100, and bondholders take a hit. Now it is a combination of short-term debt and some sort of option which makes it much more fun for financial engineers.
That might actually be good for some purposes. I think Cam was objecting, as I do, to the short maturity structure of US Government debt in the present situation. Interest rates can only go one way, up. If the US massively lengthened the maturity structure of government debt, we would be insured against a rollover crisis, or the fiscal impact of rising interest rates. If interest rates rise to 5% now, that’s going to add something like $500 billion to the annual deficit. If the US switched entirely to long-term debt – fixed-coupon perpetuities – then interest rates rising to 5% would cost us exactly zero. Bondholders would take the hit. Sure, it’s a little more expensive on average – the yield curve is upward sloping. That’s the premium you pay for insurance. The premium seems mighty small.
So, in that context, short-term debt that turns into long-term debt in a financial crisis has some advantages. It doesn’t stop the fiscal consequences of rising interest rates, but it includes an option for the government to make the debtholders take a hit during a potential rollover crisis or sudden spike in rates. For which the government will pay a premium.
In sum, the issue of the maturity structure of government debt is different from the issue whether our short-term debt is rolled over or consists of floating rate debt. I suspect what Cam Harvey really said is that he likes a longer overall maturity structure but also likes conversion of the shorter debt to floaters.
And, the key question to ask of Treasury floating-rate debt is, just how will that floating rate be set? Maybe the right answer is a spectrum: some truly floating rate debt (next subject) and some debt that resets less frequently and with an explicit cap on interest rate changes.
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A second aspect of floating-rate debt intrigues me.
We already have floating-rate debt. It’s called reserves. Reserves – accounts banks hold at the Fed – are nothing more than overnight, floating-rate government debt. They are curiously absent from the Congressional debt ceiling, but that’s it.
Interest on reserves is a great innovation. Together with more and more widespread electronic transactions, it means we can live the Friedman rule. The economy can have all the money it wants without losing anything to foregone interest. All of the cash-management shenanigans of the past can be forgotten. One of the main justifications for massively levered banks goes out the window – the idea that the economy needs a vast supply of bank deposits as very liquid assets.
The only problem is, you and I can’t access interest-paying reserves, only banks can do so. And the interest rate is not a market rate, it is set by whatever the Fed feels like paying. And the Fed loudly announces that it will lower the rate on reserves below market rates when it feels like stimulating the economy. But smart cash managers will not want to suffer lower rates, so all the financial engineering starts up again.
A good supply of floating-rate Treasuries would be great in this situation. I mean really floating - rate, with an interest rate set each day by auction at whatever value makes the price exactly $100. And they should be electronically transferrable in arbitrary denominations.
These securities would be the ideal asset for money market funds to hold, and offer (at, I presume lower cost than the Treasury) all sorts of transactions services. Now you and I can have perfectly safe, interest-paying money. And we don’t have to put up with the “demand for liquid assets” story justifying huge bank leverage, very high levels of deposit insurance, and the other pathologies of our banking system.
Will we get it? Let’s see.
Speculation and gas prices
I was getting myself frothed up about the recent idea that “speculators” are behind the recent gas price increase. Have we learned nothing in the centuries of witch hunts for “speculators” “middlemen” and “money changers”? And how horribly things go wrong when societies take these witch hunts seriously? Haven’t the Europeans just woken up from a severe attack of denial that “speculators” were to blame for their sovereign debt crisis?
Then I found that Jim Hamilton already did a better job than I could hope to do, while skewering Rep. Joseph Kennedy’s editorial in the New York Times calling for a ban on speculation.
Jim reminds us that volume numbers are meaningless because most of the trading lasts hours:
Many of the traders who bought a contract on Friday turned around and sold that same contract later in the day. If the purchase in the morning is argued to have driven the price up, one would think that the sale in the afternoon would bring the price back down. It is unclear by what mechanism Representative Kennedy maintains that the combined effect of a purchase and subsequent sale produces any net effect on the price.And what’s good for the goose is also good for the gander:
It’s also worth noting that on that same day, there were 146,000 May natural gas contracts traded… By what mysterious process can all this within-day buying and selling of “paper” energy be the factor that is responsible for both a price of oil in excess of $100/barrel and a price of natural gas at record lows below $2 per thousand cubic feet?Jim reminds us how futures markets work
But remember that for every buyer of a futures contract, there is a seller. The person who sold the initial contract to me also likely wants to buy out of the contract at some later date. I buy and he sells at the initial contract date, he buys and I sell at a later date. One of us leaves the market with a cash profit, the other with a cash loss, and neither of us ever obtains any physical oil.However, if you read too quickly, you will think that “speculators” in a zero sum game cannot affect prices. This is not true. If speculators collectively think that prices will be higher in the future, more of them want to buy than want to sell, so futures prices rise until there are equal buyers and sellers.
In turn, when futures prices rise, people who actually have some oil hold it off the market (or sell it forward). This is precisely the correct economic function of speculation. As William Tucker, quoted in the Wall Street Journal explains,
What speculators do, however, if they guess right, is smooth out the availability of supplies between the present and the future. By paying a higher price now, they assure that prices will be lower in the future. In effect, they hold supplies off the market today so that they will be available next week or next year when things become even more scarce.If they guess wrong, they lose horrendous amounts of money. There is a lot stronger self-correction mechanism at work here than among politicians.
Adam Smith described this as preventing a “dearth” from becoming a “famine”:
When the government, in order to remedy the inconveniences of a dearth, orders all the dealers to sell their corn at what it supposes a reasonable price, it either hinders them from bringing it to market, which may sometimes produce a famine even in the beginning of the season; or if they bring it thither, it enables the people, and thereby encourages them to consume it so fast as must necessarily produce a famine before the end of the season.… No trade deserves more the full protection of the law, and no trade requires it so much, because no trade is so much exposed to popular odium.Adam Smith had seen a few witch hunts. Maybe I should have just started and ended with that one.
Jim Hamilton again. The problem for all attempts to ban “speculators” whose assessments of price we don’t like, is that your “speculator” is my “liquidity provider:”
How exactly do we define the “speculators” whose participation in the markets is to be banned? Suppose for example, we stipulate that the only people who are allowed to trade oil futures are those who are actually physically producing or consuming the product. If we do that, what happens if a particular producer wants to hedge his risk by selling a 5-year futures contract, and a particular refiner wants to hedge his risk by buying a 3-month futures contract? Who is supposed to take the other side of those contracts, if all “speculators” are banned?Meanwhile, the New York Times joined the witch-hunt:
Research presented in Congressional testimony, academic papers, government and private studies indicate that excessive speculation, mainly by Wall Street index-fund traders, is needlessly driving up prices,…Speculation by index-fund traders??? I don’t have to explain just how silly that is, do I? Next thing you know, Vanguard’s S&P500 index fund will be behind bubbles in the stock market.
The Times’ links are a fun too, or a bit depressing if you value the ability of “research” to credibly inform public policy, or the Times as an impartial aggregator of consensus among serious academic researchers. The first one, by L. Randall Wray of the Levy Economics Institute of Bard College, starts out stating a fact so obvious it needs no documentation:
“Money manager capitalism has resulted in a series of boom-and-bust cycles in equities, real estate, and commodities.”“Money manager capitalism?” You get the idea where it’s going from there.
How to lie with statistics
Along with David Leonhardt’s interesting article “Taxmageddon,” last weekend's New York Times Sunday Review included this pair of graphs. These belong high up in the pantheon of “How to lie with statistics” (one of my favorite books) examples.
These graphs are paired left and right in the original. (I made them big and split them up so you could see them. They’re even clearer on the Times’ website) On the left, is this graph:
Right next to it, is this one
(The graphs had little to do with the article, so I presume they are the work of the Times staff, not Leonhardt.)
It’s damning, right? The rich got huge tax cuts (top graph) and so made a ton of money courtesy of the government (+528% change in income, numbers to the right of the first graph). The rich are also feeding at the trough of tax breaks (bottom graph). Outrage!
***
Now wait a minute here…The top graph is a tax rate, the percentage of income paid, while the bottom graph is total dollars. To say this is comparing apples and oranges is an insult to fruits.
In fact, wealthier people pay nearly all Federal income taxes. So it’s not surprising that they benefit more in dollar terms from tax deductions – except credits, which is money the government pays you even if you pay no taxes.
If we expressed the bottom graph as a percentage of taxes, or a percentage of income – the same units as the top graph – you’d see a dramatic reversal of the implication. Since the lower percentiles have so much less income and pay so much less taxes, the graph would suggest those with less income get the largest (percent) benefits.
***
The top graph is even more misleading, at least for the Times’ goal which is to back a raise in Federal income taxes for the wealthy.
Where does this 60 and 71% tax rate in the 1960s come from? The basic fact of the Federal taxation is that it raises about 20% of GDP despite wild variation in the statutory tax rates. In 1960 Federal tax receipts (NIPA table 3.2) divided by national income (NIPA 1.12) were 93.9/2013.9 = 19.8%. In 2004 this ratio was 2013.9/10534.0 = 19.1%.
Statutory tax rates in the 1960s were as much as 90% marginal rates on the highest incomes. (Remember George Harrison’s “Taxman?” “One for you, 19 for me.” He wasn’t kidding.) But the tax code was so shot full of loopholes that the Federal government didn’t collect nearly that fraction of income from anyone.
So where does the 71% come from? At least the Times gives their source, so you can go back and see what the heck the number means. These are estimates by Emmanuel Saez and Thomas Piketty of total Federal taxes – individual income, corporate income, payroll (Social Security, etc.), and estate taxes – divided by an estimate of income, which excludes Government transfers. (The paper is here and a longer working paper version here.)
To what extent is this the statutory rate and to what extent is it actual money paid? I’m still tracking this down, but it appears to be some of each. For example, “We use the TAXSIM calculator developed at the National Bureau of Economic Research … to compute federal individual income taxes.” That seems to imply this is taxes the NBER thinks they should have paid, not what people actually paid. But they do have individual level IRS data, so in theory know what people actually paid. On the other hand, it doesn’t add up: Total tax recepits are 20% of income. So how can everybody’s rate come down yet the total rate stay stuck at 20%? How can the rate of everybody who has any money in 1960 be above 20%, yet the average is still 20%?
But let’s not get in to the depths of the sausage factory, as it does not matter for the point here. (And my head starts to hurt anytime I delve in to the details of this kind of calculation.)
The important point, for the Times is that graph has basically nothing to do with Federal income taxes. All of the action comes from Saez and Piketty’s assigment of corporate taxes and estate taxes. They assume all corporate taxes are paid by stockholders and bondholders. This is conceptually right – it is not true that “corporations” bear any tax burden. Someone is paying, through higher prices, lower salaries, or lower returns to investors. Saez and Piketty assume it’s all the latter.
Here is Saez and Piketty’s breakdown of how taxes changed between 1960 and 2004 (source):
(It also appears to me that Saez and Piketty are a bit off here: If you charge corporate income tax against the rich, don’t you have to divide that tax by an income measure that includes corporate income? In general, you have to divide taxes by pre-tax income not post-tax income. Dividing corporate taxes by individual income, and not including corporate income, can produce “rates” above 100%. On the other hand, if their “income” number attributes all corporate income as individual income to the wealthy, then the distribution of income is grossly overstated. Ok, we’re not going in to the sausage factory, maybe for another post someday, but I’m still scratching my head.)
As Piketty and Saez put the matter:
The larger progressivity in 1960 is not mainly due to the individual income tax. The average individual income tax rate in 1960 reached an average rate of 31 percent at the very top, only slightly above the 25 percent average rate at the very top in 2004. Within the 1960 version of the individual income tax, lower rates on realized capital gains, as well as deductions for interest payments and charitable contributions, reduced dramatically what otherwise looked like an extremely progressive tax schedule, with a top marginal tax rate on individual income of 91 percent.Note the tiny percentages of total income involved. These are not going to balance anyone’s budget.
The greater progressivity of federal taxes in 1960, in contrast to 2004, stems from the corporate income tax and the estate tax. The corporate tax collected about 6.5 percent of total personal income in 1960 and only around 2.5 percent of total income today. Because capital income is very concentrated, it generated a substantial burden on top income groups. The estate tax has also decreased from 0.8 percent of total personal income in 1960 to about 0.35 percent of total income today. As a result, the burden of the estate tax relative to income has declined very sharply since 1960 in the top income groups
Now, when we talk about the “Buffet rule,” that is about raising the individual Federal income tax rate. If we calculate Warren Buffet’s taxes this way – including all corporate taxes paid by all Berkshire Hathaway companies (and why not property taxes, business taxes, business contributions to social insurance, and all other business-paid taxes), Buffet’s tax rates would be correctly measured, and a lot more than his secretary’s tax rate!
This assignment of corporate taxes takes us into the dark territory of who bears the burden of taxes rather than who actually pays them. Saez and Piketty are assuming that rates of return on investments are reduced because corporations pay taxes, so rich people get less return than they would otherwise. Hence, it’s “like” paying more taxes. Ok, that’s how economists think about things, but why stop here? Who really bears the burden of the much larger wedge between what employers pay and what employees get? And all the other taxes, that distorts prices and wages all over the place. And while we’re at it, why not “who bears the burden of regulation?” through higher prices or lower returns?
Bottom line: It may be fine for Saez and Piketty’s purpose, but I doubt any New York Times reader had the faintest idea they were looking at a graph that primarily said “rich people were hurt by taxes in the 1960s not because they actually paid more taxes but because we assume corporate income taxes drove down the rates of return on their investments!”
And, in case you think this all means we should go back to the days of “Mad Men” taxation, Saez and Piketty warn:
The surge in top incomes since the 1970s has been driven in large part by a steep increase in the labor income component, due in large part to the explosion of executive compensation. As a result, labor income now represents a substantial fraction of income at the top. This change in composition is important to keep in mind, because the corporate and estate taxes that had such a strong effect on creating progressivity in the 1960s would have relatively little effect on labor income.In sum, this graph has nothing to do with the main point – establishing facts about who pays Federal income taxes. It would be great if our national discussion were to broaden up and consider all taxes – yes, proper attribution of corporate taxes (all corporate taxes); along with estate, excise, state and local income taxes, sales taxes, property taxes, and so on and so forth. And proper attribution of the burden of taxes. But it isn’t.
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Now, look at the nefarious pairing of the decline in (statutory) tax rate with the change in income on the right hand side of the top graph. We cut rich people’s taxes and look how they got richer!
Here, the Times got too clever by half. The cause and effect insinuation here is actually a supply sider’s dream, if you can read and add. The insinuation is, the rich got richer because they got to keep all that income that they’re not paying to the government. Even that doesn’t add up: a 528% rise is much more than (1-0.34)/(1-0.71) = 2.28 = 128% rise in after-tax income.
But the tabulated rise is in pretax income. (At least the labels are honest.) As tax rates came down, people went out and made an enormous amount more income in the first place.
A 528% increase in income is a lot. 71% x $100 = $71.00. 34% x $100 x (1+5.28) = $213.52. So, using the New York Times’ numbers, we would infer that lowering the tax rate on the top earners corresponded to tripling the tax revenue earned from that group! The rich are, apparently, paying much more in taxes than before.
If you take the Times’ numbers seriously, Art Laffer’s wildest dreams came true.
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Update: Abel Winn notes it’s worse than I said:
The top graph’s y-axis is scaled according to position in the income distribution, while the bottom graph’s y-axis is scaled according to position in the distribution of taxpayers. Since only about half of income earners pay income taxes, being in the top x% of the income distribution means that one is in about the top 2x% of taxpayers. So when we see massive benefits going to the top 20% of taxpayers, that means the tax code was benefiting the top 40% of income earners. But that doesn’t fit very nicely into the 99% rhetoric that we’ve been hearing so much of late, and that the NYT graphs appear to be backing.
Money Market Runs
A good oped in Bloomberg’s “Business Class” series tackles money market funds. (I signed it along with the rest of the Squam Lake group, but I can’t take credit for much of the writing.)
There was a run in money market funds. We have to do something about this.
Money market funds are a bank. Their liabilities are fixed value, first-come first-serve, just like deposits. Their assets are longer term, and less liquid. This fact puts them at risk for a run. The essence of stopping future financial crises is stopping runs.
One way to stop a run is for the government guarantee all the liabilities. That stops the run, but gives horrible incentives to the fund managers, so now you need regulation. This is what we did with banks and what the industry seems to want for money market funds. Watch for what you ask for, you just might get it.
The Squam Lake group, and others thinking about these issues, note two other eminently sensible possibilities.
First, money market funds can trade at net asset value, just like equity mutual funds or exchange traded funds. (The small difference between those doesn’t matter here.) Now there is much less incentive to run. The situation that happened with the Reserve Fund in the financial crisis, that everyone sees net asset value less than a dollar per share and knows it’s time to run, cannot happen.
This seems like the simplest fix. In the modern world, liquidity need not mean fixed value.
Alas, as the more knowledgeable Squam members informed me, this conceptually simple resolution to the problem causes accounting and tax problems. Money funds are used as money. If I have to pay you $1,000, it’s easy to say “sell 1,000 shares and send the proceeds.” It’s much harder, technically, to say “sell $1,000 worth of shares and send the proceeds.”
The tax issue is that if every transaction takes place at a different market value, then you have to track capital gains and losses on a huge number of transactions.
Say I, well, for a few hundred billion dollars we can surely fix these accounting and tax law problems (like get rid of capital gains tax!). Why accept that one bad regulation must beget another? But critics are right that this does spread the difficulty of making a change.
Second, money market funds can include capital just as banks do. If there is an equity tranche holding even a few percent of value, then money funds can promise $1 per share and always have net asset value above that. Banks have equity tranches. So can money funds. If we’re going to maintain $1 per share, this seems like a no brainer, and basically what the Oped calls for. The objections, like most objections to higher capital for banks, basically don’t understand the Modigliani Miller theorem.
That said, money market funds are a lot simpler than banks, and fixing the regulatory system is a bit less crucial in my view.
The chance of a systemic run is lower for money market funds. The danger in a systemic run is that bank A is found to be insolvent; people don’t know what bank B’s assets are, so they run just to be sure. That’s not what happened at the Reserve Fund: People knew it held a lot of Lehman paper, and knew it was insolvent. People can see what assets the other money market funds had, and quickly verify if the did or did not hold Lehman paper.
The transparency of money market funds – the fact that we know the net asset values pretty well and the composition of assets – makes the chances of a “multiple equilibrium” run or a “systemic” run a lot less than that of banks.
Still, there is no reason to put up with runs at all, or to provide a blanket government guarantee, when fairly simple changes to the contracts can fix the problems.
Facilitating NAV trading or an equity buffer is important for another reason – to expand money market funds and let them take on more risk.
The SEC has already started the “regulate” part of the traditional model by forcing money market funds to shorten the maturity of their assets. Great, but as forcing institutions to buy “AAA” debt subsidized the artificial creation of “AAA” assets, forcing funds to hold “short term” debt subsidizes creation of short-term liabilities. And short term debt anywhere is the poison in the well that causes crises. It encourages banks and other issuers to finance themselves with a lot of short-term debt, exactly the opposite of what we want.
You can move risk around, you can’t eliminate it. Keeping the risk in the fairly transparent money market funds with a solid equity tranche rather than in the bowels of horribly complex too big to fail banks seems like a good idea.
Price and volatility in the great crash
I made the following cool graph last week. (Well, I think it’s cool):
The black line is the VIX volatility index. You can think of it as a market forecast of volatility over the next month. It starts at about 25, reflecting a 25% per year standard deviation of stock returns. In the financial crisis, it shoots up to 80%. Yes, 80% annualized standard deviation. Then it tails back again with another jump in early 2010. (The VIX tracks realized volatility almost perfectly in this episode, so it’s not about volatility risk premiums.)
The blue line is the cumulated return on the Fama-French total stock market index. (Data from Ken French’s website.) If you had a dollar in the market in January 2008, it shows you the percent gain or loss through time. (The level of the S&P500 shows almost exactly the same pattern.) That’s also pretty dramatic: you lose half your money by March 2009, before the market recovers.
The negative correlation between these two lines is striking. Yes, we’ve known for a long time that lower prices are associated with higher volatility, but it’s not often that you see such a striking correlation.
What do we make of it? It seems to revive the idea that mean returns and volatility are related. If volatility goes up, then mean returns must go up too, so that the average investor keeps holding the market portfolio. The only way for mean returns to go up is for the price to decline. You can almost blame the fall in prices on the rise in volatility.
The challenge is to get the numbers to add up. The standard portfolio allocation rule says
share in risky assets = 1/(risk aversion) x mean return / variance of return
Variance is volatility squared, so if volatility goes from 20 to 80, the denominator rises by a factor of 80^2/20^2= 16! If you have all your money in stocks, share = 1, we need the mean also to rise by a factor of 16; say from 6% to nearly 100%. Did participants expect the entire 50% stock market decline to be reversed in 6 months? I’ve written about time-varying expected returns, but even for me a market risk premium of +100% seems like a lot.
I think the answer is, this is the wrong equation. It’s time to get serious about Merton portfolio theory for long-lived investors. The real (Merton) portfolio theory adds to the last equation
… + (aversion to volatility risk) x (covariance of return with changes in volatility)
So, something about this term must be screaming “get in” to counteract the last equation’s advice to “get out." Why do people care about volatility risk? ("aversion”) Why does this term vary strongly over time?
Something in this event seems to be crying to explain “state variable risk” in an intuitive way, but doing so is just out of my reach. (I’ve been puzzling about this for a while, see p. 1082 of “Discount Rates”. )
Of course, volatility is not the ultimate “state variable,” and understanding the movement of stock prices will eventually means we need to dig deeper to underlying events.
Context: I was discussing two nice papers at the NBER asset pricing meetings: “Volatility, the Macroeconomy and Asset Prices, by Ravi Bansal, Dana Kiku, Ivan Shaliastovich, and Amir Yaron, and "An Intertemporal CAPM with Stochastic Volatility” by John Y. Campbell, Stefano Giglio, Christopher Polk, and Robert Turley. Both papers explore time-varying volatility and attempt to answer this puzzle. (Google for latest versions of the papers.)
Cambpbell et. al. also argue that the value effect (higher returns for value stocks than growth stocks) is explained by value stock’s tendency to move with changes in volatility. That’s why I included the value stock cumulative return in the graph.
Update
Pedro Santa-Clara sent this graph:
That’s nice, as it sometimes seems that volatility and mean return wander off in different directions, in response to different state variables, and at different frequencies. A united view of the two moments is essential.
But don’t get too exited. The graph certainly does not document a constant Sharpe ratio, or even a constant mean to variance ratio. The earnings yield corresponds roughly 1 to 1 (“roughly” means between 1 to 1 and 1 to 3) with one-year expected returns, so you’re seeing expected returns vary roughly from 4 to 7 percent. The VIX is moving orders of maginitude more. So one-year Sharpe ratios and mean/variance ratios are still moving a lot over time! But perhaps we can coalesce the state variables somewhat, and find common factors in conditional mean and variance.
Supreme court and health insurance part II
Yesterday’s post morphed into a Wall Street Journal Op-Ed, reprinted below.
Why am I going on? I think too many people don’t understand there is a coherent free-market, deregulated alternative. President Obama himself said today,
“I think the American people understand — and I think the justices should understand — that in the absence of an individual mandate, you cannot have a mechanism to ensure that people with pre-existing conditions get health care."This just isn’t true. I don’t blame Obama, but his health insurance advisers ought to know better. "Guaranteed Renewable,” or “premium-increase insurance” is a possibility. It solves the genuine pre-existing conditions problem. It’s been in the academic literature for almost 20 years (see e previous Articles, Opeds, Blog posts and citations in the Articles, especially to Mark Pauly’s work and extensive coverage on Cato’s health insurance and Universal Heath Care sites). A deregulated, competitive market can work.
The WSJ Oped:
Last week, the Supreme Court heard arguments on the constitutionality of the administration’s health law, aka ObamaCare. Opponents are giddy with the possibility that the law might be struck down.
But what then? Millions of uninsured, both those who choose not to purchase coverage and those who can’t due to pre-existing conditions, will still be with us. The rising costs and inefficient delivery of health care will still be with us.
The country can have a vibrant market for individual health insurance. Insurance proper is what pays for unplanned large expenses, not for regular, predictable expenses. Insurance policies should be “guaranteed renewable”: The policy should include a right to purchase insurance in the future, no matter if you get sick. And insurance should follow you from job to job, and if you move across state lines.
Why don’t we have such markets? Because the government has regulated them out of existence.
Most pathologies in the current system are creatures of previous laws and regulations. Solicitor General Donald Verrilli explained as much in his opening statement to the Supreme Court: “The individual market does not provide affordable health insurance,” he noted, “because the multibillion dollar subsidies that are available” for the “employer market are not available in the individual market.” Well, if the problem is subsidies, we know how to fix it!
Start with the tax exemption for employer contributions to group health-insurance policies—but if your employer contributes an individual, portable insurance policy, you pay taxes. This is why you have insurance only so long as you stay with one employer, why you face pre-existing conditions exclusions if you change jobs, and why individual lifetime insurance is unattractive to young healthy people who know they will be employed someday.
Continue with the endless mandates (both state and federal) on insurance companies to provide all sorts of benefits people would otherwise not choose to buy. It sounds great to “make insurance companies pay” for acupuncture. But that raises the premiums, and then people choose not to buy the insurance. Instead of these mandates, at least allow people to buy insurance that only covers the big expenses.
What about Medicare and Medicaid? Two words: premium support. The underlying point of premium support is simple. If insurance costs $5,000 and the government gives an individual a $4,500 voucher, that individual will still feel the correct economic signal to shop for cost-efficient health insurance and health care.
The main argument for a mandate before the Supreme Court was that people of modest means can fail to buy insurance, and then rely on charity care in emergency rooms, shifting the cost to the rest of us. But the expenses of emergency room treatment for indigent uninsured people are not health-care’s central cost problem. Costs are rising because people who do have insurance, and their doctors, overuse health services and don’t shop on price, and because regulations have salted insurance with ever more coverage for them to overuse.
If we had a deregulated, competitive market in individual catastrophic insurance, that market would be so much cheaper than what’s offered today that we would likely not even need the mandate.
Meanwhile, staggeringly inefficient markets for health care itself need a thorough, competition-focused deregulation. Americans will know there’s a healthy market when hospitals post prices on their websites, and when new hospital and health-care businesses routinely enter to challenge the old ones. Here too regulations keep competition at bay.
The number of new doctors is still restricted, thanks to Congress and the American Medical Association. Congress caps the number of residencies, the AMA has fought the expansion of medical schools, state tests make it difficult for foreign doctors to work here, and on and on.
There are hundreds of government impediments to competition. New hospitals? In my home state of Illinois, every new hospital, expansion of an existing facility or major equipment purchase must obtain a “certificate of need” from the Illinois Health Facilities Planning Board. The board does a great job of insulating existing hospitals from competition if they are well connected politically. Imagine the joy United Airlines would feel if Southwest had to get a “certificate of need” before moving in to a new city—or the pleasure Sears would have if Wal-Mart had to do so—and all it took was a small contribution to a well-connected official.
The result is a monstrous system in which insurance patients are gouged to subsidize Medicare, and cash patients are gouged most of all. Here’s Mr. Verrilli again: “Insurance has become the predominant means of paying for health care in this country.” Yes, the cash market has been badly damaged. Whose fault is that? Shouldn’t we bring it back?
Group health plans in today’s system may appear reasonable enough—they seem to resemble “buyers’ clubs,” where people pool together to get good deals from providers. But in a real buyer’s club, each buyer still pays his own bill—you don’t go into a Sam’s Club and haul off whatever you can with only a fixed $20 copayment. And real buyer’s clubs don’t depend on where you work. Real buyers’ clubs for health services could be a useful way to get competition going and revive the cash-and-carry market for individuals.
A deregulated health-care and health-insurance market can work. We can at least start by removing the obvious elephants in the room: all the legislation, regulation and interventions that needlessly keep prices up, keep competition and innovation out, shelter people from the economic consequences of their decisions, and prevent the emergence of real insurance that follows you from job to job and from health to illness and back.
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