Category Archives: Clippings

Eugene Fama should know better

Brad DeLong blasts Eugene Fama for his manifest failure to understand the investment-savings identity:

Fama… thinks that “investment” means “growth in the value of the capital stock.” He simply does not understand what the NIPA investment concept is, or that what he thinks of as “investment” is not in general equal to savings…

All of this is part of the undergraduate sophomore economics curriculum. It is gone over again very quickly in graduate school…

These mistakes are, literally, elementary ones.

They were elementary when R.G. Hawtrey and the other staffers of the British Treasury made them in the 1920s.

They carry the implication not just that government cannot stimulate or depress the economy, but that no set of private investment or savings decisions can stimulate or depress the economy either, and thus that there can be no business cycle fluctuations from any source whatsoever–because every action that shifts savings or investment simply moves resources from one use to another.

Eugene Fama really should know better…

Dani Rodrik on stocks vs. flows

Dani Rodrik writes:

Suppose you read the following statement:

In 2006 the measured economic output of the entire world was around $47 trillion. The total market capitalization of the world’s stock markets was $51 trillion, 10 percent larger…. Planet Finance is beginning to dwarf Planet Earth.

Are you impressed? You shouldn’t be.

A year’s output is the value of goods and services produced over that year, while equity values reflect the (discounted) value of all future streams of profits. If you are comparing the two, you must at least have a sense of what a decent benchmark for comparison would be.

So if, say, half of GDP originates in the corporate sector and profits are one-third of value added, the present value of profits discounted at a continuous rate of 8% amounts to 208% of GDP (=0.5×0.33/0.08). This suggest that the value of stock markets should be more than double that of annual output, not the mere 10 percent extra that the above numbers suggest. Planet Finance is not all that huge after all–at least given the numbers we are presented.

What is somewhat disconcerting is that the above statement comes from Niall Ferguson’s new book, The Ascent of Money. Ferguson knows no doubt the difference between flows and stocks, or income and wealth. But the way he sets this up is misleading nonetheless.

Objective measurement of subjective well-being

Justin Wolfers writes on Freakonomics:

Let’s see how it checks out, updating my earlier analysis of daily data on life satisfaction through 2008, courtesy of the Gallup-Healthways Well-Being Index

Not only has happiness declined during this recession, it has declined through every U.S. recession for which we have data. Here’s a chart from a paper of mine (with Betsey Stevenson), documenting the clear correlation between the U.S. business and happiness cycles:

BMJ goes myth-busting

The British Medical Journal recently did some serious myth-busting (see part one and part two). Apparently, all of the following are myths:

  • Sugar causes hyperactivity in children
  • Suicides increase over the holidays
  • Poinsettia is toxic
  • Not wearing a hat causes excess heat loss
  • Eating late in the day makes you fat
  • You can cure a hangover
  • People should drink at least eight glasses of water a day
  • We use only 10% of our brains
  • Hair and fingernails continue to grow after death
  • Shaving hair causes it to grow back faster, darker, or coarser
  • Reading in dim light ruins your eyesight
  • Eating turkey makes people especially drowsy
  • Mobile phones create considerable electromagnetic interference in hospitals.


Of ignorance and knowledge

Shamelessly copied from Obsidian Wings:

What Do You Mean ‘We’, White Man?

Robert Samuelson has an infuriating op-ed in today’s Washington Post. It’s called “Humbled By Our Ignorance”:

“It’s the end of an era. We know that 2008, much like 1932 or 1980, marks a dividing line for the American economy and society. But what lies on the other side is hazy at best. The great lesson of the past year is how little we understand and can control the economy. This ignorance has bred today’s insecurity, which in turn is now a governing reality of the crisis.

The entire column is devoted to explaining all these things that “we” were ignorant of. But who, specifically, are “we”? It’s hard to say. Mostly, it seems to be the nameless subject of the passive voice:

“It was once believed that the crisis of “subprime” mortgages — loans to weaker borrowers — would be limited, because these loans represent only 12 percent of all home mortgages. (…)

It was once believed that American consumers could borrow and spend more, because higher home values and stock prices substituted for annual savings. [Ed.: Apparently, it was also believed that stocks and home prices always went up.](…)

It was once believed that the rest of the world would “decouple” from the United States.

And so on, and so forth. All these beliefs, and no believers in sight. All this bustle and commotion, and there’s nobody around!

The closest Samuelson gets to identifying people who actually believed these things is at the beginning of his piece (“The great lesson of the past year is how little we understand and can control the economy”), and at the end (“Our ignorance is humbling.”) Which is to say: it’s “us”.

And yet, strange to say, I did not believe these things. I’m almost sure I wrote about this in 2006, but I can’t recall where, so this from March 2007 will have to do. In it I predict that the mortgage meltdown will knock the legs out from under consumer spending, create a serious credit crunch, and slam the many investors who own CDOs based on mortgages; and that the combination of these three things will be very, very bad, even without taking into account the possibility of systemic risk.

Apparently, I did better than Robert Samuelson. I’m not saying this because I think I deserve credit for that. I don’t. That’s the point. I’m not especially astute about the housing market, or an expert in economics. I do tend to be common-sensical and cautious about economics — I do not, for instance, tend to believe such things as: that houses will go up in value indefinitely, or: that we can keep living way beyond our means forever. But that shouldn’t exactly set me apart from anyone.

The only reason I saw this one coming was that I read people who know a lot more than I do: people like Paul Krugman, Dean Baker, Tanta at Calculated Risk, Stephen Roach at Morgan Stanley, and Nouriel Roubini. They all challenged one or another of the myths Samuelson lists, and they did so years ago. Moreover, they had arguments to back up their claims, and I found these arguments much more persuasive than the arguments of the people who disagreed with them.

There were very smart people who did predict this. Their writings were not arcane or hard to find — I mean, I found them, and this is not my area of expertise. Nor was their basic point that hard to grasp. If I could grasp it, then anyone remotely worthy of having an economics column in the Washington Post should have.

Whether or not Samuelson realizes it, I take the point of his op-ed to be that he is not competent in his alleged area of expertise, and moreover lacks one of the basic skills that a PhD in a discipline almost always provides: the ability to spot good arguments in that discipline made by other people, and to decide who is worth listening to and who is not. In his shoes, I would ask myself what, in the absence of competence or the ability to learn from the writings of others, could possibly justify my continuing to take up valuable space in the Post. It’s certainly not obvious to me.

Brad DeLong on Keynes and terminology

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 in Ethiopia

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.

* * * * *

Excel’s faulty statistics: a bibliography

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),

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.

Behavioral finance marches on

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.