Friday, August 28, 2015

Who is Ashley Madison?

Apparently, there's a website that has garnered some attention lately because a breach of security allowed hackers to identify the email addresses of all of its users. Ironically, the main intention of the Ashley Madison website is for the breaching of something other than security...

Perhaps the revelation of the shear number of users (33 million to be precise) is beginning to destroy your faith in humanity. If this number doesn't do it, then, perhaps, what I'm about to share will.  In 2013, the Pew Research Group provided a survey of individuals across 40 different countries where questions about the acceptability of various moral issues were raised. The results were alarming!

Here are some of the findings... When asked whether or not extramarital affairs were acceptable (A), unacceptable (U), or not a moral issue (N), only 47% of French respondents said that affairs were unacceptable. More surprising, 40% of French respondents did not believe that extramarital affairs should be considered a moral issue.

Below is the list of 10 countries ranked lowest to highest based on the percent of respondents believing affairs are unacceptable:


If you're wondering where some of the other countries ranked, the U.S. was 28th (84% U), Canada was 17th (76% U), China was 16th (74% U), and Mexico was 13th (73% U). The Czech Republic had the largest percent of respondents say that affairs were acceptable (17% A) while Turkey and Palestine had the largest percent of respondents say that affairs were unacceptable (94% U). 

With this in mind, it's possible, and even likely, that the level of morality in a particular country can have an important influence on economic outcomes. In a free enterprise system, where two agents voluntarily exchange goods and services, the perception of morality can play an important role. Seeing the list of 10 countries in the table above, you might be less inclined to buy something from someone in France. Why? Because you might think the French have no morals and who ever is selling you something in France is likely trying to rip you off. Here is a Nobel Prize winning argument by Akerloff from 1970 that makes the same argument indirectly.

I took the liberty of plotting the relationship between the unacceptability of extramarital affairs and two measures of economic performance: GDP growth and Consumption growth. I'm only able to get 2014 GDP data for 39 of the 40 countries that Pew surveyed and 2014 Consumption data for 27 of the 40 countries, but this is what it looks like.

The plots show that the relationship between the level of unacceptability and growth rates are visually positive. That is, the percent of respondents that believe that extramarital affairs are unacceptable is directly associated with economic growth rates. Further, the univariate regression coefficients on the unacceptability percentage are both positive and statistically significant (Heteroskedastic-Consistent t-statistics = 2.33 and 2.45, respectively). 

Now finding a positive relationship between morality, in this case, and economic growth is not tantamount to identifying a causal link. That is, we cannot say that morality causes greater economic growth given the tests above. It is counter intuitive, however, to think of a reverse-causality story - i.e., that greater growth rates leads to greater morality. If anything, I would argue that the more prosperous a country becomes, the more morally progressive the country becomes. Here, I'm finding the opposite relationship. More moral countries tend to have higher economic growth rates. Interesting, if you ask me.

Wednesday, August 26, 2015

Bipolar Markets and the Probability of Interest Rate Hikes...

The market has gone crazy... The largest one-day reversal since October 2008 occurred yesterday after the Dow was up more than 400 points in the morning, but closed down more than 200 points. The recent sell off and excess volatility can only be explained by one thing... The market doesn't want the Fed to raise interest rates so it went bipolar weeks before the next FOMC meeting. (Kidding!) But, like I mentioned on Monday, I'm not going to hold my breath waiting for a rate hike in September. Neither is the President of the New York Fed.

Monday, August 24, 2015

An unusual open to trading...

Uh.... this market is getting to be pretty interesting. After a weekend that allowed the "bears" to calm down, it turns out that nothing was calm about this morning's open. In fact, the New York Stock Exchange implemented a rule to try to preemptively slowdown the panic that was set to occur at the open. Rule 48 is a trading rule that speeds up the morning's opening auction process. The Rule, which has only been issued a few times in the last 10 years, is implemented by the exchange if there is excessive volatility in the pre-open futures market and in foreign markets. At one point, the Dow was down 1,000 points but halved it's losses by the end of the first hour of trading. Did the implementation of the rule successfully curb the panic? Who knows - unfortunately, we don't see what happens if the rule isn't enforced. Perhaps it could've been a lot worse at the open although its hard to imagine something more than a 1,000 point drop in the first few minutes of trading.

On another note, if Hayek (1945) is right and the aggregate prices observed in markets signal something informative about the future, then we can expect some interesting economic times ahead. If I was a betting man, I wouldn't put too much money on a Fed rate hike in September...

Saturday, August 22, 2015

Correction - China isn't doing so well...

The Dow Jones Industrial Average has experienced an usually excessive correction - down more than 10% from its mid-May high. It seems like much of this correction is due to slowing economic growth globally, particularly in China. As mentioned in a previous post, The Peoples Bank of China has devalued the Yuan in attempt to stimulate exports. This devaluation was a wake up call to financial markets about how bad it is China. The worse may not be over - at least according to Jim Chanos a well-known short seller that places pessimistic bets on stocks.

To sell short, Chanos sells stocks he does not own by borrowing them from someone or some institution with a promise to repay the stock loan along with some interest. This is a risky proposition. The upside of the short sale is the shorted stock will decrease in price and Chanos will buy it back at a lower price and return the shares of stock for a little bit of profit. The downside is the price of the shorted stock will increase and he will not only have to pay back the loan with a stock that is now more expensive, but he will also have to pay the accrued interest on the loan. Economic theory argues that these borrowing costs will crowd out uninformed investors leaving only those, like Chanos, that seem to have the most information about where future prices will go. I don't know how bad things are economically in China, but I do know that the Chinese short positions by Chanos provide at least a negative signal about things that might come to pass.

Thursday, August 20, 2015

Curing Cancer

I don't want the title of this post to sound trite - but I've been thinking a lot about cancer the last couple of days. Recently, my family and I went to the lake. There, I was internally reminded to apply sunscreen on my balding head. Turns out, the day after going, I wished I had reapplied a few times. When I was 17, my dad began to receive treatment for some spots on his already bald head and, since that time, he has continually been poked and prodded by a host of dermatologists checking for cancer cells. I don't think this is uncommon - most everyone can identify someone close that is going through, or has gone through cancer.  A panel of cancer researchers have predicted that 41% of Americans will get cancer at some point. These odds are stacked against us all and they further emphasize the quickened need to find a cure. Unfortunately, I don't conduct that kind of research and can't estimate a time frame for finding a cure. However, I will predict that time to a cure is inversely related to the presence of well-functioning capital markets.

Did I just assert that financial markets will cure cancer? Yes, indirectly. The most important by product of well-functioning financial markets is that they provide a proper allocation of investment capital. They further provide large returns to the most profitable investments. Therefore, financial markets - i.e. debt and/or equity markets - produce the proper incentive for drug companies, that are so often vilified, to invest in additional R&D in attempt to find a cure as fast as possible. Why would drug companies race and compete with one another in order to find a cure? The answer to that is simple.... To make truck loads on money.

Did I just assert that the motive behind the eventual cure for cancer will be profit?  Yes, directly! Surprisingly, drug companies are not in the business of curing diseases strictly because of altruism. And, as someone who is balding prematurely and will inevitably have sun spots on my head due to my recent trip to the lake, I'm grateful for the lack of altruism by these companies. Because the profit motive will always be stronger than the altruistic motive (sad as it may seem), we are more likely to see a cure for cancer in our lifetime.

Sunday, August 16, 2015

Income Inequality - I'm a Skeptic

A couple of weeks ago, I cited an article that reported new disclosure requirements that help identify the level of income inequality within firms. I should admit, I'm not even sure I believe that increasing income inequality actually exists. A year or two ago, a book by a French economist became highly publicized:
Capital in the Twenty-First Century
Admittedly, I haven't read the book, but I have listened carefully to several talks by Piketty and the moral of the story is twofold. First, income inequality (or the amount of income earned by the richest group of individuals) has been increasing over the last 50 or so years. And second, the reason is because the rate of return on capital is greater than the growth in income. The book is primarily a culmination of his academic research. Related to his first point, Piketty and Saez (2003 and 2007) show that, from 1960 to 2005, the share of income earned by the top 10% increased from 32% to 44% while the share of income earned by the top 1% increased from 8% to 17% over the same time period.

If you were to ask, "Why should income inequality matter?", I would answer by saying, "great question!". I'm not sure that I know. Economic theory suggests that wages should equal workers' marginal product and discrepancies in this equality may result in inefficiency. However, theory is agnostic to the idea that inequality may produce social and political uncertainty as policy makers attempt to respond to cries from the Occupy Wall Street Movement that inequality is unfair. In my opinion, this is the most persuasive argument against income inequality given that regulatory uncertainty can influence the investment decisions of both firms and individuals, which will no doubt affect economic outcomes.  But what if the statistics do not tell the full picture and the uncertainty caused by inequality is generated by policy makers instead of the current economic system?

Here's where I begin to question the idea that rising inequality even exists... Two studies by the U.S. Department of the Treasury shed light on movement within the income distribution across time. It is this movement from, say 1960 to 2005, that seems to be more important than simply looking at the tails of the distribution in 1960 and then again in 2005 and trying to draw conclusions about fairness. Said differently, we shouldn't care that much about statistical groups or categories, per se. We should be more interested in "flesh and blood people". At least, this is the argument of economist Thomas Sowell. It's possible, and indeed likely, that individuals in the bottom part of the income distribution in 1960 actually moved to the top part of the income distribution by 2005. Therefore, we should be more concerned with income mobility than with income inequality.

Turns out, that in the United States, there is much more mobility than inequality - at least this is what the two studies from the Treasury Department seem to indicate. Both studies track earnings of individuals across 10 year periods using Tax Return data. The first time period is between 1979 to 1988 while the second period is from 1996 to 2005. Here is the first table from the first of these studies:

Table 1
Percentage Distribution Across Income
Quintiles in 1988 of Taxpayers Grouped by
Their Income Quintiles in 1979 /1/
(Quintiles defined for all taxpayers)

Quintile in 1988
in 1979












/1/ Reproduced from Table 1 in 'Household Mobility During the 1980s: A Statistical Assessment Based on Tax Return Data,' U.S. Department of the Treasury,, Office of Tax Analysis,, June 1,, 1992.

The results are striking. Look at upper left part of the table. Only 14% of individuals that were in the lowest quintile of the income distribution in 1979 remained in the lowest quintile by 1988. In fact, 15% of individuals in the lowest quintile made it to the highest quintile by 1988. 86% of individuals moved out of the bottom quintile during this 10 year period. 35% of individuals dropped out of the top quintile by the end of this period. 

Fortunately, this level of mobility is not unusual. Here is the first table from the second Treasury study:

Table 1: More than 50 percent of taxpayers in the bottom quintile moved to a higher quintile within ten years

Income Mobility Relative to the Total Tax Filing Population

2005 Income Quintile
1996 Income Quintile












Notes: The rows sum to 100 percent across the five quintiles in the first five columns. The table uses the tax returns of primary and secondary non-dependent taxpayers who were age 25 or over in 1996 and filed for both 1996 and 2005. Income breaks for the quintiles and top percentiles are based on the full cross-sections of tax returns for each year, where the taxpayer is age 25 and over. Income is cash income in 2005 dollars as defined in the Technical Appendix.

Source: Tabulations by the U.S. Department of the Treasury, Office of Tax Analysis, using data from IRS Statistics of Income, Individual Income Tax Files for tax years 1996 and 2005.

It should be noted that we observe less mobility from 1996 to 2005 than from 1979 to 1988, but the level of mobility is still higher than some policy makers would like to think. For instance, about 58% of individuals moved up from the bottom quintile of the income distribution during this 10 year period while slightly more than 30% of individuals dropped out of the top quintile.

While Piketty has become famous for reiterating the notion that the gap between the rich and the poor has been widening, the analysis conducted by the U.S. Treasury Department suggests that, in general, those who start out rich and those who start out poor typically meet in the middle. Although not reported in this post, the latter of the Treasury studies further reports that nearly 50% of individuals in the bottom quintile had their incomes increase more than 100% during the 10 year period while only about 8% of the individuals in the top quintile had their incomes increase more than 100%. Piketty figuratively trademarked the idea that r > g  - i.e., the rate of return on capital is greater than growth in income.  I would submit that the data from the Treasury suggests that p > r - i.e., the growth in income of the poor p is greater than the growth in income of the rich r.

What is most disturbing about this entire discussion is that the most negative externality associated with income inequality is being observed in our society without the absolute presence of rising inequality. In other words, we get to experience political and social uncertainty without experiencing the thing that caused it.

Thursday, August 13, 2015

The Devaluation of the Yuan and What to Expect for Chinese Stocks...

In a surprise move, this happened this week...

The People's Bank of China intentionally devalued the Yuan in an attempt to (1) increase Chinese exports, which have been lagging recently, and (2) increase reserves in Chinese Banks. Falling below expectations, Chinese exports are essential to that country's economic growth rate - a rate that must be near 10% in order to account for the unusually high level of population growth.

What does this mean for Chinese stocks? The objective of the devaluation is to make Chinese exports cheaper. To the extent that this will occur, Chinese companies could eventually benefit. Alibaba, China's version of Ebay, sure hopes so.

However, there is an unintended consequence. I've been working on a couple of research projects this summer that attempt to determine how instability in currency markets affects the stability of stock prices. In general, I find a direct association between currency volatility and both the volatility of stock prices and the kurtosis of stock prices. These projects, which are in their initial stages, seem to suggest that unstable currencies are related to stock prices that are not only more volatile but prices that also have fatter tails (or prices that have a greater probability of extreme positive and negative movements). This is relatively straightforward. What is not straightforward is determining whether or not currency volatility actually causes stock price volatility and excess kurtosis. To better isolate the direction of causation, I use the exogenous 2005 unpegging of the Yuan as a natural experiment. This identification strategy, which shows that stock price volatility increases surrounding the Yuan's unpegging, suggests that shocks to the stability of currency values indeed cause less stable stock prices. As if Alibaba hasn't experienced enough uncertainty recently, the unintended consequence of the Yuan's intentional devaluation may result in greater volatility in the Chinese stock market - at least in the short run...

Saturday, August 8, 2015

Fama on the Financial Crisis...

Gene Fama, winner of the 2013 Nobel Prize in Economics, joined Russ Roberts on the EconTalk podcast to discuss markets and the financial crisis in 2012. Fama's contribution to finance is, at best, the most important among any other economist and, at worst, among the best. However, some in the media (i.e. Peter Schiff) and even some in smaller academic circles question whether or not Fama deserved the prize. I've never met him, but I have heard him speak a time or two and, up until recently, I didn't care to form an opinion about Fama and the Nobel Prize. I'm a certainly a fan of his work, but regarding the merit of the Nobel Prize, his discussion with Russ Roberts was finally the clincher for me.

When Roberts walked through the financial crisis in order to set the stage for the discussion, he talked about the crisis being brought about by the collapse of the housing market in 2007. Fama interrupts Roberts and says the recession may have been brought about by a number of things including the stock market crash in late 2008. Roberts, a little confused, says, "So, you are going to reverse the causation". Again, Fama interrupts and says, "I'm not saying I know. What I'm saying is I can tell the whole story just based on the recession. And I don't think you can come up with evidence that contradicts that. But I'm not saying I know I'm right. I don't know. I'm just saying people read the evidence through a narrow lens... And the rhetoric acquires a life of its own.."

Finally, an economist - Nobel Laureate no less - finally admitting that he doesn't know the cause of the financial crisis. It seems as if everyone has an opinion and, to steal a phrase from Fama, the rhetoric starts to acquire a life of its own.

Wednesday, August 5, 2015

New Disclosure Requirements from the SEC...

Today, Bloomberg came out with a report that the U.S. Securities and Exchange Commission (SEC) has approved, by a vote of 3 to 2, a measure requiring companies to disclose the gap between the pay of the CEO and the pay of a typical worker. Proponents of the measure feel that the public should be aware of - and no doubt outraged by - the level of income inequality within companies. Meanwhile, heartless capitalists, like myself, may support this new type of disclosure for a different reason. Hayek (1945) said that, "we must look at the price system [and in this case, the wage system] as such a mechanism for communicating information if we want to understand it's real function -...The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action." I'm concerned about the level of income inequality.  But my concern is that we don't have enough of it. I, therefore, support the measure to disclose the income inequality within companies if only to identify which firms efficiently allocate human capital. Who wants to work for a company that doesn't properly reward the accumulation of human capital and instead equalizes incomes of employees.We now have an observation of what happens when firms start to minimize income inequality instead of maximize profit. It doesn't work out so well.

Tuesday, August 4, 2015

Summer Reading...

Spent some of the summer reading a couple of books that have been on my list. Below are the books and my brief opinion.

Krugman's academic writings, which won him the Nobel Prize in 2008, are very different from his popular press writings. His academic work recognizes the benefits of trade while his popular writings seem a little protectionist. I thought it would be interesting to read some of his "in-between" stuff. As expected, "The Return of Depression Economics" was "in between". A very easy and pleasant read, it was long on stories but very short on analysis. Krugman tries to suggest that economic liberalization can lead to an environment where deep and long-lasting recessions can occur. But the attempts, which are anecdotal at best, seem to fall flat. While his writing in entertaining (for an economist), the conclusions seem a little flimsy.  Eh, I'll give it a 5/10.

I also finished reading Gneezy and List's "The Why Axis". John List, who may one day win the Nobel Prize, might be the most productive economist in the world.  Some of his work in finance has made an important splash, but that splash is minor compared to his crusade to use field experiments to test existing economic theory. Interested readers could spend hours looking through his website located here.  The Why Axis is also a nice read. The authors' straightforward discussion about the implications from their field experiments is, at times, fascinating, but by the end of the book, the discussion becomes a little predictable. Most of the research in the book has a behavioral slant. For instance, many of the field experiments discussed in the book employ the concept of loss aversion. One of the most interesting studies (in my opinion) examined secondary teachers' performance in the classroom (as measured by students' standardized test scores). One treatment group of teachers were paid a bonus prior to the beginning of the quarter under the agreement that if the students didn't meet some score threshold, the teachers would repay the bonus. Relative to the control groups (i.e. teachers that were not paid a bonus), the performance of students' tests scores improved significantly. The magnitude of the increase resembled something similar to the literature's previous estimates of a one standard deviation increase in teacher quality. Another group of interesting studies attempted to explain the gender pay gap. The press, and nearly every democrat running for office, often point out that women are paid (on average) $.77 for every $1 that is paid to men, Gneezy and List conduct field experiments to determine whether a woman's aversion to competition can explain some of this pay gap. The tests, and their results, seem to be pretty compelling. Although it was definitely worth the read, the book, however, was about 75 pages too long.  Eh, I'll give it an 8/10.

Last, but not least, I read Tom Sowell's "Black Rednecks and White Liberals". I had  read his book "Race and Culture" earlier this year and, while a tougher read, I quite enjoyed it. So I was anxious to read this more up-to-date analysis of the intersection between culture, race, and economics. Sowell provides a very thorough look of the cultures of the antebellum south, the Jews, and the Germans. He provides an impressive link between the strength of culture within these (and other) groups of people that are persistent across time. Culture, as he discusses, is present in these groups throughout several generations, regardless of the migration of these groups throughout the world. For those interested in this type of analysis, I think Black Rednecks and White Liberals is a must read. Eh, I'll give it a 9.5/10.