Growth Versus Distribution: Hunger Games Paul Krugman

It’s fairly common for conservative economists to try and shout down any discussion of income distribution by claiming that distribution is a trivial matter compared with the huge gains from economic growth. For example, Robert Lucas:

Of the tendencies that are harmful to sound economics, the most seductive, and in my opinion the most poisonous, is to focus on questions of distribution.

The usual answer to this is to point out that we don’t actually know much about how to produce rapid economic growth — conservatives may think they know (low taxes and all that), but there is no evidence to back up their certainty. And on the other hand, we know how to make a big difference to income distribution, especially how to reduce extreme poverty. So why not work on what we know, as at least part of our economic strategy?

But even this argument may be conceding too much. A new study finds that in poor and lower-middle-income countries, one of the most crucial aspects of well-being, child malnutrition, isn’t helped at all by faster growth:

An increase in GDP per capita resulted in an insignificant decline in stunting. And when the researchers compared the changes in GDP to the changes in the number of wasting and underweight children, there was no correlation at all.

“It wasn’t that [the association] was just weak or small,” Subramanian told Shots. That was the case, he said, especially for stunting. More striking was the fact that the effect overall “was just practically zero.” He says things like unequal income distribution and lack of efficient implementation of public services are possible causes.

Yes, rapid growth is good, but it doesn’t solve all problems even if you know how to make it happen, which you don’t.

The best Hyman Minsky

Hyman Minsky

I have learnt about him by going through his books ,  when he was alive he was never considered a serious economist but now economists know his contribution and thinking. Minsky spent his life on the margins of economics but his ideas suddenly gained currency with the 2007-08 financial crisis. To many, it seemed to offer one of the most plausible accounts of why it had happened. American economist Hyman Minsky, who died in 1996, grew up during the Great Depression, an event which shaped his views and set him on a crusade to explain how it happened and how a repeat could be prevented. His long out-of-print books were suddenly in high demand with copies changing hands for hundreds of dollars - not bad for densely written tomes with titles like Stabilizing an Unstable Economy.  Well , Krugman End this Depression has mentioned about the night he re-read the book and Yellen also knows the importance .

The Big Ideas

Stability is destabilising

Minsky's main idea is so simple that it could fit on a T-shirt, with just three words: "Stability is destabilising."Most macroeconomists work with what they call "equilibrium models" - the idea is that a modern market economy is fundamentally stable. That is not to say nothing ever changes but it grows in a steady way.

To generate an economic crisis or a sudden boom some sort of external shock has to occur - whether that be a rise in oil prices, a war or the invention of the internet.

Minsky disagreed. He thought that the system itself could generate shocks through its own internal dynamics. He believed that during periods of economic stability, banks, firms and other economic agents become complacent.

They assume that the good times will keep on going and begin to take ever greater risks in pursuit of profit. So the seeds of the next crisis are sown in the good time.

3 Stages of  Debt

Minsky had a theory, the "financial instability hypothesis", arguing that lending goes through three distinct stages. He dubbed these the Hedge, the Speculative and the Ponzi stages, after financial fraudster Charles Ponzi.

(Ponzi schemes -- Charles Ponzi : Similar to a pyramid scheme, an enterprise where - instead of genuine profits - funds from new investors are used to pay high returns to current investors.Named after fraudster Charles Ponzi (1882-1949), such schemes are destined to collapse as soon as new investment tails off or significant numbers of investors simultaneously wish to withdraw funds)

In the first stage, soon after a crisis, banks and borrowers are cautious. Loans are made in modest amounts and the borrower can afford to repay both the initial principal and the interest.

As confidence rises banks begin to make loans in which the borrower can only afford to pay the interest. Usually this loan is against an asset which is rising in value. Finally, when the previous crisis is a distant memory, we reach the final stage - Ponzi finance. At this point banks make loans to firms and households that can afford to pay neither the interest nor the principal. Again this is underpinned by a belief that asset prices will rise.

The easiest way to understand is to think of a typical mortgage. Hedge finance means a normal capital repayment loan, speculative finance is more akin to an interest-only loan and then Ponzi finance is something beyond even this. It is like getting a mortgage, making no payments at all for a few years and then hoping the value of the house has gone up enough that its sale can cover the initial loan and all the missed payments. You can see that the model is a pretty good description of the kind of lending that led to the financial crisis.

Minsky Moment

The "Minsky moment", a term coined by later economists, is the moment when the whole house of cards falls down. Ponzi finance is underpinned by rising asset prices and when asset prices eventually start to fall then borrowers and banks realise there is debt in the system that can never be paid off. People rush to sell assets causing an even larger fall in prices

Finance Matters

Until fairly recently, most macroeconomists were not very interested in the finer details of the banking and financial system. They saw it as just an intermediary which moved money from savers to borrowers.

This is rather like the way most people are not very interested in the finer details of plumbing when they're having a shower. As long as the pipes are working and the water is flowing there is no need to understand the detailed workings. To Minsky, banks were not just pipes but more like a pump - not just simple intermediaries moving money through the system but profit-making institutions, with an incentive to increase lending. This is part of the mechanism that makes economies unstable.

Words better than models and maths

Since World War Two, mainstream economics has become increasingly mathematical, based on formal models of how the economy works.

To model things you need to make assumptions, and critics of mainstream economics argue that as the models and maths became more and more complex, the assumptions underpinning them became more and more divorced from reality. The models became an end in themselves.

Although he trained in mathematics, Minsky preferred what economists call a narrative approach - he was about ideas expressed in words. Many of the greats from Adam Smith to John Maynard Keynes to Friedrich Hayek worked like this.While maths is more precise, words might allow you to express and engage with complex ideas that are tricky to model - things like uncertainty, irrationality, and exuberance. Minsky's fans say this contributed to a view of the economy that was far more "realistic" than that of mainstream economics.

Krugman on Inequality

Most people, if pressed on the subject, would probably agree that extreme income inequality is a bad thing, although a fair number of conservatives believe that the whole subject of income distribution should be banned from public discourse. ( Rick Santorum, the former senator and presidential candidate, wants to ban the term "middle class," which he says is "class-envy, leftist language." Who knew?) But what can be done about it?

The standard answer in U.S. politics is, "Not much." Almost 40 years ago Arthur Okun, chief economic adviser to President Lyndon Johnson, published a classic book titled "Equality and Efficiency: The Big Tradeoff," arguing that redistributing income from the rich to the poor takes a toll on economic growth. Okun's book set the terms for almost all the debate that followed: Liberals might argue that the efficiency costs of redistribution were small, while conservatives argued that they were large, but everybody knew that doing anything to reduce inequality would have at least some negative effect on gross domestic product.
But it appears that what everyone knew isn't true. Taking action to reduce the extreme inequality of 21st-century America would probably increase, not reduce, economic growth.
Let's start with the evidence.
It's widely known that income inequality varies a great deal among advanced countries. In particular, disposable income in the United States and Britain is much more unequally distributed than it is in France, Germany or Scandinavia. It's less well known that this difference is primarily the result of government policies. Data assembled by the Luxembourg Income Study (with which I will be associated starting this summer) show that primary income - income from wages, salaries, assets, and so on - is very unequally distributed in almost all countries. But taxes and transfers (aid in cash or kind) reduce this underlying inequality to varying degrees: some but not a lot in America, much more in many other countries.
So does reducing inequality through redistribution hurt economic growth? Not according to two landmark studies by economists at the International Monetary Fund, which is hardly a leftist organization. The first study looked at the historical relationship between inequality and growth, and found that nations with relatively low income inequality do better at achieving sustained economic growth as opposed to occasional "spurts." The second, released last month, looked directly at the effect of income redistribution, and found that "redistribution appears generally benign in terms of its impact on growth."
In short, Okun's big trade-off doesn't seem to be a trade-off at all. Nobody is proposing that we try to be Cuba, but moving U.S. policies part of the way toward European norms would probably increase, not reduce, economic efficiency.
At this point someone is sure to say, "But doesn't the crisis in Europe show the destructive effects of the welfare state?" No, it doesn't. Europe is paying a heavy price for creating monetary union without political union. But within the euro area, countries doing a lot of redistribution have, if anything, weathered the crisis better than those that do less.
But how can the effects of redistribution on growth be benign? Doesn't generous aid to the poor reduce their incentive to work? Don't taxes on the rich reduce their incentive to get even richer? Yes and yes - but incentives aren't the only things that matter. Resources matter too - and in a highly unequal society, many people don't have them.

Think, in particular, about the ever-popular slogan that we should seek equality of opportunity, not equality of outcomes. That may sound good to people with no idea what life is like for tens of millions of Americans; but for those with any reality sense, it's a cruel joke. Almost 40 percent of American children live in poverty or near-poverty. Do you really think they have the same access to education and jobs as the children of the affluent?
In fact, low-income children are much less likely to complete college than their affluent counterparts, with the gap widening rapidly. And this isn't just bad for those unlucky enough to be born to the wrong parents; it represents a huge and growing waste of human potential - a waste that surely acts as a powerful if invisible drag on economic growth.
Now, I don't want to claim that addressing income inequality would help everyone. The very affluent would lose more from higher taxes than they gained from better economic growth. But it's pretty clear that taking on inequality would be good, not just for the poor, but for the middle class (sorry, Sen. Santorum).
In short, what's good for the 1 percent isn't good for America. And we don't have to keep living in a new Gilded Age if we don't want to.

price-earnings (CAPE) ratio

How dare anyone challenge the sanctity of the cyclically-adjusted price-earnings (CAPE) ratio, arguably the most respected measure of stock market value.

CAPE has a very well documented track record of predicting long-term returns.

But we can't just ignore what the critics are saying about some of the model's inputs, especially as accounting standards change.

CAPE

Nobel prize-winning economist Robert Shiller popularized CAPE in his 2000 book "Irrational Exuberance," which effectively predicted the dotcom bubble when no one else would.

CAPE is calculated by taking the S&P 500 and dividing it by the average of ten years worth of earnings. If the ratio is above the long-term average of around 16x, the stock market is considered expensive

Currently, CAPE is at 25. The more bearish stock market experts point to this high CAPE as a precursor to an era of subpar stock market returns.

CAPE Critics

But CAPE has attracted its fair share of critics lately. Generally speaking, the critics argue that the earnings component of CAPE is just too low. Jeremy Siegel has argued new accounting standards have put a downward bias on earnings. Others like Jefferies' Sean Darby pointed out that the 10-year average of earnings is being unfairly penalized by a rare stretch of deflated earnings levels of the financial crisis.

UBS

In a note to clients on Monday, Societe Generale's Andrew Lapthorne took issue with net income, the earnings component referenced in Shiller's CAPE ratio.

Lapthorne argues that the year-over-year growth rate in net income in 2013 was actually inflated by the fact that there were a number of large, multi-billion dollar write-downs in 2012.

Write-downs were enormous impediments to net income during the crisis(see chart).

Because nonrecurring items like write-downs aren't reflective of ongoing operations, analysts often pay closer attention to earnings adjusted for these items.

Futhermore, evolving accounting standards have changed how write-downs are handled during merger and acquisition transactions. Shiller's CAPE does not account for this sufficiently.

Shiller's CAPE is beautiful in its simplicity and proven by its long track record. But this doesn't mean it can't be improved.

CAPE Alternative

Back in November, Deutsche Bank's David Bianco offered an adjusted CAPE measure. Among other things he made a tweak to account for changing accounting standards and noisy items that aren't adjusted for in Shiller's GAAP net income measure. From Bianco:

Shiller method uses GAAP EPS for the entire time series. We use GAAP EPS from 1900 to 1976, S&P Operating EPS from 1977-88 and IBES pro-forma EPS from 1989 onwards. SEC was not created until the Securities Exchange Act of 1934 and it took decades for US GAAP to develop and many changes have been made to the accounting standards. Since 2000 goodwill and asset write-downs increased owing to the elimination of pooling accounting for mergers and there are now regular impairment tests of acquired goodwill. This causes GAAP EPS to understate true EPS as high value assets are never written up.

Bianco also overhauled the way Shiller addressed inflation:

Historical EPS used in the Shiller method are inflation adjusted. As we argue earlier, adjusting only inflation does not account for the substantial changes in dividend payout ratio. The Bianco PE is based on equity time value adjusted (ETVA) EPS. We raise past period EPS by a nominal cost of equity estimate less the dividend yield for that period.

Bianco also took issue with the folks relying on 100+ year average for a baseline CAPE:

The current Shiller PE is usually compared to its 100+yrs average of 16.3x. This includes the WWI EPS cycle, when companies benefitted tremendously from supplying Europe. Profits tripled from 1914 to 1916, and then fell to less than a fifth during the 1921 post war recession. This exceptional profit swing distorts the long-term average 10yr PE a full point.

We advise comparing the current PE to its average from 1960 onwards as the S&P 500 didn't exist until 1957. From 1926-56 S&P Index data is based on the S&P 90 composite which comprised of 50 Industrial, 20 Railroad and 20 Utility stocks. Prior to 1926 the data is based on Cowles Commission Index data.

Considering all this, where does this put Bianco's CAPE?

Bianco's CAPE is 17.0 now. The Shiller PE is 24.9. The 1960-2013 average for these PEs are 15.6 and 19.6, respectively.

"Shiller PE suggests that S&P is overvalued, Bianco PE is reasonable," wrote Bianco in hist February 28 update.

Deutsche Bank

Updated February 28.

It's worth noting that Bianco is no raging bull. With a 1,850 target on the S&P 500, he's arguably the most bearish strategist on Wall Street. So he's not tweaking Shiller's CAPE just to support some bullish thesis.

What Would Robert Shiller Say About This?

How dare anyone challenge Shiller's CAPE?

This is the question posed by the folks who mostly have a "If it ain't broke, don't fix it attitude."

Bianco's alternative probably isn't perfect either. But the purpose of this exercise is to recognize that Shiller's CAPE is not without its problems.

In an April 2012 interview with Money Magazine, Shiller himself said something interesting about his CAPE.

"Things can go for 200 years and then change," he warned. "I even worry about the 10-year P/E - even that relationship could break down."

Though he does not address the accounting issues directly, his warning about his model's infallibility is pretty clear.