The role of capital in “A model of secular stagnation” Eggertsson Mehrota (2014)

Eggertsson and Mehrota (2014) introduced capital in section 9 of their working paper.

The role of capital and investment in their model, however, is a bit different from my recent work:

First, the capital investment for the middle-aged is another way to smooth consumption just for the middle-aged, so more investment means less loan supply. While in my model, more investment means more borrowing and lending between the young and  the middle-aged, hence also alleviating the borrowing constraint.

Second, Explaining the Keynesian paradox of thrift.Here’s the mechanism –> more desire to save –> less demand for today –> lower inflation –> higher real return –> leads to even lower demand. Really there’s no role for investment here in the story. The key is that the investment only respond passively to demand, a decreasing demand means we don’t need so much investment, and because of decreasing marginal returns, when Y is low, in the steady state we only need to replace a small amount of capital –> a low I/Y ratio.

In my model, however, I directly model this investment channel, which I think is not done in this paper.

Some other drafts that maybe useful for later use: (For my own reference)

Notice in their paper, Steady state investment to GDP ratio is low when real interest rate is high, that’s kind of natural, because when output is low, the return on capital would surely be high so r_K is high, but also we have I=\delta * K, so steady state investment is linear in capital, and output is a concave function in K, so when I/Y will be increasing in K. where as r_K is decreasing in K, so I/Y is decreasing in r_K

China’s problem

Krugman bombarded the China authority this morning. Saying the authority should not rescue the stock market.

I think the authorities are not doing it right, by any means if they are trying to boost the stock market, they will need to do “whatever it takes”, rather than “do my best”.. Which may then cause inflation problem.

And then his analysis here in 2013:

It’s an interesting piece explaining why China has so many investment in the GDP. Because of peasant labors, so investment return is quite high. Why? Somebody doesn’t have a job, you invest in a firm and pull him into production, of course it’s worthwhile. But as everyone gets a job, when I build a new factory, I will have to compete with the other factories, competing up labor and bang.. Now quantitative exercise is needed, a good trade paper, hmmm?

“How is that even possible? … The story that makes the most sense to me … rests on an old insight by the economist W. Arthur Lewis, who argued that countries in the early stages of economic development typically have a small modern sector alongside a large traditional sector containing huge amounts of “surplus labor” — underemployed peasants making at best a marginal contribution to overall economic output.

The existence of this surplus labor, in turn, has two effects. First, for a while such countries can invest heavily in new factories, construction, and so on without running into diminishing returns, because they can keep drawing in new labor from the countryside. Second, competition from this reserve army of surplus labor keeps wages low even as the economy grows richer. …

Now, however,… to put it crudely, it’s running out of surplus peasants. That should be a good thing. Wages are rising; finally, ordinary Chinese are starting to share in the fruits of growth. But it also means that the Chinese economy is suddenly faced with the need for drastic “rebalancing”… Investment is now running into sharply diminishing returns and … consumer spending must rise dramatically to take its place. The question is whether this can happen fast enough to avoid a nasty slump.

And the answer, increasingly, seems to be no. The need for rebalancing has been obvious for years, but China just kept putting off the necessary changes…”

Collateral Crisis: (Gorton Ordenez), and My Reading About it (and my new work)

A nice paper on AER (2014), except that’s probably not the answer.

First I discuss the paper:

The paper embeds a contract theory model into an OLG framework. Collateral (Land) can be good (with probability p) or bad (with probability 1-p), depending on the belief of the investor.

Lenders will either choose to “acquire information”, or choose to not to do so. When p is too high or too low, faced with a fixed information acquisition cost, people choose not to acquire information, but then when a bad aggregate shock comes, the economy can be dragged down into a state where it’s optimal to acquire information, hence creating a slump. 

What’s worse, there are some cases when the aggregate shock is not as severe. In that case, the aggregate economy will experience a slump, but because short-lived agents don’t start to acquire information, p is taken to be low, this tightens the borrowing constraint, and such “information overhang” will last for a long time. An social planner would be good in this case because it has the incentive to acquire information for the use of agents born in the future (Two periods lived agents don’t have such incentive.)

Then I discuss my own understanding:

In the introduction, the authors cite evidence from the crisis, such as the run on repo, the evidence that eventual loss on MBS is small, and that a small shock leads to a systemic risk to justify the model in this paper.

I certainly agree that information acquisition can be costly, especially during the peak days of the crisis, leading to bankruptcies, et al. But I have my concerns.

In reality corporations and banks are sitting on piles of cashes / excess reserves, and nobody still in lending the money out. We are not in the lack of good collateral (cash is the perfect collateral). At the same time, many real investment take place without posting any collateral: When GE decides to invest a new production line, who’s gonna post GE collateral? When I invest in the stock market, who’s gonna post me some collateral? For these two reasons the mechanism cannot be the key for the slow growth after the crisis took place.

Why is financial crisis so harmful? The answer may lie in debt, equity investors know they are faced with crash risk, so they are prepared. Debt investors are less so. A recent study by Alan Taylor et al 2015 points out, a financial crisis preceded by a credit boom is much more severe than a financial crisis without a debt issue (Cited by The Economist).

Above I rule out the case for Collateral Crisis.

One explanation is just a debt overhang problem. Too many debts makes the firms unwilling to invest. But I don’t know.

Another explanation is my new work —- my new work shows that it is the insufficient supply of safe projects than pulls the economy down to a liquidity trap.

Silicon Valley

A great article in the Economist on Silicon Valley, several things in mind:

Today, there’s less of a technology bubble compared with 2000s dot.com bubble. Many of the investment are done by a small group of insiders, and the PE ratio for technology firms valued above 1 billion is at a modest level of 21, compare with 170 for the Nasdaq in the 2000s.

A lot of IO stuff, like if my competitors fight, I will fight — so we both burn money. Also when the economy. Also because the firms needs to be famous, they cannot really scale themselves down, but too big to be sold.

Common stocks for the start-ups can be a good “arbitrage” between working in private and public firms.

They also mentioned a precautious saving motive for investors to hold cash.

A bit more on Greece and the Great Depression

Brad Delong has this nice post. 

Some quotes:

“Back in May 2010 Brussels and Frankfurt anticipated that their proposed first program would be associated with a further 3% fall in Greek GDP below 2010 levels that were then 4% less than 2009. The first program was duly implemented–mostly. But by March 2012 it was clear that 2012 would not see the forecast beginnings of recovery, but instead a Greek GDP that was expected to be 12% below the 2010 level. The second program was duly implemented–mostly. Yet 2012 Greek GDP was not 12% but 17% below the 2010 level.”

And he says the Europe leaders are making the same mistake as in the Great Depression.

“And this story is too, too familiar. This is the story of the 1930s. And so Matthew Yglesias tells us to reread Sheri Berman’s The Primacy of Politics about the unraveling of European social democracy in the 1930s, as Germany’s “SPD took the view… that capitalism was an inherently flawed system… but short of a revolution… there was just nothing to be done…” and Britain’s “Labour Party… enact[ed] spending cuts necessary to keep the country on the gold standard… [eventually] forming a[n austerity] coalition with Conservatives.”

Reading today: banks’ capital requirement

Interesting blog posting here, criticizing one of the WSJ journal article on banking regulation. I am mostly interested in this point:

“Even so, the Journal says that banks will have to decide “whether to pay the cost of new regulation, which will fall to the bottom line, or change their business models.” This is not true.

Say some bank has $100 in assets and $95 in liabilities, so it has $5 in capital. Its “bottom line” profits are basically the interest it earns on the assets minus the interest it pays on the liabilities. Then say Janet Yellen comes along and tells the bank that it has to have $10 in capital for every $100 in assets. So the bank sells new shares to the public for $5 and uses the $5 in cash to pay off $5 of its liabilities. Now it has $100 in assets and $90 in liabilities, so its profits actually go up (since it has less debt to pay interest on, and it pays a lower interest rate because its debt is less risky).

The banks’ complaint is not about the “bottom line,” but about something else: return on equity. Even though profits go up, they are now spread across twice as much capital. If you think of capital as the money invested by shareholders, then the shareholders are getting a lower return than they were previously. But this ignores the fact that stock in the bank is also less risky than it was before, so shareholders don’t demand as high a return on their money. Under a few basic assumptions, the return on equity is exactly what it needs to be to meet shareholders’ expectations.”

Return on Equity seems to be the reason for banks to be so keen on a low capital buffer. Of course, by taking an option like buffer they would get only the upside and lose little of the downside — this makes banks more risky.

Reading today: Financial Regulation and Eurozone

Nothing much new for the day, Krugman stands out

1. Mark Thoma discusses the financial regulation. When things involves politics, it gets complicated. Ideally, we should  design the rules carefully and gradually implement them. However, in terms of financial regulation, we either do it when it’s politically possible, but economically not optimal (impose Dodd Frank at a point of high uncertainty, and more importantly, the regulation items haven’t really be well thought through one by one), or we just not do it at all.

2. Krugman again criticize Eurozone. I am a bit tired of Greece story now, and Spain doesn’t seem to be any better, 22% unemployment with little economic growth. I don’t see any way out in the foreseeable future, and what a tragedy.

As of my second year paper, I’m really working hard to develop a model with liquidity / safety trap, I feel better than the last time I try to write a model myself, and I hope at least my model is on the right track.