Grasping Reality on TypePad, by Brad DeLong

The reference is to the late tenth century English king who lost his kingdom to the invading Danes, Ethelred the Unready--in Old English Aethelraed Unraed. "Aethelraed" was his name, meaning "noble judgment." "Unraed" was attached to it as a pun--"unraed" meaning not "unready" but "bad judgment." It's a pun.

Anyway, Paul Krugman is good this morning:

George the Unready - New York Times : Iraqi insurgents, hurricanes and low-income Medicare recipients have three things in common. Each has been at the center of a policy disaster. In each case experts warned about the impending disaster. And in each case.... Knight Ridder's Washington bureau reports that from 2003 on, intelligence agencies "repeatedly warned the White House" that "the insurgency in Iraq had deep local roots, was likely to worsen and could lead to civil war." But senior administration officials insisted that the insurgents were a mix of dead-enders and foreign terrorists. Intelligence analysts who refused to go along with that line were attacked for not being team players. According to U.S. News & World Report, President Bush's reaction to a pessimistic report from the C.I.A.'s Baghdad station chief was to remark, "What is he, some kind of defeatist?"

Many people have now seen the video of the briefing Mr. Bush received before Hurricane Katrina struck... really striking, given the gravity of the warnings, is the lack of urgency Mr. Bush and his administration displayed in responding to the storm... Newsweek reports, for several days nobody was willing to tell Mr. Bush, who "equates disagreement with disloyalty," how badly things were going. "For most of those first few days," Newsweek says, "Bush was hearing what a good job the Feds were doing."

Now for one you may not have heard about. The new Medicare drug program got off to a disastrous start: "Low-income Medicare beneficiaries around the country were often overcharged, and some were turned away from pharmacies without getting their medications, in the first week of Medicare's new drug benefit," The New York Times reported. How did this happen? The same way... experts who warned of trouble ahead were told to shut up....

[O]ur country is being run by people who assume that things will turn out the way they want. And if someone warns of problems, they shoot the messenger. Some commentators speak of the series of disaster... as if it were just a string of bad luck. But it isn't. If good luck is what happens when preparation meets opportunity, bad luck is what happens when lack of preparation meets a challenge. And our leaders... think they can govern through a mix of wishful thinking and intimidation...

Impeach George W. Bush. Impeach Richard Cheney. Do it now.

Possibly the best Fafblog ever:

Fafblog! the whole worlds only source for Fafblog. :

Q. Why are we in Iraq?

A. For freedom! Recent intelligence informs us it is on the march.

Q. Hooray! Where's it marching to?

A. To set up a government of the people, by the people, for the people, and held in check by strict adherence to the laws of Islam.

Q. Huh! Freedom sounds strangely like theocracy.

A. No it doesn’t! It is representative godocracy, in which laws are written by the legislative branch, enforced by the executive branch, and interpreted by an all-powerful all-knowing deity which manifests its will through a panel of senior clerics.

Q. Whew! Is democracy on the march?

A. Democracy was on the march. Sadly, freedom and democracy were caught in a blizzard and freedom was forced to eat democracy to survive. It died as it lived: sautéed in garlic sauce with a side of scalloped potatoes. Democracy is survived by sectarian violence and fanaticism. In lieu of flowers, please send a coherent exit strategy.

There is more.

Lecture Notes on the Equity Premium: Part I
J. Bradford DeLong
March 2, 2006

There is, somewhere, a marginal investor: somebody just about indifferent between stocks and bonds. If the expected return to stocks were a little higher, he or she would move more money to stocks. If the extra risk associated with holding stocks were a little lower, he or she would move more money to stocks. In either case, that increase in demand for stocks would push their prices up, and so push the relative returns on stocks--which are the dividends that will be paid out on stocks in the future divided by the stocks' current price--down. But this marginal investor fears the risk as much as he or she values the return, and so does not move more money into stocks, and that is why the current price of stocks and the current value of the equity risk premium are what they are.

Now let's look at patterns of returns over the twentieth century, and try to figure out what this marginal investor has been seeing and thinking to make the equity risk premium what it has been, and then try to figure out what the current equity risk premium is.

Our first candidate marginal investor is someone who has some wealth that they want to invest for one year, and is considering whether to invest it in (relatively safe) one-year government bills (a "bill" is a short term bond) or in a (riskier) diversified portfolio of stocks. Figure 1 below plots the difference in returns for these two strategies for each year from 1900 to 2004--with the return differentials ranked from lowest to highest. 1931, with its (geometric) return differential of -60% (yes, 1931 was a bad year for the stock market) is at the far left; 1933 (the rich may not have voted for Roosevelt, but they certainly voted with their dollars that his "New Deal" was going to add value to American corporations) is at the far right.

Given this distribution of one-year returns over the twentieth century, the marginal one-year investor looks at it and reasons as follows:

Stocks certainly pay a healthier and higher return on average: over the twentieth century the inflation-adjusted real stock return has averaged 6.6% per year, while the real one-year Treasury bill return has averaged only 1.7% per year for an average gap of 4.9% per year. But look at all that extra risk: there's a 35% chance that you will do worse with stocks than bonds, a 10% chance that you will--relatively--lose more than 1/5 of your wealth if you put it in stocks, and in 1931 the (geometric) relative stock return was -60%! Considering the portfolio positions I already hold, the extra expected return to moving a little more of the wealth I'll need to spend next year out of bills and into stocks is simply not worth the risk.

Thus we understand why a--rational, reasonable, well-informed--marginal investor putting money away to spend in a year would not decide that stocks are underpriced, that the equity risk premium is appropriate. And so such a marginal investor would not put downward pressure on the equity risk premium.

The problem--the reason that the large value of the equity risk premium is called a "puzzle" is that the marginal one-year investor is not the only possible marginal investor. Consider the marginal twenty-year investor: somebody 40 with ten-year-old children who is putting money away to spend on his or her children's college, or somebody 50 saving for expenditures at 70 after they have retired. This marginal investor has to be satisfied with the configuration of asset returns as well. And what does the distribution of twenty-year-returns--either buy and hold a distributed portfolio of stocks (reinvesting the dividends) or buying and rolling over short-term Treasury bonds--look like? The answer is shown in Figure 2, which plots the twenty-year return differential over the twentieth century. The average return differential is (of course) the same: 4.9% per year. Over twenty years that cumulates to a lot: e^{20 x .049} = 2.67. But much more important is the lower tail: only 4% of the time do stocks do worse than bills over a twenty-year horizon. And the worst observation is the twenty years starting in 1965, when investing in stocks yields -0.84% per year less than investing in bills--a relative wealth loss of 17%.

What kind of investor would turn up a 96% chance of gain, associated with an expected more-than-doubling of relative wealth, that carries with it only a 4% chance of any relative loss and a maximum loss of 17% of relative wealth? Where is this twenty-year marginal investor, and what is he or she possibly thinking? All such twenty-year marginal investors should be furiously pulling much more money out of short-term bills and investing it into diversified portfolios of stocks, thus making the equity risk premium lower and stocks less of an overwhelmingly attractive long-run investment. That is the equity premium puzzle.

One possible answer that initially looked promising was that the marginal twenty-year investors had already moved all the money they could out of the short-term money market: that it was hard to short-sell Treasury bills (a large part of the value of them, after all, is certainty of immediate liquidity, which nobody other than the government can promise), and that the holders of Treasury bills are overwhelmingly institutions that needed them for specific institutional liquidity or transaction-cost-minimization reasons. The problem with this possible answer is that the same equity premium puzzle emerges when we look at twenty-year differential returns between diversified stocks and investment-grade corporate or longer-term bonds, which are extraordinarily widely held, and which do not have the special certain-liquid-value properties of short-term Treasury bills. Figure 3 shows the distribution analogous to that of Figure 2, where this time the marginal twenty-year investor is considering the relative returns to investing in a diversified stock portfolio (and reinvesting the dividends) as opposed to investing in a bond portfolio (and rolling maturing bonds over into new issues).

This time the lower tail is even smaller: in only 1% of the years in the twentieth century would investing in bonds for twenty years outperformed investing in stocks; and in that year--1929--the twenty-year returns to bonds would be only 8% ahead of the twenty-year returns to stocks. The equity premium puzzle is not due to the specific liquidity or collateral or other institutional properties of Treasury bills that make them especially valuable.

We have climbed into the box of the equity premium puzzle, which has now been locked and sealed with us on the inside. How are we going to get out of it? There are four possible roads, four possible arguments. They are:

1. The twenty-year-horizon marginal investors are very, very risk averse--so averse to risk that they should be too scared to dare get into the bathtup (Daniel Altman cleaned this up a bit).
2. There are no twenty-year-horizon marginal investors. Institutional features of Wall Street force everybody able to mobilize significant money to have a very, very short time horizon.
3. The distribution of actual returns over the twentieth century does not match the true ex ante distribution of returns: we've been very lucky. If we hadn't been so lucky, relative stock returns would not look nearly so impressive and there would be no equity premium puzzle.
4. Investors over the course of the past century have misjudged the return distribution: the true ex ante long-run return distribution matches the ex post distribution we see in Figures 2 and 3, but for one of a number of possible reasons investors have greatly overestimated the risk associated with lon-run diversified stock market positions.

To be continued...

I promised the journalism students that I would come up with a list of smart, talkative, and thoughtful macroeconomists that they could refer to. My first thought was to send out the list of people who have signed up for Martin Wolf's economists' forum . But I can't: the list is ovary-free.

So let me add a random free-associated twenty who ought to be on the list: Anne Krueger, Valerie Ramey, Laura Tyson, Catherine Mann, Carmen Reinhart, Susan Collins, Christie Romer, Kristen Forbes, Karen Lewis, and Helene Ray.

Here's Martin Wolf's list:

Alberto Alesina, Harvard University
Olivier Blanchard, MIT
Willem Buiter, London School of Economics, Goldman Sachs
Ricardo Caballero, MIT
Stephen Cecchetti, Brandeis
Paul Collier, Oxford University
Richard Cooper, Harvard University
Guillermo de la Dehesa, Goldman Sachs
Brad De Long, Berkeley
Peter Diamond, MIT
Michael Dooley, University of California - Santa Cruz
Sebastian Edwards, UCLA
Barry Eichengreen, Berkeley
Martin Feldstein, NBER
Jeffrey Frankel, Kennedy School
Richard Freeman, Harvard University
Fan Gang, China Academy of Social Sciences
Wynne Godley, Cambridge University
Robert Gordon, Northwestern University
Ricardo Hausmann, Kennedy School
Glenn Hubbard, Columbia University
Taketoshi Ito, Tokyo Univeristy
Robert Laurence, Kennedy School
Richard Layard, London School of Economics
Robert Lucas, Chicago University
Gregory Mankiw, Harvard University
Alan Meltzer, Carnegie-Mellon
Ronald McKinnon, Stanford University
Edmund (Ned) Phelps, Columbia University
Jean Pisani-Ferry, Bruegel
Richard Portes, London Business School
Adam Posen , Institute for International Economics
Helmut Reisen, OECD
Danny Rodrik, Kennedy School
Kenneth Rogoff, Harvard University
Andrew Rose, University of California - Berkeley
Nouriel Roubini, New York University
Jeffrey Sachs, Columbia University
Andrei Sapir, European Centre for Advanced Research in Economics
Paul Seabright, Toulouse
Hans-Werner Sinn, University of Munich
Lawrence Summers
Tony Venables, London School of Economics
Juergen von Hagen, University of Bonn
Robert Wade, London School of Economics
Adrian Wood, Oxford University
Charles Wyplosz, Graduate Institute of International Studies
Luigi Zingales, Chicago University

Added to the pile this week:

1. (2005), The Silver Spoon (New York: Phaedon: 0714845310).

2. Jeffrey Frieden (2006), Global Capitalism: Its Fall and Rise in the Twentieth Century (New York: Norton: 0393058085).

3. John Scalzi (2006), Ghost Brigades (New York: Tor: 0765315025).

The only one of them I have managed to dip into so far is Scalzi's Ghost Brigades. It's very good, but not quite as good as his earlier Old Man's War. It's hard to write about without spoiling something. I found there was a little too much of "tell, not show." And I never could wrap my mind about the motivations of the antagonist.

Scott Rosenberg writes:

Scott Rosenberg's Links & Comment : 85 percent of U.S. troops in Iraq polled by Zogby "said the U.S. mission is mainly 'to retaliate for Saddam's role in the 9-11 attacks.'"

This is the saddest thing I have read in a long time. (Thanks to Tim at War Room for pointing it out.) comment

Lying, mendacious swine. Impeach them now.

Matthew Yglesias is bemused:

Dialogue of the Deaf | TPMCafe : My understanding of [GENE] Sperling's view is that he thinks the government ought to provide health care for all Americans, increased investment in education and other public services, a tax code more favorable to working people and less favorable to the wealthy, labor law reform so as to mandate card-check election procedures, and pursue reductions in farm subsidies inside the framework of the Doha Round of WTO talks.

Faux's view, by contrast is that the government ought to provide health care for all Americans, increased investment in education and other public services, a tax code more favorable to working people and less favorable to the wealthy, labor law reform so as to mandate card-check election procedures, and pursue reductions in farm subsidies outside the framework of the Doha Round of WTO talks because we shouldn't sign any new trade deals unless or until the trade deficit is closed.

This struck me as a very narrow disagreement, all things considered. It would be remarkable if two serious thinkers could get in a room together and agree about everything. When you agree about 90 percent of stuff, you ought to be pals. What's more, the disagreement was, to my view, of questionable relevance. Faux's notion of unilateral US reductions in agricultural protectionism is substantively correct, but politically impossible. Sperling's vision of the Doha Round isn't completely inconceivable but seems unlikely to happen irrespective of who runs the USA due to European and Japanese opposition. But even if the disagreement is relevant, it's just not all that significant relative to the very large range of things they agree about.

Faux and Sperling, however, didn't seem to see it that way at all. The debate was incredibly heated for an exchange on the dull-but- important topic of macroeconomic policy and there was a remarkable amount of vehemence. What's more, it didn't sound like vehement disagreement on a narrow point in the context of broad agreement, it sounded as if both participants, but especially Faux, felt they were engaged in a very grand clash of visions.

I'm totally open to the possibility of a grand clash of progressive visions but, honestly, I didn't see it

What's going on inside China? Richard McGregor reports for the Financial Times:

A fierce battle hobbles China’s march to the market Liu Guoguang, a once influential but long retired Marxist economist, recently burst back onto the scene with an incendiary warning for the Chinese government. If it did not rein in market reforms and deal with the growing, gaping rich-poor divide, China would “change its colour”: code for the “red” Communist party losing power.... Almost overnight, symposiums were staged around the country to study his “economic thought”....

On one level, the attack by the elderly economist seemed to symbolise a backlash against Mr Hu’s government. But such straightforward interpretations no longer apply in a China where few debates fit neatly into an old-style Marxists-versus-the-market template. How, after all, could Mr Hu be criticised for the rich-poor gap when he, along with Mr Wen, has made tackling it a centrepiece of his economic policy?

When Mr Hu took over from Jiang Zemin three years ago, he inherited a country wealthier than it had been for generations but also more unequal. China is now less equal than the US and Russia, according to the World Bank, and income inequalities are still widening.... Even as official poverty levels have been falling and literacy rates rising, education researchers are discovering that drop-out rates among rural children from junior secondary schools average 30-40 per cent. “This is the most under-reported story in China – the country’s massive failure to educate its rural youth in the 1990s.” says Yasheng Huang.... Mr Hu and Mr Wen... declaring that addressing the rich-poor gap and improving the lot of those left behind by the boom years, especially farmers, would be a hallmark of their administration. Their policy response, however, has so far satisfied few.... To old Marxists such as Mr Liu, Mr Hu and Mr Wen have not done enough to uphold government – and, by implication, party – control of the economy.... [C]elebrity economists such as Lang Xianping... have criticised privatisation as a slow-motion Russian-style theft of state assets. Many mainstream economists counter that the Hu-Wen administration is shaping up as a disaster precisely because it refuses to tackle the state’s still dominant role....

For the Marxists, the growth in inequality and popular disenchantment with reform are directly related to the rise of the entrepreneurial economy and private wealth. Mr Huang at MIT turns this proposition on its head.... “The resilience of the state sector is a result of vast, powerful vested interests, powerful because so many of the remaining state enterprises are essentially wholly-owned subsidiaries of government agencies,” he says. “The best examples are the health and education sectors. Price inflation in these sectors since the mid-1990s has been rampant. At the same time,private entry into these two sectors has been minimal. Bureaucratic windfalls are enormous.”...

In the one area that there is a consensus on the need for urgent action – the countryside and small villages where most Chinese live – there is also increasing division about the proper response.... In rural areas the most sensitive issue, and one the government so far has dared not touch, also revolves around giving greater play to the market, with all the risk that entails. City residents can now buy and sell their homes but rural land remains under collective ownership and cannot be traded by farmers. As a result, land in rural areas has less than 10 per cent of the value of urban land.... Such differentials offer an irresistible financial incentive to corrupt officials to take rural land, reclassify it and sell it on for homes or factories....

---

Zhou Xiaochuan has been an unusually activist governor of the People’s Bank of China.... So for anyone attuned to the subterranean rhythms of Chinese politics, an article published last month in a small Hong Kong newspaper attacking Mr Zhou had ominous undertones. The article gave him no credit for his policy work as central bank chief, instead damning him as unprofessional. His support for market devices such as derivatives would attract foreign “wolves” into China and lead to an explosion in bad debts.... It is no secret why Mr Zhou and his supporters have accumulated enemies over the past year. At a time when market reforms have been under pressure, they have pushed ahead with their agenda and achieved notable successes....

Mr Zhou has not strayed from the orthodox party line on politics, but a number of prominent economists who are broadly aligned with his reforms have suffered in the crackdown on liberal think-tanks and non-governmental organisations in the past year. Economists Mao Yushi and Wu Jinglian have both had research institutes closed, in Beijing and Shanghai respectively. Others, such as Zhang Weiying of Peking University, have been taken to task for being too close to China’s new breed of entrepreneurs.... Hu Jintao and Wen Jiabao, prime minister, have engineered a stifling political climate, which has seen numerous newspapers closed and editors sacked.... [T]heir views on economics and on issues such as privatisation and foreign investment in banks are much less clear. Some see that as a product of weakness and indecision....

“We are all very much on the defensive right now,” says another well-known economist with close connections to the liberal camp. The economist... was stunned by the reaction to a recent speech he delivered in Beijing to a university economics faculty, a group that he thought might be open to ideas and debate.... Members of the faculty rose not to debate but to denounce him. “We must keep in mind our [foreign] enemies,” one professor told him, to wide applause. “We are still a socialist country.”...

The classroom thumps, and everyone surfs their laptops over to:

Recent Earthquakes - Map for 122-38: Maps of Recent Earthquake Activity in California-Nevada

Magnitude 3 just over the Berkeley Hills at 11:34 AM PST on March 1, 2006.