Monthly Archive for January, 2009


More on fiscal multipliers

In my previous piece on this, I highlighted that the fiscal multiplier will be different for different ways of “spending” the money (I put spending in quotes because there is also the possibility of simply offering tax cuts).  Via Menzie Chinn, I see that the Congressional Budget Office has put out estimates of the fiscal multiplier for different forms of fiscal stimulus:

That’s table 5 from this document.


How to value toxic assets (part 4)

Okay.  First, a correction:  There is (of course) a market for CDOs and other such derivatives at the moment.  You can sell them if you want.  It’s just that the prices that buyers are willing to pay is below what the holders of CDOs are willing to accept.

So, here are a few thoughts on estimating the underlying, or “fair,” value of a CDO:

Method 1. Standard asset pricing considers an asset’s value to be the sum of the present discounted value of all future income that it generates.  We discount future income because:

  • Inflation will mean that the money will be worth less in the future, so in terms of purchasing power, we should discount it when thinking of it in today’s terms.
  • Even if there were no inflation, if we got the money today we could invest it elsewhere, so we need to discount future income to allow for the (lost) opportunity cost if current investment options generate a higher return than what the asset is giving us.
  • Even if there were no inflation and no opportunity cost, there is a risk that we won’t receive the future money.  This is the big one when it comes to valuing CDOs and the like.
  • Even if there’s no inflation, no opportunity cost and no risk of not being paid, a positive pure rate of time preference means that we’d still prefer to get our money today.

The discounting due to the risk of non-payment is difficult to quantify because of the opacity of CDOs.  The holders of CDOs don’t know exactly which mortgages are at the base of their particular derivative structure and even if they did, they don’t know the household income of each of those borrowers.  Originally, they simply trusted the ratings agencies, believing that something labeled “AAA” would miss payment with probability p%, something “AA” with probability q% and so on.  Now that the ratings handed out have been shown to be so wildly inappropriate, investors in CDOs are being forced to come up with new numbers.  This is where Knightian Uncertainty is coming into effect:  Since even the risk is uncertain, we are in the Rumsfeldian realm of unknown unknowns.

Of course we do know some things about the risk of non-payment.  It obviously rises as the amount of equity a homeowner has falls and rises especially quickly when they are underwater (a.k.a. have negative equity (a.k.a. they owe more than the property is worth)).  It also obviously rises if there have been a lot of people laid off from their jobs recently (remember that the owner of a CDO can’t see exactly who lies at the base of the structure, so they need to think about the probability that whoever it is just lost their job).

The first of those is the point behind this idea from Chris Carroll out of NYU:  perhaps the US Fed should simply offer insurance against falls in US house prices.

The second of those will be partially addressed in the future by this policy change announced recently by the Federal Housing Finance Agency:

[E]ffective with mortgage applications taken on or after Jan. 1, 2010, Freddie Mac and Fannie Mae are required to obtain loan-level identifiers for the loan originator, loan origination company, field appraiser and supervisory appraiser … With enactment of the S.A.F.E. Mortgage Licensing Act, identifiers will now be available for each individual loan originator.

“This represents a major industry change. Requiring identifiers allows the Enterprises to identify loan originators and appraisers at the loan-level, and to monitor performance and trends of their loans,” said Lockhart [, director of the FHFA].

It’s only for things bought by Fannie and Freddie and it’s only for future loans, but hopefully this will help eventually.

Method 2. The value of different assets will often necessarily covary.  As a absurdly simple example, the values of the AAA-rated and A-rated tranches of a CDO offering must provide upper and lower bounds on the value of the corresponding AA-rated tranche.  Statistical estimation techniques might therefore be used to infer an asset’s value.  This is the work of quantitative analysts, or “quants.”

Of course, this sort of analysis will suffer as the quality of the inputs falls, so if some CDOs have been valued by looking at other CDOs and none of them are currently trading (or the prices of those trades are different to the true values), then the value of this analysis correspondingly falls.

Method 3. Borrowing from Michael Pomerleano’s comment in rely to Christopher Carroll’s piece, one extreme method of valuing CDOs is to ask at what price a distressed debt (a.k.a. vulture) fund would be willing to buy them at with the intention of merging all the CDOs and other MBSs for a given mortgage pool so that they could then renegotiate the debt with the underlying borrowers (the people who took out the mortgages in the first place).  This is, in essense, a job of putting Humpty Dumpty back together again.  Gathering all the CDOs and other MBSs for a given pool of mortgage assets will take time.  Identifying precisely those mortgage assets will also take time.  There will be sizable legal costs.  Some holders of the lower-rated CDOs may also refuse to sell if they realise what’s happening, hoping to draw out some rent extraction from the fund.  The price that the vulture fund would offer on even the “highly” rated CDOs would therefore be very low in order to ensure that they made a profit.

It would appear that banks and other holders of CDOs and the like are using some combination of methods one and two to value their assets, while the bid-prices being offered by buyers are being set by the logic of something like method three.  Presumably then, if we knew the banks’ private valuations, we might regard the difference between them and the market prices as the value of the uncertainty.

Other posts in this series:  1, 2, 3, [4], 5, 6.


The fiscal multiplier

This is mostly for my EC102 students.  There’s been some argument in the academic economist blogosphere over the size of the fiscal multiplier in the USA.  The fiscal multiplier is a measure of by how much GDP rises for an extra dollar of government spending.  There are several main forces in determining it’s size:

  • The Marginal Propensity to Consume (MPC) determines the upper limit of the multiplier.  Suppose that for each extra dollar of income, we tend to spend 60 cents in consumption.  Because the economy is a massive, whirling recycling of money – I spend a dollar in your shop, you save 40 cents and spend 60 cents in the second shop, the guy in the second shop pockets 40% of that and spends the rest in the third shop and so on – one dollar of government spending might produce 1+ 0.6 + 0.6^2 + 0.6^3 + … = 1 / (1 – 0.6) = 2.5 dollars of GDP.
  • The extra government spending needs to be paid for, which means that taxes will need to go up.  For it to be a stimulus now, it’ll typically be financed through borrowing instead of raising taxes now (i.e. taxes will go up later).  If people recognise that fact, they may instead choose to consume less and save more in anticipation of that future tax bill, therefore lowering the multiplier.  If it gets to a point where there is no difference between raising-taxes-now and borrowing-now-and-raising-taxes-later, we have Ricardian equivalence.
  • If the extra government spending is paid for by borrowing, that will raise interest rates (Interest rates and the price of bonds move in opposite directions – by selling more bonds, the government will be increasing their supply and thus lowering their price; hence, the interest rate will rise).  If the interest rate goes up, that makes it more expensive for private businesses to borrow, which means that private investment will go down.  This is the crowding-out effect.  Since GDP = Consumption + Private Investment + Government spending + Net exports, this will lower the multiplier as well.
  • The size of the multiplier will also depend on the size of the extra government spending.  Generally speaking, the multiplier will be smaller for the second extra dollar spent than for the first and smaller again for the third.  That is, increasing government spending exhibits decreasing marginal returns.  This is because the second and third points listed above will become more and more relevant for larger and larger amounts of extra government spending.
  • Everything gets more complicated when you start to look at current tax rates as well. An alternative to a debt-funded expansion in spending is a debt-funded reduction in revenue (i.e. a tax cut). The multiplier can be very different between those two circumstances.
  • Then we have what is arguably the most important part: where the extra spending (or the tax cut) is directed. Poor people have a much higher marginal propensity to consume than rich people, so if you want to increase government spending, you should target the poor to get a larger multiplier. Alternatively, cutting taxes associated with an increase in a business (e.g. payroll taxes) will lower the cost of that increase and produce a larger multiplier than a tax-cut for work that was already happening anyway.
  • Next, it is important to note that everything above varies depending on where we are in the business cycle.  For example, the crowding-out effect will be strongest (i.e. worst) when the economy is near full employment and be weakest (i.e. less of a problem) when the economy is in recession.
  • Finally, we have the progressivity of the tax system.  This won’t really affect the size of the multiplier directly, but it is important that you think about it. Rich people pay more tax than poor people, not just in absolute levels (which is obvious), but also as a fraction of their income. That means that the burden of paying back the government debt will fall more on the shoulders of the rich, even after you take into account the fact that they earn more.

Much of what you’ll read arguing for or against a stimulus package will fail to take all of those into account.  People are often defending their personal views on the ideal size of government and so tend to pick-and-choose between the various effects in support of their view.


Not good

Uh oh.  This doesn’t look good at all.  I did Engineering for my undergrad, spent five years working in Computer Science and am now becoming an economist.

On the plus side (for me, at least), my wife studied Philosophy and Political Science in her undergrad, is now in Law school and speaks four-and-a-half languages.


One of the challenges in negotiation for Israel/Palestine

There’s a perennial idea of proposing Northern Ireland as a model of how progress might be achieved in the fighting between Israelis and Palestinians.  After reading this recent posting by Megan McArdle, one of the difficulties in such an idea becomes plain.

In Northern Ireland, both sides had moral, if not logistical, support from larger powers that were themselves allies.  So while the nationalists found it difficult to trust the British government, they would generally trust the US government, who in turn trusted the British government, while the same chain applied in reverse for the loyalists.

By contrast, while Israel receives moral and logistical support from the USA, none of America’s close allies really comes close to giving the Palestinian cause at large, let alone Hamas in particular, the sort of tacit support that America gave the Irish nationalists.