Archive for February, 2009

What is the responsibility of the government in times of recession? What is meant by “stimulating the economy”?

US GDP (in the long run) = number of working people * productivity of each working person.

Thus there are three levers the government can pull today to  increase GDP by 2025.

1. Increase the number of people
2. Increase our productivity
3. Increase the number of people willing to work

The first would require increased immigration or a higher birth rate. The second is a function of education and the capital stock (which the government is in the habit of depleting) and the third (in the case of full employment) is a matter of personal choice.

Over the long run, there is very little the government can do to increase per capita GDP other than ensuring optimal productivity of the workforce and creating conditions which would ensure full (or close to full) employment without inflation. Sacrificing productivity is always the long term peril as labor is shifted to the public sector.

On the demand side of the equation, the government has the option of preventing people from saving and enforcing spending. Of course, in the longer run, the only option is preventing people from spending or saving and allowing the government to do the spending for them. Consumption is merely shifted from the private sector to the public sector with no net increase in demand on the generous assumption that government spending is as efficient as private spending.

Hayek gave a convincing critique of government action’s ability to stimulate “aggregate demand.” Hayek viewed the boom and bust of the business cycle as primarily a monetary phenomenon created by governments’ artificial inflation of money and credit.

Sound money policy, conversely, allowed the disparate knowledge of millions of economic actors to be conveyed through the price system, rationally allocating capital and labor through relative prices. The problem with government attempts to manipulate the economy through fiscal policy — spending that takes resources away from those who are productive and redistributes it to politically favored interests — is that it is audacious. It assumes that government knows better how to spend and invest than individuals acting in their families’ best interest.

“The real question,” according to Hayek, “is not whether man is, or ought to be, guided by selfish motives but whether we can allow him to be guided in his actions by those immediate consequences which we can know and care for or whether he ought to be made to do what seems appropriate to somebody else who is supposed to possess a fuller comprehension of the significance of these actions to society as a whole.”

The usual retort to this argument is a variant on “in the long run we are all dead”. In the short run, then, the role of the government is to act as a counter-cyclical economic agent. Short runs turn easily into long runs, though, and short-lived is the president who decides the economy needs not “stimulating” but … what? We don’t even have a word for it.

David Brooks expressed this thought succinctly, if somewhat belatedly, with his call for “epistemological modesty”

Many people have pointed out that stocks all become perfectly correlated in times of crisis. That’s not strictly true but correlations do increase dramatically. Over the past six months (August 4th, 2008 to January 30th, 2009) notice how correlations (for a portfolio containing a selection of the Dow components) have averaged 0.67 and volatility across the portfolio has been 3.1% for the daily return standard deviation.

 

Â	Â	BAC	GE	IBM	INTC	JNJ	KO	MCD	MMM	MRK	MSFT	PFE	PG	T	WMT	Return	StdDev
Bk Of America Cp	BAC	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	-95.8%	9.8%
Gen Electric Co	GE	0.63	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	-80.9%	4.8%
Intl Business Mac	IBM	0.66	0.68	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	-48.1%	3.0%
Intel Corporation	INTC	0.57	0.64	0.74	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	-66.9%	4.1%
Johnson And Johns	JNJ	0.50	0.58	0.67	0.69	Â	Â	Â	Â	Â	Â	Â	Â	Â	Â	-28.4%	2.5%
Coca Cola Co The	KO	0.39	0.45	0.56	0.66	0.72	Â	Â	Â	Â	Â	Â	Â	Â	Â	-35.8%	2.8%
Mcdonalds Cp	MCD	0.54	0.62	0.66	0.66	0.69	0.66	Â	Â	Â	Â	Â	Â	Â	Â	-5.5%	2.7%
3 M Company	MMM	0.56	0.66	0.68	0.68	0.77	0.66	0.75	Â	Â	Â	Â	Â	Â	Â	-39.3%	3.0%
Merck Co Inc	MRK	0.55	0.62	0.71	0.75	0.80	0.66	0.73	0.72	Â	Â	Â	Â	Â	Â	-23.6%	3.5%
Microsoft Corpora	MSFT	0.58	0.55	0.75	0.80	0.72	0.68	0.68	0.68	0.73	Â	Â	Â	Â	Â	-54.0%	4.0%
Pfizer Inc	PFE	0.61	0.60	0.66	0.70	0.76	0.64	0.67	0.71	0.80	0.70	Â	Â	Â	Â	-37.5%	3.2%
Procter Gamble	PG	0.53	0.62	0.68	0.69	0.84	0.70	0.73	0.78	0.82	0.72	0.77	Â	Â	Â	-30.1%	2.6%
At&T Inc.	T	0.60	0.57	0.72	0.72	0.77	0.64	0.69	0.69	0.79	0.75	0.75	0.76	Â	Â	-29.7%	3.6%
Wal Mart Stores	WMT	0.44	0.51	0.57	0.57	0.75	0.61	0.72	0.66	0.71	0.61	0.64	0.73	0.66	Â	-34.4%	2.7%
Exxon Mobil Cp	XOM	0.49	0.56	0.71	0.72	0.81	0.64	0.71	0.72	0.78	0.76	0.76	0.78	0.81	0.67	1.9%	4.3%
Portfolio																-44.6%	3.1%

Historically, the same portfolio has exhibited correlations between the various components which have been considerably lower. In fact, over the past twenty years (February 2nd, 1989 to Jan 30th, 2009), correlations have averaged 0.32, approximately half the correlation we have seen recently. The standard deviation of the daily returns was only 1.1%