Speculating about the Nobel

Next week, we can expect the winner to be announced for this year's Nobel Prize in Economics. (Last year, the Aplia Econ Blog posted an article about the previous winner, Edmund S. Phelps.) This weekend will see lots of speculation over who will take the prize. Proving there's a market for everything, Intrade posted its odds on this year's prospective Nobel laureates, and allows speculators to bet on who they think will win (thanks to Greg Mankiw for finding this site). The early favorite on Intrade (though trading has been extremely light) is the University of Chicago's Eugene Fama. Truth be told, Professor Fama is my favorite for this year's Nobel (at least, my favorite non-Aplian!).

It's a challenging matter determining how to judge academics relative to each other, especially when they may publish in significantly different fields. The number of citations an academic receives is probably the gold standard for measuring performance in academia. An author receives a citation when a later author recognizes the original author's work as contributing to the later author's own research. This site seeks to objectively measure economists' citations, but applies a weighting scheme to control for individually authored papers relative to co-authored papers and for the time elapsed since papers were cited. Eugene Fama also resides at the top of this list (though a lot of us at Aplia think number 21 on the list deserves a good look too).

Professor Fama has made major contributions to the finance field with his work on market efficiency and asset pricing. He is regarded by many as the father of the efficient market hypothesis. In the early 1990s, he published a series of papers with Kenneth French in which they challenged the Capital Asset Pricing Model's assertion that a stock's market beta is the primary determinant of variations in stock returns. They argued that the market and its participants are too complex to be encapsulated by a single factor. In an article entitled "The Cross-Section of Expected Stock Returns," they developed a three-factor model that tried to explain stock returns using two observed anomalies. They incorporated the fact that small companies tend to outperform big companies, while value stocks (with higher book/market ratios) tend to outperform growth stocks (with lower book/market ratios). Since the paper's publication, Fama-French's three-factor model has become a fundamental evaluation tool in the portfolio management industry.

Discussion Questions

1. Why is an economist's number of citations a relevant measure for his or her impact on the field?

2. The citation list weights recent citations more heavily than older ones. Why might this distinction be relevant when judging an academic?

3. Are markets efficient?

4. There have been a few times in stock-market history when crashes (huge stock-price declines) occurred, such as the stock-market crashes of 1929 and 1987 and the burst of the Internet bubble. What would an analyst who believes in market efficiency say to explain these events?

A Failure of Markets?

As everyone learns halfway through their first principles of economics course, sometimes markets "fail." Many economists argue, however, that the so-called failure of markets is just the reverse: it's the fact that there aren't enough active markets to reach an efficient outcome.

But can there be too many markets? Consider the latest problem with the housing market. In the good old days, when you took out a loan to buy a house, you had to convince the lender that you were creditworthy. After all, if you defaulted on your loan, they would be the one holding the bag. So they had a strong incentive to make sure that you could make your monthly payments.

This isn't the way loans work anymore, thanks to a financial innovation called mortgage-backed securities. What happens is this: when a homebuyer takes out a loan from a bank, the bank bundles that loan with many other loans to create a kind of mutual fund—except that instead of containing stock from hundreds of companies, this fund includes the debts (mortgages) of thousands of homeowners. The idea is simple: as with any mutual fund, even if a single homeowner defaults, it has a negligible effect on the value of the overall fund. The fund's price should reflect the overall risk of all the homeowners rather than the particular risk of any one homeowner.

This notion illustrates the concept of diversification—the fact that although one borrower may have considerable risk, much of that risk is unique, or diversifiable. A well-diversified portfolio of mortgages is only subject to systematic, or non-diversifiable, risk, and its value should reflect that. In other words, with a new kind of security and a market for it, the capitalist system becomes more efficient, because it spreads borrowers' risk across a wide class of investors rather than concentrating it on single lenders (banks, in this case).

So what's wrong with this picture? Think back to the initial lender. They know that they're not making a long-term loan—all they're doing is making a loan that they're then going to sell in this new market. Once they've sold the loan, their exposure to the loan's risk is over. Therefore, they have little incentive to see whether a homeowner can actually afford the payments, because they no longer bear responsibility for the credit decision. Quite the reverse, in fact: they have an incentive to sell the mortgage even if the homeowner cannot afford the payments—for example, by setting a low teaser rate that starts out fixed, but then balloons into a drastically higher variable rate. This has been one root cause of the various scandals about predatory lending practices that have been in the news in the last few months.

In the meantime, those looking to buy a home with no money down might take some advice from Saturday Night Live:



Discussion Questions

1. The crisis in the financial markets has caused some people to lose their jobs and made it harder to apply for a home loan, causing home sales to decline, both of which are very upsetting to Jim Cramer. Indeed, whenever a bubble bursts, lots of people get hurt, or at least find themselves considerably worse off than they were in the artificially inflated world of the bubble. Suppose you were a policymaker overseeing a market in which people were prospering in a way that was unsustainable. What would you do?

2. Cramer practically begged the Federal Reserve to intervene, which it did by lowering the discount rate (though not, presumably, because Jim Cramer asked it to). Does this get at the root cause of the problem? If not, what would?

3. How should society decide who gets to own a home and who does not? What would be the ideal set of institutions that could help achieve the optimal solution to such a problem? Could mortgage-backed securities play an important role in your solution?

Oil Shock, Part I: The Microeconomic View

Economists use the term "supply shock" to refer to an unexpected event that causes a sharp change in the supply of a good. A classic example occurred recently when BP closed down the Prudhoe Bay oil field after finding "unexpectedly severe corrosion" in a pipeline. Pumping about 400,000 barrels per day, the pipelines from Prudhoe Bay carry about 8% of the nation's domestic oil production.

The chain of events that followed the announcement of the shutdown present a textbook example of economics in action. According to the New York Times:

Word of the shutdown rattled global commodities and equities markets. In the United States, oil prices rose more than two dollars a barrel. The benchmark contract for light, sweet crude to be delivered next month rose as high as $77.30 a barrel before settling at $76.98 a barrel in New York trading. Prices rose even higher in London, where Brent crude for September delivery closed at a record $78.30 a barrel…

Stocks, meanwhile, fell in American trading and slid across Europe. Major indexes in Britain, Germany and France all posted substantial declines for the day.

In microeconomic terms, the Prudhoe Bay closure shifts the supply curve of oil to the left, increasing the equilibrium price and decreasing the quantity of oil in the market (Figure A). Because oil is so important for the production of goods and services, an increase in its price will increase business costs worldwide (Figure B). Because higher costs reduce firms' profits, investors bid down stocks in equity markets.

See Part II of this post for the macroeconomic impact of this supply shock.

1. Why do unexpected changes, such as this one, impact the stock market so much more than expected changes?

2. Which goods and services are most affected by changes in the price of oil? Draw a supply and demand diagram for one of those goods. How will the closing of the oil field affect the market you chose?

3. BP has been plagued by safety problems in the past few years. Like any company, it faces a tradeoff between safety and profitability. Using cost-benefit analysis, how would you find the optimal level of safety? Do you think BP chose the optimal level, or do you think it spent too little on safety? How could you find out the answer to that question?

Why Does Bernanke's Small Talk Move Markets?

Consider the Bartiromo Affair: At a media dinner party, Federal Reserve Chairman, Ben Bernanke tells CNBC reporter Maria Bartiromo that Wall Street types underestimate his inflation-fighting credentials and expresses his willingness to continue raising the Fed's interest rate target in order to check inflation. Ms. Bartiromo finds the comments newsworthy, reports the chairman's sentiments on her CNBC program, and sets off a sharp decline in stock prices just before the market closed on Monday, May 1. Keep in mind that stock prices move up and down all of the time for lots of different--often inexplicable--reasons. Ms. Bartiromo's TV show may or may not explain the movements at the end of the day on May 1. Generally, however, changes in interest rates (or expected changes) send stock prices in the opposite direction--that is, interest rates and stock prices are negatively related. Why?

The Fed influences a variety of interest rates in the economy by targeting changes in the federal funds rate. Interest rates have a direct effect on stock values, because investors have required returns they demand for holding financial assets, like stocks. Suppose an investor thinks she can earn a 5% return on her money by purchasing financial assets. Holding risk aside, she will only buy a stock if she expects it to provide a 5% return, but if the Fed raises interest rates, investors will require higher returns for holding stocks.

We can perform a crude stock valuation by assuming a stock will pay a constant dividend forever (a perpetuity) and investors’ returns are derived solely from dividends. Under this assumption, the price, or present value, of a stock simplifies to:

Present Value of Stock = Dividends per Share / Interest Rate

Suppose IBM's stock earns $1 per share. At an interest rate of 5%, the present value of IBM's stock is $1 / 0.05 = $20. If tightened monetary policy raises the interest rate to 6%, our crude valuation model predicts the stock’s value falls to $1 / 0.06 = $16.67. If dividends per share remain constant, an increase in the interest rate reduces stock values.

1. According to this valuation model, what happens to stock prices (present value) when the Fed targets lower interest rates?

2. Peoples' expectations about interest rates or dividends per share change stock values as well. Excessively tight monetary policy (higher interest rates) can lead to an economic recession. What happens to corporate profits during recession? If people expect that tight monetary policy will lead to recession, what will happen to stock values?

3. How did Ms Bartiromo's report about the Fed chair's dinner party comments affect peoples' interest rate expectations? How will a change in interest rate expectations affect required returns and stock valuations?

4. The Federal Reserve is one of the only central banks without an explicit inflation target. As a result, there is still considerable guesswork involved in determining the Fed's tolerance for inflation--that's one reason the Fed chairman's offhand comments receive so much attention. Uncertainty about the inflation target makes it more difficult to anticipate monetary policy. In the absence of clear monetary policy goals, small bits of information that change expectations can disrupt financial markets.

Ben Bernanke is an advocate of explicit inflation targeting--publicly announcing an inflation target and committing the central bank to its achievement. Would an explicit inflation target take some of the mystery out of monetary policy? How would explicit inflation targets change the likelihood of another Bartiromo Affair? How might an explicit inflation target inhibit the Fed's use of monetary policy during an economic crisis?

Nell Henderson offers a more detailed account of the Bartiromo Affair in the Washington Post.

Vikas Bajaj discusses the links between Fed policies and changes in both American and foreign financial markets in a New York Times article.

The idea for the post comes from Paul Romer's Econ 510 community discussion forum. Thanks also to Chris Buzzard for shoring up the finance.