Some thoughts on market expectations from Trump

My previous post on what stock markets expected from Trump’s economic policies relied on a paper from Eric Zitzewitz and Justin Wolfers, claiming that markets expected S&P 500 stocks to be worth about 12% more under Clinton than under Trump. From there, I argued that a lot of the expected effect could probably be attributed to expected effects on GDP.

The thing is, the market’s opinion of Trump seemed to quickly reverse itself after the election. Justin Wolfers himself attempted to explain why this happened, noting that previously, markets had reacted negatively to increases in Trump’s likelihood of winning (and vice versa). In fact, the S&P 500 is up about 13% since November 8 (with about a 1.5% gain in the week after the election). There are a few questions to be asked here.

Have U.S. stocks risen because of the expectation of a corporate tax cut?

The IGM Economic Experts Panel said yes on January 17th (see Question A). But since then, various things have happened that would seem to reduce the probability of this happening. Previously, more heavily-taxed firms were doing better than the S&P average (probably because of the expectation of a tax cut), but since December 2016, this has reversed. Tax reform bills have been delayed, and the administration has admitted that it will probably not be able to pass corporate tax reforms by its August 2017 deadline. Also, while PredictIt markets are often illiquid and inefficient, PredictIt’s market for whether a corporate tax rate cut will happen in 2017 has fallen from an estimate of 80% on March 1, 2017 to 32% today.

The latter two details could be explained away if the market thinks a corporate tax cut will happen in 2018 or later. But heavily-taxed firms should still have had a higher gain since the election than the whole market, and they haven’t.

Scott Sumner points out that the market had little reaction to the failure of the first version of the American Healthcare Act, which could have been an indication of the difficulty of getting House Republicans to pass Trump’s desired reforms. He also observed in that post that markets in other countries, including China and Japan, rallied after the election. This is still the case with Japanese markets (the Nikkei 225 is about 14.6% higher than it was on November 8th), although not with Chinese markets (the SSE Composite Index is down about 1.2% since November 8th).

So the situation here is quite murky, and if anything, it seems like the chances of a corporate tax reform are lower than they used to be. It is worth noting that the S&P has changed very little from its level on March 1, 2017 (it’s about 0.8% higher today), so most of the rally was before then. So perhaps one could argue that the rally happened due to expectations of lower corporate rates and then has cooled off, but if so, why hasn’t the S&P fallen from its peak?

Have U.S. stocks risen because of the expectation of higher GDP growth?

The IGM Economic Experts Panel said no on January 17th (see Question B). This seems reasonable, both from looking at market expectations and from considering relevant supply and demand factors.

For inflation, we have 10-year Treasury Inflation-Protected Securities markets, which indicate an expected rate of about 1.8%. (This is for CPI-U, although we would expect that CPI-U and the GDP deflator would at least be in the same ballpark.) There is a Hypermind market for what nominal GDP growth will be in 2017, with participants indicating an answer of 4.1%. (Scott Sumner posted about the introduction of this market, noting that its level of prize money will be at least $5000 and probably more.) Of these two markets, the Hypermind market is probably less reliable, but it still tells us something, and for reasons I’ll address below, a 4.1% nominal GDP growth rate is probably a reasonable estimate. These estimates lead us to a real GDP growth estimate of roughly 2.26% for 2017. 96% of participants in the Good Judgment Project attempting to predict real GDP growth for the second quarter of 2017 say it will be between 1% and 3%. The CBO estimates that real GDP growth for 2017 will be about 2.1%.

Is 2.1-2.3% (or something close to it) a reasonable estimate? It probably is. It’s close to what real GDP growth rates have been in the past few years. Would anything change under the Trump administration that would significantly increase it? Probably not. Demand-side stimulus (such as tax cuts or infrastructure) is not guaranteed to even happen, and if it does, it could be offset by the Federal Reserve tightening monetary policy (and by crowding out, even without direct tightening). As for supply-side reforms that could increase GDP, it’s not clear what if anything will happen here, and it seems unlikely that anything that’s been talked about so far would raise real GDP growth rates to the 3-4% range that Trump administration officials have talked about. (A significant immigration increase could accomplish that in future years, and a nationwide push to encourage cities to scrap land use restrictions could potentially do that, but neither of those things have advocated prominently by Trump administration officials.)

So why have stocks gone up since the election?

It’s unclear. The expectation of a corporate tax cut late in 2017 or in 2018 (or perhaps later) could be the reason, but there should probably be more uncertainty about that happening now than there was earlier this year. Meanwhile, the S&P 500 price-to-earnings ratio is now about 25.55, which is high by historical standards. I don’t claim to be able to time the market or say with a large degree of certainty which way it will go, but a valuation this high is puzzling.

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What the market expects from Trump

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It’s been well over a year since anything’s been published on this blog. Good to be back!

Justin Wolfers, professor of economics at the University of Michigan, has recently argued that the stock markets react negatively to the possibility of Trump being elected President. And indeed, when the FBI announced today that they were looking into some of Hillary Clinton’s email messages again, stocks fell and volatility measures increased.

It’s worth remembering what the S&P 500 index is to see what the market is actually expecting from Trump:

S&P 500 index value = (1/the divisor)*(the price-to-earnings ratio for the whole S&P 500)*(S&P 500 earnings as a percentage of GDP)*(nominal GDP)

What would Trump supporters argue here? They could argue that the market is wrong about its expectations, and that it would initially fall but eventually rise if Trump is elected. In that case, they should bet accordingly by buying in the short-term period after Trump is elected (if he is elected). They could do the opposite if he isn’t elected (namely, once the market rises in the short run, start betting against it).

Or they could argue that the market expects nominal GDP to rise relative to trend but S&P 500 earnings as a a percentage of GDP (we’ll call this E/Y) to fall relative to trend. If there were no change in the divisor or in the P/E ratio, then E/Y would have to fall far enough that E would actually fall (relative to what the market would otherwise expect). What would the reasoning here be? They could argue that S&P 500 companies would lose business, but that smaller firms and/or workers would benefit by a greater amount. Perhaps if Trump encouraged better antitrust enforcement, this could happen. It could also happen if he reduced immigration to the point where labor share of GDP increased, but this would probably reduce nominal GDP, so it would become harder for them to argue that nominal GDP would rise relative to trend. (Also, in most models, immigration doesn’t affect labor’s share of GDP in the long run because the capital-to-labor ratio can readjust.)

They could also argue that Trump being elected would reduce the price-to-earnings ratio (we’ll call it P/E). Trump’s proposed tax cuts might be expected to raise P/E by increasing people’s willingness to invest at current stock prices. But if he is expected to run large deficits, the market might expect the deficits to raise interest rates and crowd out private investment, which would presumably lower P/E. Trump could also create policy uncertainty that would discourage investors and reduce P/E, although this doesn’t seem like an argument that Trump supporters would want to use.

They could argue that Trump would somehow increase the divisor I mentioned earlier. Perhaps more S&P firms will issue new shares and dilute their existing ones, although this doesn’t always actually reduce the share prices (since the firms now have more cash). A potential pathway here is that Trump could cut corporate income taxes, making equity financing more favorable compared to debt financing and thereby encouraging companies to sell shares and pay off debt. (Here is one paper arguing that the current tax system encourages debt financing). However, this could also end up raising the P/E ratio, since investors are willing to pay some amount for an increased book value for the firm. So it’s not clear how Trump’s expected policy proposals would affect anything here.

Lastly: Trump supporters could just admit that Trump would reduce expected nominal GDP compared to what it would be under Clinton. This doesn’t destroy their argument for him. They could still claim that Trump would increase American life satisfaction. Or they could argue that electing him would help foreigners. Or they could argue that Trump would raise real GDP compared to trend but reduce nominal GDP compared to trend, although they would have to then admit that this would make managing the federal debt more difficult. This also seems unlikely, because then market expectations of inflation would fall, but they actually just rose slightly (from a 10-year TIPS breakeven rate of 1.71% yesterday to 1.72% today). So Trump supporters who argue this position would have to say that the market expectations are wrong.

So it seems like the following holds:

  1. The market probably expects that nominal GDP will fall relative to trend if Trump is elected
  2. Trump supporters could either agree that this will happen and still defend Trump, or they could argue that the market is wrong and bet against it.

Which will it be?

EDIT: To add some more data to this, the S&P 500 fell from a high of 2140.61 just before the news came out to 2126.41 right now (trading has closed). That’s a 0.66% fall in the S&P 500. On BetFair, there was a 5.6 percentage point decline in Clinton’s odds.:Screen Shot 2016-10-28 at 7.54.11 PM.png

Professor Wolfers had found an increase of 0.71% in the S&P associated with a 6-point gain for Clinton. So with that ratio, we would expect a 0.66% fall in the S&P 500, which is exactly what we saw.

SECOND EDIT: My co-blogger tells me that it’s worth mentioning arguments against this hypothesis. Prof. Tyler Cowen has a post citing evidence that Trump’s odds aren’t significantly correlated with stock returns.

My view is that betting markets, including conditional ones that can provide information on how markets expect one event to affect the likelihood of another, should be liberalized (and can even provide policymakers with valuable information). I still think that with available data, Trump supporters must face the choice I described in this post.

Immigration might be good, but does it look good?

One claim about liberalized immigration policy is that it will raise the incomes of immigrants and quite possibly natives, but that average incomes of First World countries will fall.

How is this possible? It’s a matter of averaging two groups together. Suppose you have Country A with 100 people each earning $50,000, and Country B with 100 people each earning $10,000. Then, everyone in Country B moves to Country A and earns $30,000 due to their higher labor productivity in Country A. And in this case, Country B’s labor complements Country A’s labor. So the people of Country A see their incomes rise to $60,000. Both groups benefit. But now the average income of Country A has fallen from $50,000 to $45,000, even though every single person is better off. This is an example of Simpson’s paradox.

So there is a political concern that, even if immigration doesn’t harm natives, it could look like it’s harming natives. What’s the solution? One possibility is publishing another set of income figures: not income per person in America, but average income of native-born Americans. (And average household income for households whose heads are natives, and average hourly compensation for native workers; a variety of measures would exist.) This is the “income per natural” idea developed by Michael Clemens and Lant Pritchett of the Center for Global Development.

Is this dishonest? No. The new figures would be published alongside the old ones, not as replacements. And the concepts these figures refer to are relevant: they reflect how well native-born Americans are doing. If people care about the welfare of native-born Americans, surely these numbers matter. Citizenists want to maximize the well-being of native-born Americans, and if they used numbers for all people living in America, they would come to policy conclusions that are not actually optimal for native-born Americans. Clearly that’s a failure for them.

I think natives probably would benefit on net from liberalized immigration, so I think publishing these statistics would politically help supporters of liberalized immigration. But either way, it would help better depict what’s happening to the welfare of natives.

The Problem with Divestment: Helping Wealthy Investors Instead of Victims

A lot of social movements call for divestment of the shares of firms which are opposed to their goals. In particular, many colleges and universities have faced student protests demanding that college endowment funds divest from fossil fuel companies. However, they should be concerned about divestment’s actual effects.

If a group decides to sell off its shares of some Company XYZ, the price of the shares will fall. However, nothing has changed about Company XYZ’s expected future cash flows. Therefore, nothing has changed about investors’ valuations of Company XYZ. So when the share price falls, other investors simply get an opportunity to buy the shares for cheap. Net result: no damage to Company XYZ.

Furthermore, by creating this buying opportunity for other investors, what divesting groups are actually doing is transferring wealth to said investors. This usually means transferring wealth to wealthy individuals in the First World.

Of course, one argument could be that divestments act as public statements and make action by others more likely. A Harvard Political Review article argues that this was the case with divestments from South Africa in protest of apartheid: they had little financial effect, but helped raise awareness.

But divestments are public statements that cost money. What if universities instead aimed for high investment returns and donated the difference to efficient charities? (Possibly charities aimed at helping victims of whatever is being protested.) The result would be transferring money to effective causes instead of wealthy investors. And universities could still publicize their donations to charity as a way of raising awareness.

Let me reiterate: the main impact of divestment is that a few wealthy investors benefit, while the offenders are unharmed. Is that really ideal?

Immigration and the Zero Lower Bound: A Twist on the “Alien Invasion” Metaphor

I was thinking earlier today about the effect of immigration on interest rates. In particular, I thought of an unusual argument for immigration restrictions when short-run interest rates are at the zero lower bound.

Some New Keynesian economists have suggested that destroying productive capacity can raise current output in said circumstances. (For academic journal articles asserting this, see the beginning of this paper by Johannes Wiedland, also cited below.)

The reasoning is that a negative supply shock can lower expected production, thereby increasing expected inflation. When short-term nominal interest rates are stuck at zero, this has the effect of lowering expected real interest rates. This in turn causes people to spend more money now, raising output and employment.

Intuitive example: You have money in a bank account earning nearly zero interest. A hurricane forms, threatening the supply of various goods. What do you do? Simple: you take money out of the account and buy goods whose prices you expect to go up. The opportunity cost of doing so is minimal, and buying the goods before they go up in price makes you better off.

Paul Krugman’s example of an “alien invasion”: Nobel laureate economist Paul Krugman gave an infamous example of an attack by aliens on Earth, in which governments would scramble to spend money on defense. This example is a bit different from the one I gave, because the spending is done for the purpose of fighting off a potential supply shock, rather than just reacting to one.

However, in the case of the alien invasion, there is an expected possibility of aliens doing damage to the earth, and some diversion of resources towards fighting aliens instead of producing other goods. Both of these raise inflation expectations, lower real interest rate expectations, and increase present-day spending.

What does this have to do with immigration? When the economy is at the zero lower bound, it could make sense (under the model previously described) to further restrict immigration. This reduces expectations of real GDP, thereby increasing inflation expectations and inducing more spending.

Indeed, some people have referred to the existence of an “illegal alien invasion” (Google the term for examples); namely, of people entering the United States unlawfully. (Put aside the question of whether it is accurate to call mostly-peaceful migration an “invasion”.) But, unlike Krugman’s, this “alien invasion” would lower current output! With more immigrants adding to future real GDP, and short-term nominal interest rates stuck at zero, people would expect that goods will be cheaper in the future than they previously thought, and would hoard more money as a response.

A few reasons why I don’t actually endorse this argument for immigration restrictions:

  1. Even accepting the described view on supply shocks, one might not want to trade off future production for present production. Krugman was joking with his suggestion of faking an alien invasion, and it’s unfair to say that people who endorse this model don’t care about the long term at all.
  2. There are empirical issues with the claim that negative supply shocks at the zero lower bound are expansionary. Johannes Wieland of UC Berkeley argues in the previously linked paper “Are Negative Supply Shocks Expansionary at the Zero Lower Bound?” that “financial frictions” prevent this effect from working. He claims that negative supply shocks reduce the value of banks’ balance sheets, thereby constraining their lending and preventing the positive effect on aggregate demand from taking place. Using a general equilibrium model with these “financial frictions” built in, he finds that negative supply shocks at the zero lower bound do hurt short-run output. More research here may be needed, but his case seems plausible.
  3. There are better ways of dealing with the zero lower bound. I don’t want to get into my views on monetary policy here, but it should suffice to say that most people across the various schools of thought find there to be better ways of getting out of the zero lower bound than deliberately destroying productive capacity.
  4. Immigration could raise returns on capital and investment demand, thereby raising interest rates. Generally speaking, expanding the supply of labor is expected to raise the return on capital by acting as a complementary good. However, I say “could”, because the complementarity between labor and capital is very complex, and there are cases in which immigrants act as substitutes for capital. Dartmouth economist Ethan Lewis has done some work on this subject; see, for instance, “Immigration and Production Technology”.

I can’t say I find the “restrict immigration more at the zero lower bound” argument persuasive, but it is at least interesting, and I think I am the first to suggest it.

A Question on Human Rights Abuses and Secession

It is a fairly common belief that secession is legitimate in cases where it is necessary to stop human rights abuses. There is a somewhat less common view that secession is legitimate if it is supported by a majority or supermajority of people in the seceding region, as long as it does not create human rights abuses in that area. (See, for instance, Christopher Wellman on the matter, and Ilya Somin’s discussion relating to Crimea.)

However, what about the possibility of secession creating human rights abuses in the country which a region is seceding from?

Here’s an example: suppose some of the more anti-slavery Northern states in the U.S. had seceded in the decades before the Civil War. (There was some support for this, since many Northerners viewed the Fugitive Slave Act and wars fought for the expansion of slavery as unjust.) Suppose then that it had swung the remainder of the U.S. in a pro-slavery direction. Perhaps some results could be the expansion of slavery into the West, or more strictly enforcing the Fugitive Slave Act in non-seceding free states.

Could one then argue that the seceding states have an obligation to stay in the Union and keep pro-slavery policies from taking hold?

My current thought is that, since it can be very difficult to predict the outcomes of any given secession, a seceding region should not be blamed for these kinds of issues occurring.

In the previous example, it’s also quite possible that the remaining U.S. would have difficulty expanding slavery into the West without Northern military support. It’s possible that the Fugitive Slave Act would be weaker, since escaping slaves would be closer to permanent safety. (Getting to, say, Wisconsin, is easier than going all the way to Canada.)

Nonetheless, it does seem like this question could pose some issues for deciding when secession is appropriate, both in mainstream and less-mainstream theories. Feel free to post your ideas in the comments.

“Money is Not Speech” Misses the Point

The news of the U.S. Senate Judiciary committee approving a constitutional amendment allowing Congress and the States greater power to restrict political spending may bring attention to the issue of campaign finance. A fairly popular phrase in populist circles (especially on the left) used in favor of campaign finance restrictions is “money is not speech“.

Notably, former Supreme Court Justice John Paul Stevens used the phrase when describing his opposition to the Citizens United decision, which allowed corporations and other associations to make independent expenditures on political campaigns. Maryland State Senator Jamie Raskin even claimed that treating the spending of money as free speech would require that prostitution be protected as a form of free speech.

Frankly, the “money is speech” characterization is disingenuous. The point is not that spending money on things generally is a sign of one’s preferences and thereby a form of “free speech”. The point is that spending money on resources and labor directly used in the act of communication is protected.

For instance, most publishing companies are corporations. If a publishing company spends money from its general treasury to publish a book containing political advocacy, should that act be protected under the First Amendment? I would say so. In this case, the free speech rights of the authors would be at stake.

And yet this not was the view of the government in Citizens United (see this link, pp. 26-29). The case was later re-argued, and the government decided that there might be other reasons justifying a challenge to restrictions on book publishing (see this link, pp. 64-65), but the same basic argument still applies to broadcast media, which was the issue in Citizens United. Should a TV broadcaster be allowed to spend its general treasury funds on producing and distributing political content?

When the issue is phrased in terms of spending money on speech, rather than just spending money, it becomes clear that restricting political spending is, in fact, a form of censorship.