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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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 note on Walras’/Say’s Law, monetary equilibrium, and aggregate demand

Very often, people seem to confuse Say’s Law (or the closely related Walras’ Law) for the proposition that nominal spending doesn’t matter, or that aggregate demand shortfalls and excesses cannot occur. As I shall demonstrate, however, its clear implication is the opposite when one considers the case of money as a tradable good.

Imagine an economy in which money and goods are exchanged for each other. (Multiple different types of money can exist, although this does not change the outcome.) Many of the trades made involve money being traded for other goods. However, money is still “supplied” and “demanded” in the same sense that any other good is, and has a “price” in terms of other goods. Thus, there exist states of monetary equilibrium and disequilibrium.

Monetary disequilibrium exists when, at a given real value of the monetary unit, the the real quantity of money the public demands to hold (and is willing to purchase by selling other goods to obtain money) is not equal to the real quantity of money actually provided. As Walras’ Law implies, a shortage or surplus of money is matched by a surplus or shortage (respectively) in all other goods collectively, as measured by the market value of said surpluses and shortages.

So what, then, does monetary disequilibrium imply in terms of nominal spending? When a surplus of money is held (in real terms), there exists a shortage of other goods to be bought with money, and the public seeks to reduce its real holdings of money by increasing nominal spending of held money on goods. Such a situation is that of an excess of aggregate demand.

Conversely, when a shortage of money is held (in real terms), there exists a surplus of other goods to be bought with money, and the public seeks to increase its real holdings of money by decreasing nominal spending of held money on goods. Such a situation is that of an aggregate demand shortfall.

Walras’ and Say’s Laws concern themselves with markets in equilibrium and disequilibrium, and the fact that a shortage of good A in terms of some other good B it is traded for implies that there also exists a surplus of the good B in terms of good A. One need not reject this insight to accommodate the empirical existence of shortfalls and excesses of nominal spending. One must only consider what it is that is actually being spent.