Felix Salmon

Jacob Harris is absolutely right to hate word clouds. You take a long and complex text, and then you boil it down to a group of individual words, with the most-used words being the biggest? That’s just silly. “Reporters sidestepping their limited knowledge of the subject material by peering for patterns in a word cloud,” he says, is “like reading tea leaves at the bottom of a cup”. Word clouds are crude, inaccurate, misapplied, and place the onus of understanding onto the reader.

But there’s one place where word clouds are I think both useful and accurate — and that’s when a pollster has asked a group of people to say the one word they would use to describe X. Here, for instance, is the word cloud generated when a Reuters/Ipsos poll asked Republican voters for the first word that came to mind after watching the weird Herman Cain “smoking ad”:

And here’s the word cloud from the latest Kauffman poll of econobloggers:

Here the size of the words is interesting, but more germane is the overwhelming negativity of the vast majority of words used. There’s a couple of tiny good ones in there — “rebounding” us up by the Canadian border, and “bounceback” is in the Bay Area somewhere — but they’re in a distinct minority.

Incidentally, that Kauffman poll has some fascinating responses elsewhere, too. Check out the sudden enormous popularity of NGDP targeting:

There’s also a very high degree of skepticism when it comes to how good colleges are at teaching kids useful stuff.

The bar charts here are again an effective way of communicating information. Things like chart types and word clouds are tools, and you have to know which tools are best used in various different circumstances. And while word clouds are usually stupid, sometimes they can be exactly right.

This, ladies and gentlemen, is how the sausage gets made — it’s yesterday’s eurozone rescue plan, as presented by an unidentified adviser to one of the European Union governments involved in the negotiations.

Frankly, there’s lots of it I don’t understand. (Although the little map of the PIIGS in the top-left-hand corner is clear, and quite adorable.) At the top you have the €440 billion EFSF, with €150 billion already having been spent on those PIIGS. The remaining €250 billion (let’s not worry about these numbers not adding up precisely) gets leveraged, somehow, into €1 trillion — with a special-purpose vehicle in there somewhere for private sector investors to put money into. (The private sector, I’m pretty sure, is represented by that big “PS” box.) The leveraged EFSF then spends its money on the PIIGS as well, with some of that money going to recapitalize banks in those countries.

Meanwhile, the IMF and the Eurozone are also helping out the PIIGS. And Europe’s banks are being recapitalized by June 30, 2012, which will cost €106 billion; it seems that some of that money is coming from the private sector and some of it is coming from the leveraged EFSF. The IMF and the Eurozone are also helping to partially guarantee the new Greek bonds which will go to the banks tendering their old Greek bonds. (I think the tender of the old bonds is that “Greek bonds 100%” line, but I’m unclear on that.)

At the bottom of the sheet we have the sequencing. First comes Greece, which gets its debt written down by the banks, and gets a new loan from the IMF and the Eurozone. Then comes the bank recapitalization, which has to be done by June. Third up are the non-Greek PIIGS. And finally there’s that wonderful question mark at the end.

The main thing which worries me about this plan is the sequencing: it seems that everything else is contingent on Greece getting its writedown first. And I’m highly skeptical that a 50% writedown from the banks is practicable or likely any time soon. I know the IIF has agreed in principle, but that doesn’t mean the banks are actually going to tender their bonds in practice. And if they don’t, does that mean the whole deal falls apart? We need a lot more details on this, I think. Or, maybe, we don’t. Trying to extract details could mean forcing players to confront the fact that they all think they’ve agreed to something slightly different. And that might not be a good idea right now.

You won’t be surprised to hear that shareholders in Allied Irish Banks have not done very well for themselves in the past five years. It did go bust, after all, and had to be nationalized; the share-price chart is above. But recently, as part of the recapitalization of the bank, the number of shares outstanding rose dramatically. Here’s the announcement, which doesn’t quite spell things out:

The Capital Raising will comprise an equity placing (the “Placing”) of ordinary share capital of €5 billion to the NPRFC and an issue of up to €1.6 billion of contingent capital convertible notes (the “Contingent Capital Notes Issue”) to the Minister. The Placing will comprise an issue of new Ordinary Shares for cash at a price of €0.01 per share.

If you do the math, you can see that injecting €5 billion of capital at €0.01 per share means that 500 billion new shares were created. And ever since those shares were created, if you multiply the shares outstanding by the share price, you can see that technically the market capitalization of AIB is somewhere north of €30 billion! Here’s the same stock, only this time charting market cap rather than share price:

Even when a bank has been nationalized, there are good reasons for the shares to continue to be traded. For one thing, it’s helpful when you’re handing out equity to senior management; for another, it’s very useful if and when the time comes to try to privatize the bank and take it off the government’s hands. So at some point there’s going to have to be a reverse stock split, with the shares trading for some sensible amount.

But right now, the shares are genuinely trading at somewhere over €0.06 a piece — and indeed have risen in value quite dramatically over the past three weeks. I have no idea what the mechanism is here, or who’s buying these shares, but if you want proof that markets aren’t always efficient price-discovery mechanisms, this has got to be Exhibit A. It would help of course if these shares could be shorted, but that still doesn’t explain why people are buying at these levels.

(Thanks very much to Patrick Brun for the tip and the data.)

This chart was put together by Jialan Wang, and it shows the degree to which companies’ reported assets and revenues deviate from a Benford’s Law prediction over time. (If you want some good background on Benford’s Law and how it can uncover dodgy numbers from eg the Greek government, Tim Harford had a great column last month on the subject.)

Writes Wang:

Deviations from Benford’s law have increased substantially over time, such that today the empirical distribution of each digit is about 3 percentage points off from what Benford’s law would predict. The deviation increased sharply between 1982-1986 before leveling off, then zoomed up again from 1998 to 2002. Notably, the deviation from Benford dropped off very slightly in 2003-2004 after the enactment of Sarbanes-Oxley accounting reform act in 2002, but this was very tiny and the deviation resumed its increase up to an all-time peak in 2009.

So according to Benford’s law, accounting statements are getting less and less representative of what’s really going on inside of companies. The major reform that was passed after Enron and other major accounting standards barely made a dent.

This doesn’t necessarily mean fraud, per se; it could just be a chart of the degree to which companies are managing and massaging their quarterly figures over time. The kind of fraud that’s so respectable, Jack Welch got lionized for it. Once you start down that road, it’s easy to go further and further forwards, while it’s almost impossible to reverse course. So I can easily see how the natural tendency in this chart would be up and to the right.

Still, it’s worrying; all the more so because I can’t think of any way of reversing the trend. If Sarbox can’t do it, nothing will.

Why has no one thought to do this before? Every month, the Current Population Survey goes out to a nationally representative sample of more than 50,000 interviewed households and their members. And in one of the questions, those households — or at least the households who didn’t answer the same question the previous month — are asked how much money they made, in total, over the past 12 months. That question has now been asked in 138 successive months, since January 2000. Which means that with a bit of clever analysis, it’s possible to put together an apples-to-apples comparison of what has happened to household income every month.

And when you do that, the results are very scary indeed.

The red line, here, is median real household income, as gleaned from the CPS, indexed to January 2000=100. It’s now at 89.4, which means that real incomes are more than 10% lower today than they were over a decade ago.

More striking still is the huge erosion in incomes over the course of the supposed “recovery” — the most recent two years, since the Great Recession ended. From January 2000 through the end of the recession, household incomes fluctuated, but basically stayed in a band within 2 percentage points either side of the 98 level. Once it had fallen to 96 when the recession ended, it would have been reasonable to assume some mean reversion at that point — that with the recovery it would fight its way back up towards 98 or even 100.

Instead, it fell off a cliff, and is now below 90.

In dollar terms, median household income is now $49,909, down $3,609 — or 6.7% — in the two years since the recession ended. It was as high as $55,309 in December 2007, when the recession began.

Some of this decline has been hard to see because nominal incomes have been holding very steady: before taking inflation into account, median household income was $51,465 in December 2007, and $51,140 in June 2009. But even then, over the past two years, nominal incomes have shrunk significantly to the current level of $49,909.

All of these numbers come from Gordon Green and John Coder, economists who both worked at the Census Bureau for more than 25 years. They’ve now set up a private company, Sentier Research, to collate these household income figures every month; the full report costs a reasonable $20.

Why is this work being outsourced to private-sector economists, rather than being done by the Bureau of Labor Statistics and published officially? I’m having dinner with a government statistics wonk on Wednesday, and will be sure to ask him.

But in the absence of any good reason to discount the reliability of these numbers, it’s definitely worth taking them seriously, and asking why incomes have eroded so quickly and dramatically over the past two years. We’ve known for years that America has a huge unemployment problem. But I had no idea that the plight of the employed was this bad.

Many thanks to the wonderful Silvio DaSilva for putting this chart together; I think it explains a lot of what happened with Apple over the years.

During Steve Jobs’s first stint at Apple, before he was fired in 1985, he was making consumer products which were far out of the reach of most consumers. The Apple II cost $1,298 in 1977, and that was the bare-bones version with 4K of RAM; if you wanted a more powerful version with a whopping 48K of RAM, that would cost you $2,638. Or $9,862 in today’s dollars.

The Macintosh, when it came out in 1984, was even more expensive. $2,495 was a lot of money, back then. (And never mind the LaserWriter: that had a list price of $6,995.)

When Jobs was fired, then, Apple was trying to sell consumer products to people who simply couldn’t afford them.

But when Jobs returned, in 1996, it was a different story. His first big product launch, the iMac, was priced at $1,300 — or just about $1,800 in today’s dollars. Not cheap, but at least somewhere in the ballpark of mass-market. Today, the entry-level MacBook Air — arguably the most gorgeous computer Apple has ever produced — is $999, just 55% of the real price of 1998′s iMac. And you can get a Mac Mini for $600.

And the non-Macintosh products are cheaper still. Here’s what you see when you visit the Apple Store online today:

This is a range of hugely powerful computers — the iPad 2 has the same computing power as a 1980s Cray supercomputer — at prices which are accessible to hundreds of millions of people around the world. The iPhone 4S — the first computer in the world to be able to have some approximation of a natural-language conversation — starts at just $199. And the iPhone I’m using right now is being given away for free. (With a two-year contract, but still.)

Jobs, of course, can’t take credit for the fact that technology becomes steadily cheaper over time. In fact, his technology has always sold at a premium; given the choice between making the entry-level Apple computer cheaper and making it better, Jobs always chose the latter option.

But Jobs can take credit for always being a step or two ahead of the technology curve, for seeing where the technology puck was going, and skating to that point before anybody else. Both in terms of what was possible, and in terms of what wasn’t needed any more. He saw, when he returned to Apple in 1996, that technology had improved to the point at which he could basically put his NeXT workstation ($6,500 in 1990, or $11,267 in 2011 dollars) on the desks of millions of people in the US and around the world. There was a basic level of quality he had to have, in any computer. And by the time that he launched OS X in 2001, he had built a company capable of delivering that quality at a price accessible to the broad non-geek middle classes.

The rest is history.

Update: I forgot the Lisa! $10,000 in 1983. That’s $22,745 in today’s dollars.

This was originally posted at Rortybomb

For the next few posts I need to allude to an ongoing battle of ideas about what is troubling our economy and what solutions are available. I figured it might be a good idea to try and create some sort of topological map of the various clustering of ideas and policies that constitute these arguments as well as the overlap among them. This is a preliminary version of this map: I’d really appreciate your input about what is missing and how to make this better.

From those who think that the problem is related to demand and Keynesian ideas, there tends to be three areas of focus: fiscal policy, monetary policy and the debt hangover in the broken housing market. One can think all three are important – I certainly do – but most think one has priority over the others. Many will think one of the three isn’t in play or particularly useful as a focus of policy and energy. Here’s a rough map. Quotations are ideas, non-quotes are policies and parentheses are people associated with each:

This war of ideas is being fought in white papers and articles, and at academic institutions, policy shops and the blogosphere. As a general resources, here are the best one-stop resources online for most of the bulletpoints above:

Fiscal Policy as Expectation Channel: Woodford on Monetary and Fiscal Policy, Paul Krugman.

Quantatitive Easing: The World Needs Further Monetary Ease, Not an Early Exit, Joe Gagnon.

NGDP Targeting: The Case for NGDP Targeting: Lessons from the Great Recession, Scott Sumner.

Mass Refinancing: Economic Stimulus Through Refinancing — Frequently Asked Questions, R. Glenn Hubbard and Chris Mayer.

Inflation to help Deleveraging: U.S. Needs More Inflation to Speed Recovery, Say Mankiw, Rogoff, Bloomberg. Overcoming America’s Debt Overhang: The Case for Inflation, Chris Hayes.

Higher Inflation Target: A 2% Inflation Target Is too Low, Brad Delong.

Bankruptcy Reform/Cramdown: January 22nd, 2008 Testimony, Adam Levitin.

Foreclosure Spillovers: Foreclosures, house prices, and the real economy, Atif Mian, Amir Sufi and Francesco Trebbi.

Balance Sheet Recession: U.S. Economy in Balance Sheet Recession: What the U.S. Can Learn from Japan’s Experience in 1990–2005, Richard Koo.

Housing Backlog: There is a Boom Out There Somewhere, Karl Smith. Yes, Virginia, Our Housing Stock Is Now Way, Way Below Trend, Brad Delong.

Debt-for-Equity Swaps: Why Paulson is Wrong, Luigi Zingales.

Debt, Deleveraging, and the Liquidity Trap: Debt, deleveraging, and the liquidity trap, Paul Krugman. Sam, Janet and Fiscal Policy, Paul Krugman.

The flip-side to a demand crisis is a supply crisis, and there’s been a large effort to explain our high unemployment and below-trend growth as the result of supply-side factors. Having surveyed the arguments, I’ve split them into two categories. There are those who think that the government has created an increase in uncertainty. This is from a combination of deficits that scare bond vigilantes/job creators, new regulations that have killed all the potential new jobs as well as the government creating disincentives to work. The second area of focuses is on the productivity of the labor force, with special emphasis on skills mismatch, the characteristics of the long-term unemployed and the idea that something has changed fundamentally in our economy that will keep so many unemployed for the foreseeable future.

I’m making the productivity circle conceptually expansive enough to include “recalculation” stories, though I suppose I could add a third circle in the next version. I tend not to find these arguments convincing, but here are the arguments made in full as best as I could find them online:

European Policies: The U.S. Recession of 2007-201?, Robert Lucas. The classical view of the global recession, Gavyn Davies.

Expansionary Austerity: A Guide for Deficit Reduction in the United States Based on Historical Consolidations That Worked, AEI. Large changes in fiscal policy: taxes versus spending, Alesina and Ardagna.

Liquidate the Homeowners: Are Delays to the Foreclosure Process a Good Thing? Charles Calomiris and Eric Higgins.

Stimulus is Sugar: Geithner Finds His Footing: Zachary Goldfarb.

Two-Deficit Problem, Bond Vigilanties: Spend and Save, Noam Scheiber.

Great Vacation: Compassionate, But Inefficient, Casey Mulligan. The Dirty Secret of Unemployment, Reihan Salam.

Long-Term Unemployed: Potential Causes and Implications of the Rise in Long-Term Unemployment, Andreas Hornstein, Thomas A. Lubik, and Jessie Romero. 10 Percent Unemployment Forever?, Tyler Cowen, Jayme Lemke.

Great Stagnation: The Great Stagnation, Tyler Cowen.

Patterns of Sustainable Specialization and Trade (PSST): PSST vs. the Aggregate Production Function, Arnold Kling.

Labor Mobility: Housing Lock is not a Major Part of this Crisis, Plus Scatterplots of Deleveraging!, Mike Konczal.

So what did I miss? What should go in the next version of this chart?

Read the original post here

Two charts jump out at me from Doug Elmendorf’s presentation to the Joint Select Committee on Deficit Reduction. The first is the sheer size of various loopholes in the tax code:

If you want to make a serious dent in long-term deficit reduction, this is a good place to start. Everybody knows that Social Security and Medicare — pensions and healthcare — comprise a massive part of the government’s future spending. What’s less well known is that pensions and healthcare are also the two biggest tax expenditures in the tax code: the deductibility of healthcare premiums will cost the government about $650 billion over five years, with the deductibility of pension contributions running it a close second. That’s over a trillion dollars in lost revenue right there. Add in the mortgage-interest deduction and the lower rates on long-term capital gains, and you get to $2 trillion pretty quickly. Double that to get a ballpark ten-year figure.

This is something that proponents of private health insurance don’t often grok: that it’s heavily subsidized by the federal government already, due to its tax-exempt status. And it stands to reason that if the government is going to spend hundreds of billions of dollars a year subsidizing private health insurance, then it ought at the very least to get some kind of control over the healthcare industry in return. If you want to keep the system fully private, then fine, but don’t ask the government for massive subsidies at the same time.

As for the tax deductibility of pension contributions, Mark Miller wrote a great post on the subject in June, in which Teresa Ghilarducci makes a very strong point.

Ghilarducci argues that retirement saving wouldn’t decline if the deduction disappeared. “There’s no evidence that it increases saving; much of the academic literature shows that higher income people are simply moving investments they would have made anyway [in taxable accounts] to a tax-preferred account. And there are 25 million taxpayers in the bottom two quartiles who don’t take deductions, so they’re getting no subsidy at all from the federal government on their contributions.”

Everybody’s talking about the necessity of making hard choices: there are lot of hard choices here which could have an enormous effect on government revenues while at the same time simplifying the tax code and even maybe allowing a reduction of the headline rate of income tax. I’m in favor of taking a whack at all of the bars on this chart, with the exception of the EITC. Doing so would make the tax system more progressive, simpler, and more lucrative. Which is exactly what we need.

So, that’s one opportunity facing the deficit committee. But here’s something scarier:

This is the official CBO unemployment projection, on which all of its economic forecasts are based. And it shows unemployment plunging to 5% after 2015. That’s considered the long-term unemployment rate, and I guess that 2015 is considered the long term, or something. In any case, it ain’t gonna happen — there’s absolutely no reason to believe that the economy will suddenly add an enormous number of jobs in four years’ time.

As a result, actual tax revenues are going to be lower than the CBO is projecting, since the CBO is anticipating revenues from millions of people who won’t in fact be employed. And government expenditures on unemployment insurance, Medicaid, and the like will be substantially higher than the CBO is projecting.

So when we get to work on the deficit, it’s important to remember that the problem is bigger than the official CBO numbers would have you believe. Partly because the CBO is assuming things like a 30% reduction in Medicare payments for physicians’ services after 2011, which simply isn’t going to happen. And partly because the CBO is being incredibly overoptimistic on the unemployment rate. So let’s get to work on reducing the size of those loopholes. It’s the only way we can credibly free up enough money to provide the stimulus the economy needs right now.

As a general rule, it’s the risk-on trades which have a tendency to blow up in your face. If you borrow in a low-yielding safe currency and invest in a higher-yielding risky currency, you make money every day, but can lose it all — and then some — with one violent currency move, when the risky currency suddenly weakens.

Today, however, it’s the other way around. With one announcement, the Swiss National Bank sent the Swiss franc — a classic safe currency, which rallies in times of uncertainty — plunging. To give you an idea of just how insanely huge today’s currency move was, here it is in the context of the past 12 years or so:

What this chart shows is that even during the recent crises, the Swiss franc basically never rises or falls more than 2% in one day. Today, it moved more than 8% — that’s a 20 standard deviation move. If market movements were normally distributed (which, of course, they’re not), 20 standard deviation moves would never happen. You can be quite sure though, that the SNB move today caused a lot of pain to a lot of people. Remember what the Swiss franc volatility surface looked like a couple of weeks ago?

As I wrote back then, this chart shows a market very bullish on the Swiss franc and bearish on the euro — a market betting strongly against the SNB’s ability to weaken the Swiss currency. Well, that didn’t work out very well. But just check out what the same chart looks like today, post intervention:

The first thing to note here is that the crazy implied volatilities seen two weeks ago seem positively low by today’s standard. Check out the y-axis: it’s now going all the way up to 31.35, compared to a maximum of 26.975 last time we looked at this chart. And in general the entire surface has risen a lot over the past couple of weeks. If you want to bet on the Swiss franc today, in any direction, you’re going to have to pay a lot of money to do so.

But there’s still a huge amount of skew here, in exactly the same direction. Over the near term, it’s not as pronounced as it was — there are lots of people betting that the SNB might be able to weaken the Swiss franc over the next few weeks. But over the long term, the market is speaking clearly: everybody thinks the Swiss franc is going to strengthen and many fewer people think it’s going to weaken. The SNB might have won this battle, but it’s not going to win the war.

And this is a hugely important war for Switzerland. Michael McDonough puts the Swiss franc’s strengthening into the context of Switzerland’s domestic economic health:

The problem is that the international capital flocking to the safe haven of the Swiss alps really doesn’t care about Swiss exports. And if you look at Swiss exporters, even the top gainers, like Swatch, which rose 6% on the day, actually fell in euro terms. The broad Swiss stock market, up 3.9% today, didn’t even come close to making up for the currency losses imposed by the central bank on foreign investors.

The main winners today, I suspect, are just going to be black swan funds and anybody else making bets on extreme market moves. You don’t see 20-standard-deviation events very often, and when you do, there are always one or two people with out-of-the-money options who suddenly make a fortune. But over the long term, the markets are stronger than any central bank. The Swiss franc will test 1.20 again, and when it does, we’ll see in practice just how many euros the Swiss National Bank can stomach before it gets full.

This chart comes from Eric Burroughs, who calls it “one of the best gauges for showing the extreme nervousness over what the endgame really is in Europe”. But I’m assuming here that you’re not the kind of person who looks at FX volatility surfaces on an everyday basis, so it might be worth a little bit of explanation.

The chart is showing how expensive it is to buy options on the EUR/CHF exchange rate — that is, the number of Swiss francs per euro. When the Swiss franc strengthens, as it has been doing of late, the exchange rate goes down. The current exchange rate can be seen in the middle the “Delta” axis, where it says “ATM” — that stands for “at the money”. So everything to the left of that line — the PUT contracts — shows the price of a bet that the Swiss franc is going to strengthen. And everything to the right of the line — the CALL contracts — shows the price of a bet that the Swiss franc is going to weaken.

Now the Swiss franc has appreciated a lot against the euro of late — you could get more than 1.5 Swiss francs to the euro this time two years ago, while a couple of weeks ago the exchange rate dropped to as low as 1.03, and it’s still at 1.12 right now. To put it another way, a 100 Swiss franc meal in Zurich would have cost you €65 two years ago, €76 one year ago, and €89 today. At this point, the Swiss franc is so strong that the Swiss National Bank is doing everything in its power to try to weaken it. So the time to bet on a strengthening Swiss franc was clearly in the past.

But just look at the chart — it’s much higher on the left-hand side, the PUT side, than it is on the right-hand side. That’s known as “skew”, and it means that the market is decidedly bearish on EUR/CHF. If you want to bet that the exchange rate is going to go back up, that will cost you quite a lot of money. But if you want to bet that the exchange rate is going to continue to decline, that’s going to cost you an absolute fortune.

And in fact the market seems to think that even if the Swiss National Bank manages to weaken the Swiss franc in the short term, over the long term its efforts won’t count for much. The lowest parts of the chart — the cheapest bets of all — are the ones saying that the Swiss franc is going to weaken over the long term of 18 months to 2 years. Meanwhile, the highest parts of the chart — the most expensive bets you can make — are the ones saying that the Swiss franc is going to strengthen a lot over the long term of 18 months to 2 years.

Some of this activity is hedging, of course, rather than speculation. Let’s say you’re one of those corporate chieftains attending Davos in January as a Strategic Partner. That’ll cost you 590,000 Swiss francs. In 2011, that was €457,000. But as of right now your Davos membership fee has already risen to €523,000; you might well want to lock it in right there before it goes any higher. (If you’re unfortunate enough to be paying in dollars, it’s even worse.)

But the main message of the chart is that people are almost irrationally worried right now. The Swiss franc is a classic flight-to-safety play, a bit like gold or Treasury bills. That’s why it has appreciated so much of late. But the markets are saying that its recent appreciation might only be the beginning, and that the Swiss franc might well end up being worth more than the euro pretty soon. Here’s how Burroughs puts it:

When the skew starts to normalize, then the market may be convinced that Europe is getting a handle on this crisis. We are far from that point.

I’ll trust Eric to keep an eye on this chart — I wouldn’t know where to start even trying to build such a thing. But it seems clear to me that he’s right: we’re going to wait a long time before this chart stops sloping down and to the right. Which is another way of saying that we’re going to continue to have a crisis in Europe for the foreseeable future.

The economic historian James Macdonald emails with a very different version of my earnings-yield chart. Instead of going back to 1985, he’s found annual data all the way back to 1920. And instead of using Treasury bonds — a sui generis asset class with its own dynamics surrounding flight to quality and the like — he’s uses the yield on BAA-rated bonds instead. The result is fascinating:

Writes Macdonald:

It is not reasonable to relate earnings yields to T-bonds. They are not comparable investments. The proper comparison is with the corporate bond yields. My preference is not even AAA, since that is quite rarefied, but rather BAA – definitely investment grade but more reflective of the typical corporation and more susceptible to market jitters.

The historical pattern seems to me to be as follows:

• a twenty-year period from 1920-1940 when bond and earnings yields were more or less comparable
• a twenty-year period from 1940 to 1960 when earnings yields were significantly higher than bond yields
• a twenty year period from 1960 to 1980 when the two yields were more or less comparable
• a twenty-five year period (?) from 1980 to 2005 when earnings yields were significantly lower than bond yields. (I put a question mark, because there is also a major divergence of yields in 2009. However, I take that as a temporary aberration because of the collapse of S&P earnings during the Great Recession thanks to the losses of the financial sector).

Now the two yields are more or less the same. Are we supposed to take that as a signal to sell bonds and buy shares?

I am not at all convinced, at least on the basis of the historical evidence. We may be entering a long period when the two yields track each other. Or we may be entering a period (perhaps to be expected after a major financial disaster) when investors demand a premium yield from shares compared to bonds. In any case, the period from 1985 onwards can scarcely be taken as the historical norm, since, as we know from other statistics, such as long-term PE ratios, shares have been overvalued for almost the whole of this period.

My feeling is that a long-term period when investors demand a premium yield from shares compared to bonds is precisely the kind of period that a long-term investor wants to be putting her money into shares rather than bonds. Again, there are market timing issues here — shares might fall rather than rise for much of that period, especially during times when the premium is rising rather than falling. But if you just go back to basics and look at securities as giving you ownership of an income stream, then it seems perfectly sensible to me to pick the larger stream, given the choice.

If there’s a big risk to this strategy, it seems to me, the risk is overleveraged companies. If companies get in over their head and find themselves unable to make their interest payments, then their equity can be wiped out, and ownership transferred to bondholders. But in this particular economy, I don’t see that as a big risk — certainly not for BAA-rated companies. We saw during the financial crisis that nearly all non-financial public companies had been decidedly conservative with respect to the big debt binge known as the Great Moderation; if you were looking for massive corporate leverage, you needed to look to private equity deals.

And what if we’re just entering another period akin to the 60s and 70s, where the two yields track each other while rising? Again, I think I’d rather be in stocks, if only because they’ll do much better than bonds if and when inflation kicks in.

Finally, there’s the possibility I raised in my original chart — that stock prices are uncommonly cheap relatively to bond prices right now. Which certainly seems to be the case if you think that history began in 1985. If stocks revert to the post-1985 norm of yielding less than bonds, then moving from bonds to stocks at these levels would probably make a fair amount of sense on a mark-to-market basis. As a long-term investment, though, stocks might look a bit less attractive: you’d be less reliant on earnings and more reliant on capital gains to make up the difference.

What really surprises me about Macdonald’s chart, however, is nothing to do with the difference between stock yields and corporate bond yields, but rather the way in which nominal corporate bond yields move very slowly and smoothly. There does seem to be something reassuringly safe and reliable in that orange line. So if your priority is preservation of nominal capital, rather than maximizing your long-term net wealth, there’s something pretty attractive about corporate bonds, too.

Update: I missed this on Friday, but Jake from EconomPic Data has his own version of the chart, using T-bonds but going back even further than Macdonald does. I love this:

What happened in 1970 or thereabouts that this correlation suddenly became so strong, after barely existing before that? Could it possibly be the arrival of Modern Monetary Theory and Modigliani-Miller?

After I wrote my post on Monday about the huge divergence in yields between stocks and bonds, I wondered just how historically unprecedented this divergence was. And now, with the help of this fabulous chart (many thanks to Nick Rizzo, Dan Burns, and Stephen Culp), it’s pretty easy to see: we’re at levels which match those at the height of the financial crisis, and which are otherwise historically utterly unprecedented.

Indeed, from 1985 through about 2002, it was just as common for the S&P earnings yield to be lower than the Treasury yield as it was for the yields to be the other way around. The two tracked each other, and the spread between them almost never moved beyond 2 percentage points either way.

In 2002, everything changed. The spread between the two jumped up to a very high level and stayed there, all the way through the onset of the financial crisis. This was the Great Moderation.

And when the Great Moderation imploded, the spread only widened further. Today, it’s about 7 percentage points. At these levels, it’s almost impossible to see how stocks could possibly be a worse long-term investment than bonds. Yes, earnings can fall. But even if they fall in half, stocks will still yield double what bonds do.

I have to admit that I really don’t understand what’s going on in this chart at all. While any given spike can always be attributed to a fearful flight to quality, that doesn’t explain the decade-long trend.

There does seem to be a feeling in the markets that current earnings levels are somehow illusory — a feeling which long predates fears of a double-dip recession. I’m not so sure about that: while earnings are surely cyclical, in the grand scheme of things corporations seem to be doing much better when it comes to earnings growth than individuals are, and I don’t see that trend reversing itself any time soon.

Even QE2 doesn’t seem to have helped on this front: while it boosted all asset classes, bonds seem to have been the primary recipients of the Fed’s flows, with stocks lagging behind.

So with the explicit proviso that I’m not going to try to explain this graph, I’ll tentatively put forward one hypothesis: that the dot-com bust of 2000-2002 had a much bigger effect on stock-market psychology than we might have thought. It made stock investors realize how fragile stocks really are, and concentrate on the risk that they could fall substantially in price. If you’re think that stocks are going to fall, then it almost doesn’t matter what their earnings yield is — you feel as though you should sell them at any price.

But frankly I don’t really believe it. There’s something more profound going on here; I just can’t put my finger on what it is.

Even without understanding what’s going on in this chart, though, it does seem to say quite clearly that now’s a good time to buy stocks, if only because the opportunity cost of not buying stocks is so enormous. Bonds and cash yield nothing: it’s really hard to see how they can be a better bet than stocks over the medium to long term. Which is not to say that stocks can’t fall, of course: they can. They can fall a lot. I’m not trying to time the market here. But the chart is striking, all the same.

I love this global equity snapshot from Bloomberg’s Michael McDonough. For one thing, it clearly shows how European bourses are in much worse shape than those in the U.S. First look at the green dots in the little 52-week sparklines: the American and European highs weren’t all that far away from each other, chronologically speaking. And then look at the red dots: every exchange in Europe is hitting new 52-week lows, usually quite dramatically. By contrast, the U.S. indices all have their red dots over to the left: we still haven’t even dropped back to where we were a year ago.

A similar tale is told in the percentage-change columns. News headlines, of course, concentrate on what’s happened on a daily basis, with U.S. stocks down more than 4% and European stocks trading up on the day. But take a step back and the bigger picture is rather different: the sea of red, marking stock markets down more than 20% from their 52-week highs, is almost entirely European. And the biggest loser of all, the Italian market, is down a whopping 35%. If the Dow fell that much from its 52-week high, it’d be at 8,331, with the S&P at 887.

The lessons here, then, are firstly that if you spend your time looking at intraday stock-market movements on a country-by-country basis, it’s easy to miss what’s really going on. I’m in the UK right now, where there are lots of headlines about the plunging stock market, but no indication that it’s up there with Canada as the best-performing stock market in the world.

And secondly, the Eurozone is in serious trouble. Instead of looking at the amount that the markets have fallen from their highs, try looking at the degree to which they’ve recovered from their lows. The Euro Stoxx 50 hit a low of 1,809 on March 9, 2009; it’s rallied 18% since then. By contrast, the S&P 500 is up 101% from its March 2009 low: even after Wednesday afternoon’s swoon, it’s still at more than twice the level it closed at on March 5 of that year.

Does this mean that U.S. stocks simply have that much further to fall, before they catch up with their European counterparts? I suppose that’s one way of looking at it. But more realistically, the worst-case scenario for the U.S. is a double-dip recession; the worst-case scenario for the Eurozone, by contrast, is downright existential. Even on an up day today, the French banks are still seeing their shares marked down ever further. The very solvency of the Eurozone banking system in general, and the French banking system in particular, seems to be in doubt. U.S. banks don’t have that kind of European sovereign exposure, so we have a significant advantage on that front.

It might seem a bit like schadenfreude to take solace in the fact that other countries are much worse off than we are. But as the current stock-market volatility continues, it’s worth keeping such things in perspective. Europe is a global economic powerhouse; it can’t suffer these kind of woes without infecting the rest of the world somehow. And the U.S., in the grand scheme of things, seems — still — remarkably insulated from what’s going on across the Atlantic.

This chart comes from Barrie McKenna’s great article on US tax rates, and pretty much speaks for itself. While the rest of the developed world has seen its tax rate rise as it got richer, the US stands out as the one country where tax rates have been going down. In the OECD, only Chile and Mexico have lower tax burdens, and neither of them have been decreasing: both have relied very much on state-owned commodity wealth to stand in for tax revenue.

As McKenna reports,

The total tax burden on Americans, as a percentage of gross domestic product, stood at 24 per cent in 2009 – lower than it was in 1965 and still falling. That compares to 31.1 per cent in Canada, 34.3 per cent in Britain, 42 per cent in France, 37 per cent in Germany and 43.5 per cent in Italy. The Japanese, Australians and South Koreans all pay significantly more.

The United States is the only major country without a national value-added tax and its sales taxes are lowest in the OECD. Likewise, U.S. fuel and sin taxes are at the bottom among rich countries. And generous tax breaks mean many businesses and individuals pay few taxes, placing a heavy burden on a relatively narrow tax base…

Bill Frenzel, a former Republican congressman and now a scholar at the Brookings Institution in Washington, agrees no budget fix is possible without tax hikes…

Americans, he said, will never accept the kind of tax levels that exist in most other countries.

“The U.S. has always been a low-tax country,” he explained. “And we like it that way.”

This raises two questions. The first is why America’s taxes are so much lower than anybody else’s. Its system of government, after all, is a pretty standard democracy, so it’s not exactly baked in to the Constitution. The second question is why Americans don’t actually appreciate how low taxes are here. It’s a standard talking point in US politics that taxes are too high, and must be lowered; Republicans are adamant that even modest tax hikes, to levels still well below the rest of the developed world, would be economically devastating.

Right now a deal seems to be getting done in Washington which reduces the deficit by means solely of spending cuts, with no tax hikes at all. That makes no sense: just as it’s right that people should pay a higher tax rate as they get richer, the same is true of countries as well. Instead, the US seems to think that it can work as an advanced democracy while maintaining a tax rate more commonly associated with tinpot basketcases. Up until now, it’s managed to do that by borrowing the difference. But if it wants to try to cut spending to a level commensurate with its tiny tax base, it’ll soon learn how economically disastrous that can be.

(Via Kedrosky)

Bill Dowd emails to ask about short-term Treasury yields, which finally seem to have noticed the debt ceiling debate in recent days:

When treasury yields are discussed in the media, everyone seems to default to talking about 10-year bonds. The yields on those remain well below 3%, and indeed have fallen a bit today. On the other hand, yields on 1-, 3-, and 6-month bonds have increased considerably today, with the yield on the 1 month bond exceeding 17bp (up nearly 50% today). It seems to me that there’s no concern among investors about America’s long-term debt, just about its ability to get its act together in the short term. Of the three maturities I noted above, 1-month bonds are the highest. It seems as though investors are pricing in the possibility that payments might be delayed.

I put together a little chart from this page, which isn’t a thing of beauty; for one thing, in order to show changes at the short end of the yield curve, I had to switch the y axis to a logarithmic scale.

What you’re seeing here is, indeed, a sharp rise at the very short (1-month) end of the yield curve. And all the way out to one year, yields on Friday are significantly higher than they have been for a long time.

Still, a couple of points are worth making. For one thing, a yield of 0.16% is still minuscule, and doesn’t imply any real credit or payment risk. The fact that the yield curve is now inverted between 1 month and 3 months is interesting, but it’s basically an indication that the markets are now paying attention. The dog has pricked up its ears; it has yet to actually do anything.

Secondly, and this isn’t very obvious on the chart, we’re seeing an even bigger drop in long rates than we are an increase in short rates. The yield on the one-month bill rose 6bp from 0.10% to 0.16% on Friday; the yield on the 10-year bond dropped by 16bp from 2.98% to 2.82%.

And thirdly, the yield curve is only inverted between one and three months. From 3 months on in, its still got a nice upward gradient to it. If there’s worry here at all it’s about possible payments problems over the next month; there’s no indication of concern about a debt downgrade coming in the next six months to a year.

The next big debt maturity comes at the end of August, and it makes sense that if you’re only getting 0.16% yield in any case, you might as well just hold cash instead of very short-dated bills. But even cash has to be on deposit somewhere, and that somewhere is a place with non-zero credit risk. (Unless you’re a bank, in which case you can hold cash on deposit at the Fed.)

I’m getting really rather worried about the debt ceiling. This is now the second consecutive last possible weekend to get something done, and it frankly looks as though the August 2 deadline is all but certain to be missed. Meanwhile, the White House is pouring cold water on the idea that we might get saved by the 14th Amendment.

People like Tom Davis are drawing parallels to the TARP vote, which is understandable, but also dangerous:

“He’s going to have to pass it with Democratic votes. That’s going to be a tough decision, but he doesn’t have any choice at that point, particularly if the markets are reacting,” said Tom Davis, a former House Republican leader from Virginia. “That’s the position they’ve got themselves in.”

But, he added: “The stakes are much higher here. If interest rates start spiking up, it’s going to cost us a lot more than anything you could save. They’re playing brinkmanship with our credit rating. That’s not very smart.”

Mr. Davis recalled his vote in late September 2008 for the $700 billion Troubled Asset Relief Program that President George W. Bush sought to rescue a financial system near collapse. “I hated TARP, but no one had a better alternative,” he said.

But most of his Republican colleagues opposed the rescue measure and helped defeat it, sending the stock markets tumbling even as the vote was taking place. That reaction forced the Republicans to retreat, and days later a bailout bill carried on a second try.

The problem here is that this is much more serious than the TARP vote. With TARP, a no vote sent the stock market down, and then a yes vote largely rectified the damage done. The debt ceiling doesn’t work that way — a failure to get it raised will have enormous long-term consequences, much more serious than a twitch in the stock market, which couldn’t be rectified by a subsequent change of mind by Congress. Even in the worst-case scenario, the debt ceiling is going to get raised somehow, sooner or later.

And this I think is what we’re really seeing in the yield curve. Never mind twitches at the very short end — look at the speed with which long-term rates are going down. That’s a sign of pessimism about long-term U.S. growth — an indication that Congressional failure to raise the debt ceiling will hobble the economy for the next decade. Thanks, guys.

Update: In the comments, GRRR puts Treasury’s yield information together in another way, by having two different y-axes. I like this: