Why money matters

I think this is an absolutely fantastic, clear and concise explanation for why money matters in macroeconomics:

In normal times, people receive apples and money from the sky in the form of endowments (i.e. their wealth), and they make decisions about how to balance their cash and apple balances. Apples are transacted, bellies are filled, and life is good.
But suddenly, a recession hits. What does this look like? By definition, a recession is when there is a general glut of goods that aren’t consumed. In this toy economy, this corresponds to a situation in which some people have apples but choose not to eat them! This may seem peculiar, but remember that the market for apples in this model represents a composite of all goods markets. So it could be the case that while everybody has apples, some want Red Delicious while others are looking for the tartness of Granny Smith. In more formal economic models, this is glibly incorporated by requiring that people do not consume their own endowment and instead trade for consumption. In any case, apples aren’t eaten and we have a rotten general glut.

But this seems peculiar — aren’t markets supposed to clear? Not necessarily. Prices don’t always adjust instantly, so we can have excess supplies and excess demands. However, economists do have a way to constrain what this non-clearing state looks like. In particular, according to Walras’ law, assuming everybody spends all of their wealth, if there are excess supplies (i.e. too much produced) in some markets, then they must add up to excess demands (i.e. too little produced) in other markets. In other words, even if supply does not equal demand in each market, supplies must add up to demands across markets.

The requirement that everybody spends their endowment is crucial. It means that Walras’ law doesn’t apply just to the market for apples because not everybody spends all their wealth on apples. Instead, some people may put their wealth in money. But once we include the money market, we do have the condition that everybody spends their endowment, and therefore Walras’ law does apply to the entire macroeconomy of apples and money.

This leads to the most important conclusion from general equilibrium theory as related to monetary economics:

If there is an excess supply of goods, it must be the result of excess demand for money.

Go read the whole thing and follow Yichuan Wang’s blog. He’s one of the best communicators in economics right now.

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Broken heartland

Every so often someone writes about how this or that region is going to collapse. Today we get a perspective on why agriculture will collapse in the Great Plains:

The seed, it turned out, was organic, as were all of Teske’s crops — though he was quick to clarify that this was “not just for moral reasons.” On the contrary, organic farming seemed to him the only sensible option left. Decades of innovation had turned conventional farming into such an expensive and technical proposition that it was hopeless for anyone but agribusiness conglomerates to attempt it. This, he said, was the real cause of depopulation. Modern technology made it possible, and more or less obligatory, for a single owner to work fifty times as much land. So neighbors got to buying out neighbors, and then were bought out themselves. The only way forward, Teske figured, was to reject all those modern innovations, at which point you were basically “organic.”…

Sprawling beneath eight states and more than 100 million acres, the Ogallala Aquifer is the kind of hydrological behemoth that lends itself to rhapsody and hubris. Ancient, epic, apparently endless, it is the largest subterranean water supply in the country, with an estimated capacity of a million-billion gallons, providing nearly a third of all American groundwater irrigation. If the aquifer were somehow raised to the surface, it would cover a larger area than any freshwater lake on Earth — by a factor of five.

Within a decade thousands of wells were drilled, creating a spike in productivity as unprecedented as it was unsustainable. Land that had been marginal became dependable; land that was dependable became bountiful. Even as the U.S. population surged, with soldiers returning and babies booming, the output of the plains rose fast enough to meet and exceed demand…Then, during the early 1990s, farmers throughout the Great Plains began to notice a decline in their wells. Irrigation systems from the Dakotas to Texas dipped, and, in some places, have been abandoned entirely…None of which, he went on, is likely to come back. For complex reasons involving wind, weather, and soil composition, the Ogallala does not recharge in the way one might expect. In fact, of the eight states above the aquifer, only Nebraska, with its sandhill dunes, is permeable enough to contribute any serious replenishment…

The farmers we stopped to talk with seemed to break his heart more each day. On a 12,000-acre plantation near Weskan, Kansas, we stood inside a cavernous warehouse of gleaming tractors and combines while the owner chattered and Teske interjected questions about loan terms and well output. He nodded gravely at the answers and chomped on the stub of his cigar until, as we headed down the driveway, his face collapsed and he moaned, “That poor bastard can’t even see the cliff he’s going off.”

One of the major ecological problems in the country – in the world – is the drainage of aquifers and dwindling water supply. It actually shocks me how little news it gets. Read the article, it’s absolutely great writing and had me gripped throughout the long, long article.

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In which Harvard Business School is revealed to be an episode of Gossip Girl

My biggest takeaway from this in-depth piece on gender equality in Harvard Business School is that it sounds like Gossip Girl is real, it’s just in Cambridge:

But she wanted to meet someone soon, maybe at Harvard, which she and other students feared could be their “last chance among cream-of-the-crop-type people,” as she put it. Like other students, she had quickly discerned that her classmates tended to look at their social lives in market terms, implicitly ranking one another. And like others, she slipped into economic jargon to describe their status.

The men at the top of the heap worked in finance, drove luxury cars and advertised lavish weekend getaways on Instagram, many students observed in interviews. Some belonged to the so-called Section X, an on-again-off-again secret society of ultrawealthy, mostly male, mostly international students known for decadent parties and travel.

Update: From the reaction to the original article, the New York Times is astonished to learn that perhaps class is an issue, too, at HBS:

When Christina Wallace, now the director of the Startup Institute, attended Harvard Business School on a scholarship, she was told by her classmates that she needed to spend more money to fully participate, and that “the difference between a good experience and a great experience is only $20,000.” [emphasis added]

…The result is a school that mixes students of relatively modest means with extremely wealthy ones, including in recent years the children of Leon Black, a private equity investor, and Gerald D. Hines, the founder of one of the world’s largest real estate firms, among many others….

According to Ms. Boyarsky and others, the members are mostly male and mostly international students from South America, the Middle East and Asia. They organize “the real parties, the parties where it’s a really limited list, the extravagant vacations — I mean really extravagant,” she said. (No students interviewed admitted to being members of the group, though some said they had attended its parties.)

“More than once I heard that ‘the only middle-class students here are the Americans,’” another recent graduate said. [Which is clearly not true when read after the preceding paragraph.]

Real info on HFT

There is a great comment from a higher-frequency trader that was left on a post on Marginal Revolution. It’s a few comments down on that page. Here’s the background that he gives:

I work as a quant at one of the major high frequency trading firms, this paper is definitely one of the better academic works I’ve seen on the subject. I’ll add a little more. Generally the way that HFT works is by looking for a set of predictive signals in the market. Those signals are combined with liquidity and execution constraints to try to find the most profitable set of parameters after transactions costs are taken into account.

90% of these signals are fall into two major categories: 1) Looking at the price movements of related securities. A good example is SP500 versus Nasdaq. The correlation between the two is around 85% on a daily horizon, but over a horizon of 10 secs or so correlation is virtually zero. So when one moves a certain you bet that the other one will either follow or the first mover will fall back. 2) The other one is by looking at the state of the limit order book and it’s evolution through time. As a very simple example if say you have 20,000 size quantity on the bid and it’s been monotonically increasing and 5,000 size quantity on the ask and it’s monotonically decreasing then it’s very likely that the level on the ask will get wiped out first and the price will go up.

In general what these two add up to is trying to distinguish noisy trades versus signal trades. Speculators/investors/hedgers/etc. are the primary players in the market. Some of those trades contain high information (e.g. maybe a person with access to insider information buying up stock before some announcement), some of them contain virtually no information and are pure noise (e.g. granny liquidating some of her portfolio for monthly expenses). In a naive market with no HFT signals we have no way of assessing the informational content of individual trades, we only have an estimated aggregate or average informational content of trade. Market makers will set their spread and sizes according to this aggregated informational content.

But over any sample the estimated average informational content of trades will not be the same as the realized, for example one week might more than usual insider trading, one month it might make up a small fraction. There’s also a ton of path dependency when you work out the math, that amounts to pure randomness. Because of this securities will not perfectly track their “true price.” The deviation is still stationary, because the more out of line the prices get with the fundamentals the more speculators will step in and push it back. No one is smarter than the market 100% of the time so every time a fundamental speculator sees a price that’s too low/high there’s some chance that the market is right and his valuation is missing something and some chance he’s right. Speculators that aren’t very good are probably only going to be “beating the market” when the valuation on securities looks insanely out of whack or by distributing his portfolio over a wide range of perceived mis-valuations to reduce his volatility. Only the very best speculators are going to be able to get their fundamental valuations consistently right within a small margin of error. So without HFT/Stat Arb./technical trading/whatever you want to call it/etc. the thing that keeps securities from randomly drifting too far are fundamental speculators.

Basically what HFT is doing, instead of fundamentally valuing securites, determining the informational content of individual trades or small time frames, using the signals I mentioned earlier. A segment of the price evolution with high information content tend to look very different from noisy trades on the small scale, but when aggregated up lose this distinguishability. It’s almost symmetrical when you think about it. Fundamental speculators estimate a price for the security and trust in the reliability of the price evolution process in brining the market price to their estimated “true price”. HFT trusts in the reliability of the initial price as being the best estimate of the value of the security and tries to identify errors and miscalculations in the price evolution process.

There is a lot more to that comment there, and plenty of other worthwhile comments as well. Go give them a read!

Manufacturing: Both down and up

Everyone loves to talk about the decline of American manufacturing. Here is manufacturing employment as a percent of the workforce:

It increased through WWII, then held steady for about ten years, then has been decreasing linearly since then (from which we can confidently predict that we will have no one working in the sector in 25 years). Let’s look at total manufacturing employment, though:

Here we see the total number of jobs increasing until about 1970-1980, then plateauing until the 2000’s when it dropped precipitously. I think this tells a very different story than the previous graph. When we examine manufacturing employment and total output we see that output has been increasing consistently:

Which obviously brings us to the productivity gains:

I don’t have any particular commentary on this, I just think it’s good to keep all the facts in mind. Note, though, that productivity increases do not really lead to job loss, but they might lead to decreased share of employment (see also: agriculture). The comments in the links are occasionally insightful, so go ahead and browse through them.

Efficient Presidents Hypothesis

Isn’t that a great chart? And since the shorter US Presidential candidate has won the popular only 33% of the time, shouldn’t the EMH suggest that intrade betting converges months ahead of time? Arbitrage should be easy. I wonder how the two variables interact?

Pre-fabricated post-apocalyptic cities

We keep hearing about pre-fabricated cities designed for millions of people popping up all over China. With the hundreds of millions of people arriving into cities from the countryside, this might be a simple solution to an overcrowding problem. Besides the clear impression that China hasn’t learned much from New Urbanism, there’s also the problem of these planned cities failing. China is trying to plan these things en masse, and not letting them grow organically. Perhaps twenty years down the line they will be a useful, though crumbling, investment. Until then, there will be the few residents wandering like post-apocalyptic zombies through a landscape of empty skyscrapers and the shells of extravagant museums.


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