Brad DeLong's Semi-Daily Journal (2004)

This means the (long-term) dollar-denominated price of gasoline is gonna keep going up, doesn't it?

So what should i do...buy euros? buy gold?

i've been saving for a down payment and need to know what i should do with that cash now that i've decided the housing market has gotten too insane to buy now in hawaii.

someone help!

Not to sound like too much of a dope Brad but what exactly is "uncovered interest parity?"

Note to Sampo - you must have wandered in the wrong door.

Renormalization

How the balance of payments affects suburban residential housing prices.

"There Goes The Neighborhood", Benjamin Wallace-Wells, Washington Monthly for April 2004, discussed the metrocoastal housing boom areas like urban and suburban California, New York, New Jersey, Massachusetts, Connecticut, Rhode Island, New Hampshire, Florida, Pennsylvania, Maryland, Virginia, Washington, Hawaii, etc. He assumes that because home prices in these regions are unaffordable to ordinary people earning ordinary salaries for these regions, that they will therefore collapse to affordable levels.
Brad DeLong's website j-bradford-delong.net has a section at 4/29/04 titled "Dude! Where Is My Uncovered Interest Parity?" on the overvaluation of the US dollar. These are connected.
The US has imported so much that one third of all tangible objects we consume are from overseas, from fuel to food, from sweaters to sneakers. Another third are made, harvested, refined, smelted, or otherwise processed by immigrants. Both of these have economic consequences that affect real estate prices.
Services benefit from localization economies and they tend to move to cities, almost always coastal cities, and particularly those with good weather or cultural attractions like New York, San Francisco, Boston, Miami, Seattle, Washington, etc. As employment shifted from primary and secondary production and manufacturing to services, so did the location of America's population. Iowa is literally aging to death as crop prices fall in real terms. So are many other rural areas. Only their greater birthrate as compared to the metrocoastal areas is keeping the rural population up to any extent.
Immigrants tend to cluster where other immigrants have already moved and lowered language barriers to employment, housing, and shopping. The drastic increase in housing prices in California has discouraged this to some extent. In the 80's the proportion of immigrants that moved to California was one third and in the nineties this decreased to only one fourth. Similar trends are visible in other metrocoastal areas as immigrants move away from high housing costs into the flyover areas and their less skilled primary and secondary production employment opportunities.
The change in America's net credit and trade balances is not sustainable. Sooner or later America is going to have to pay for it's imports with exports, or cease importing. When it does the trend will reverse and because the trend has gone on so long and to such a great extent the reversal will probably be rapid and ungraceful. We can adjust our housing locations if the reversion is gradual, if the dollar falls slowly and steadily, but not if the collapse is rapid. Houses last a long time. They don't move easily. Even mobile homes require transportation, water, sewage, power, and communications infrastructure to function as housing. Not to mention schools, firehouses, police stations, retail facilities, offices, etc.
To put some numbers into the discussion, last years balance of trade deficit was about 500,000,000,000 dollars. That represents about 10,000,000 jobs at 50,000 dollars a job, counting a job as 40,000 dollars and 10,000 dollars in other expenses such as withholding and health insurance for those that have it. Figure each job comes with two people on average, for a total movement of 20,000,000 people.
More than that, each primary and secondary industry job requires about four other jobs to service the employees. You, your family, and the family of the store clerk, the hamburger stand attendant, the nurse, the teacher, the butcher, the baker, and the candlestick maker all are going to be located some place, and that place is not going to be a metrocoastal downtown. Well, not at first. Eventually so many people will move to the primary and secondary jobs of the flyover that metrocoastal land costs will renormalize.
You might argue that wages are not a significant expense in capital intensive industries such as mining, farming, steel making, etc. This is not the case at all. Capital intensive operations are really construction labor intensive operations. The labor cost is up front for the production of the facility. Operations is just a minor component of total labor costs for many primary production facilities. Manufacturing of the kind of goods you buy at a store is also labor intensive when you follow the manufacturing chain all the way back. Sure, maybe only a small proportion of a car is the wages of assembling it, but the parts assembled are made someplace else. All the factories along the way cost large amounts of human labor.
And all of this labor is going to be done someplace either close to the primary production resources, or close to someplace with cheap labor with cheap housing. Neither of these is going to be a metrocoastal area. Yes, there are oil fields under Los Angeles, yes, there is a lot of good agricultural land left on Long Island, but not significant amounts of either in comparison to the service industries of either.
Eventually the price of land in Mississippi (the most industrial state in the nation) and New York City will begin to converge.

It's because the market is inefficient Brad, because people in aggregate have irrational systematic biases in their economic decision making. One of these biases is that they're used to treating the US Treasury note as a risk-discounted financial instrument. It will take time for perception to catch up with reality.

When it does, because in the meantime there will have been an "overshoot", the correction will likely be sharp and sudden rather than a gradual adaptation. As Keynes pointed out however, no one knows when that will occur. As he stated, the market can stay irrational longer than you can stay solvent.

When the market corrects, you'll have your interest rate parity all right.

So does an analysis of the last few years lead us to the conclusion that markets are not dominated by "rational actors"?

Bob,

The rationality of markets does not depend upon domination of markets by rational actors -- any more than the airworthiness of airplanes depends on their being dominated by birds.

The rationality imputed to markets is related only to there being a variety of actors and a shifting array of margins where they equilibrate their hopes, wants, and fears with others.

A rational actor, when confronted with data that shows he has made a mistake, corrects it.

A rational market, composed of rational actors, will correct when they see that other rational actors are correcting.

That's why we call it a market "correction". Think of it as getting back the paper you worked three weeks on and on the front it reads.

"A very interesting theory, should, at any time, we prove that the velocity of light is 1 furlough/fortnight".

uncovered interest rate parity depends on expectations.

Thye simple solution to the problem is to talk to the economists who influence the markets i.e. non academic economists ; they clearly by words and by deeds (buy) expect that the dollar will be appreciating this year.

UIP still holds - its other areas of internatinal economics that deserve scuitiny

I have ANOTHER question for you, Dewd:

Where DID you find that "sustainable" trade deficit you just dropped?

Too.

Go, go Brad go!
US Competitiveness:Beyond the Trade Deficit
by N.Hatsopoulos, Paul R. Krugman, Lawrence H. Summers!

The dollar has not been supported these last two years by private investors looking for profits, but instead by Asian central banks looking for export markets. That's the answer to Brad's interest rate mystery.

Off topic:
Hey Brad, no opinions on Wal Mart?

(The) General has the same line as Kasriel:
http://www.northerntrust.com/popups/popup.html?http://www.northerntrust.com/library/econ_research/weekly/us/pc042904.pdf
who thinks that the 'official'( BOJ) support is near the end of its tether.

Walter Willis: Very good analysis. Sounds plausible to me. I'm not sure about the final conclusion, but it depends on your definition of "converge". My look at the SF Bay Area housing market is that aside from luck and other "random" factors, the income pyramid defines who chooses houses/properties first, and who has to choose from what others didn't/wouldn't want (or didn't choose anyway). Thanks for "metrocoastal"; I had this concept but was for a long time struggling to express it concisely.

Oldman: People will discount the risk assessment of treasury instruments roughly to the extent that they believe the US will be capable of serving them, either by delivering real economic performance, or convincing/coercing others to deliver on their behalf. It strikes me that we are increasingly moving towards the latter.

Martin Weil:

Uncovered Interest Rate Parity says that
the rate of returns on domestic assets
(nominal interest rates) should be equal
to the rate of return on foreign assets, which
in turn equals foreign nominal interest rates
plus expected appreciation of the exchange
rate.
The formula is

R(US)=R(forners)+(Exp(E)-E)/E

where E is the dollar/forner exchange rate.
So if the US interest rates are low relative
to other countries then Exp(E)-E<0 or in other
words you investors should expect the exchange
rate to rise - the dollar to depreciate.
You can also tag a Risk Premium term on
on the end there.

But UIP doesn't seem to hold up very well
in general, not just in US and not just
today - though some of that can be attributed
to the Risk Premium term which is bit hard
to measure, but in this case it's not a plausible
expectation unless you think there's a huge
difference in risk between assets, and say
European assets.

sampo. You could buy eurobonds.

Who says investors have a long-term investment horizon.

When is "eventually"? How much does it cost to hold a short dollar positions untill "eventually" happens? And if "eventually" is more than a few years away, the much worse demographic dynamics of Europe and Japan imply greater credit and inflation risk for investing in bunds or JGBs than for investing in Treasuries.

Also, it is a first-order mistake to equate the cumulative current account deficit with foreign claims on the U.S. From end-1995 to end-2002, foreign claims on the U.S. increased by $4.8 trillion; the cumulative current account deficit came to $2 trillion. (The increse in U.S. claims on the rest of the world explains the difference.) Even were the U.S. current account defict to close soon, ongoing financial integration would generate a trend rise in foreign exposure to U.S. assets.

When is "eventually"? How much does it cost to hold a short dollar positions untill "eventually" happens? And if "eventually" is more than a few years away, the much worse demographic dynamics of Europe and Japan imply greater credit and inflation risk for investing in bunds or JGBs than for investing in Treasuries.

Also, it is a first-order mistake to equate the cumulative current account deficit with foreign claims on the U.S. From end-1995 to end-2002, foreign claims on the U.S. increased by $4.8 trillion; the cumulative current account deficit came to $2 trillion. (The increse in U.S. claims on the rest of the world explains the difference.) Even were the U.S. current account defict to close soon, ongoing financial integration would generate a trend rise in foreign exposure to U.S. assets.

Don't have much time, so I'll be rushing here...

Suppose the yen is certain to be trading 10% lower in a year. A BOJ official who is buying dollars and selling yen, is therefore losing 10% on any intervention (assuming he unwinds in a year...). He is not seeking compensation for this, hence no interest rate premium required; he considers it a cost. And American officials are right to consider this an implicit export subsidy to all Japanese exporters.

China is beginning to sort out ways to act on what it perceives as a very overheated and speculative economy. I suspect in some back room right now Chinese economists are thinking changing the peg on the yuan might be a healthy thing to do soon (they've begun to make noises to that effect). If they do, and stop supporting the dollar, I suspect interest rates will soar and the dollar will fall heavily all pretty quickly.

I think the interest rate parity is locked up in China's overheated and increasingly speculative economy, and they know it, and they're darn well going to do something about it before it gets too dangerous (unlike a certain Greenspan fellow here).

Sampo, If I could predict the future of financial markets I wouldn't be wasting my time posting at Brad Delong's blog--I'd have my butler do it for me. That said, Warren Buffet is in cash and has also bought a lot of euros.

radek: thanks for the explanantion. I remembered vaguely the math (inflation was part of the formula I once learned) but I had never heard the UIP term before.

Walter Willis: Quite an interesting analysis of a link between metrocoastal housing values and dollar values but a lot of holes in the predictive part.
1) You presume that a fall in the dollar would drive a substantial increase in domestic production. In order for domestic production to be repatriated and not just shifted to another low-cost foreign country, this dollar fall would have to be very drastic and this would likely cause a severe recession first.
2) You exclude externalities from the scenario. E.g. what happens if China implodes? Dollar rises.
3) Even if your scenario is correct, currency value shifts occur often within months yet the shift in manufacturing location would take years - for the same reasons you offer about housing being hard to move. Therefore a "renormalization" of land costs would be a 5-10 year process at least
4) A rise in domestic manufacturing does not in any way imply a decline in the domestic service economy. Therefore high demand for metrocoastal land could just as easily remain, or even increase, as the dollar drops making US services more globally competitive.

I therefore have to return to the Wallace-Wells explanation for why metrocoastal land prices sooner or later will have to normalize.

Sorry, that should begin, "Suppose the dollar/yen is certain to be trading 10% lower in a year."

Andrew writes "American officials are right to consider this an implicit export subsidy to all Japanese exporters." Point taken.

So should these officials be adjusting the value of these (Japanese) exports in our GNP calculations?
Currently the face value of these imports are subtracted from GNP, no? Implicit subsidies brought about by foreign currency intervention are not part of this valulation(?)
If the value of these imports are understated, GNP figures are overstated. (Which I believe, since I am unable to swallow the implied productivity numbers).
With Japan's exit from the fx markets, this implicit feature declines markedly and we should expect more palatable productivity numbers. Any ideas?

Response to comments by Martin Weill
*****************
Walter Willis: Quite an interesting analysis of a link between metrocoastal housing values and dollar values but a lot of holes in the predictive part.
1) You presume that a fall in the dollar would drive a substantial increase in domestic production. In order for domestic production to be repatriated and not just shifted to another low-cost foreign country, this dollar fall would have to be very drastic and this would likely cause a severe recession first.
***************
Too right it would, everywhere except America would have lost those ten million jobs for a rise in unemployment. There would also be a serious deflationary impact as the least efficient factories overseas shut down and only the most efficient and lowest cost producers survived. Furthermore, in America the increase in the cost of import/export goods would cause inflation. Even worse for the US economy is the increase in real interest rates for new loans when we stopped getting overseas investment. Old US loans would depreciate by inflation.
****************************
2) You exclude externalities from the scenario. E.g. what happens if China implodes? Dollar rises.
****************************
That's probably why the rest of the world has subsidized America to such a great extent. Tax evasion by the Red Princes, the Nomenklatura, the Permit Raj, the Oil Sheikhs, the Eurotrash, the Narcotrafficantes, the WaBenzi, etc, and the money reinvested in Treasuries by the laundering institutions. It's almost funny.
****************************
3) Even if your scenario is correct, currency value shifts occur often within months yet the shift in manufacturing location would take years - for the same reasons you offer about housing being hard to move. Therefore a "renormalization" of land costs would be a 5-10 year process at least
***************************
Structure prices would increase to match inflation in construction material prices. It's land prices that would renormalize. The value of the houses would remain the same or even increase. It's just the land price component that would converge. I presume that agricultural land prices would not increase, but that depends on agricultural subsidies and whether they were ended when the price of primary agricultural production increased in the US. What happens to crop price supports when the dollar falls that much and causes crop prices to go up?
********************************************
4) A rise in domestic manufacturing does not in any way imply a decline in the domestic service economy. Therefore high demand for metrocoastal land could just as easily remain, or even increase, as the dollar drops making US services more globally competitive.
****************************************
No, just the labor component of the cost of services would go up. The labor component of your McDonald's hamburger would go up, the land and structure cost would not go up. The minimum wage labor is portable and will move to higher wages. The local McDonalds building isn't going anywhere.
US service exports like movies and software would do really well. If the Chinese started paying for our movies and software, especially. This might happen, but it also might not happen.
Another way the population of the metrocoastal areas might not fall is if we imported the necessary ten million workers from Mexico. This also might happen.
*********************************************
I therefore have to return to the Wallace-Wells explanation for why metrocoastal land prices sooner or later will have to normalize.

Posted by: Martin Weil on April 30, 2004 09:04 AM

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