D-U-N Done!

Well, almost. I still have one packet to mail out. I tried to submit it via e-mail, but was told that electronic submissions were not being accepted. Still, the packet is made up, addressed, and stamped. So you can stick a fork in me.

Of course, now the hard part is here: the waiting. Even if departments start looking at the packets before Thanksgiving (and not all of them do), it seems like the earliest I could expect a call or e-mail to schedule an interview in Atlanta would be around the second week in December. That means I have almost a month to wait and hope and worry. That doesn't seem like a lot of fun.

As for the application process, I didn't like physically mailing out packets, mainly because I felt I was sending them into the void. There's no response of "Hey, thanks, we got your packet." I may have to call a few places next week and ask if they received it, just to be on the safe side. The e-mail applications were my favorite. Not only were they the easiest (although econjobmarket.org was pretty easy too), but they often e-mailed back and said thanks for applying, we got your stuff. Very nice.

I still have a bit of (minor) work I would like to do on my paper before my interviews and any flyouts. Also, I need to work on my job paper talk. I had a sort of pre-interview with the Federal Reserve Board last week and I found myself jumping around too much in explaining my work. I'll have to write something down and practice a bit so it's a little more understandable.

Applications, Application, Applications

So, I'm also done with my applications. I'm applying to more than 100 jobs, including a lot of liberal arts colleges, a lot of universities, and a bunch of government agencies (including most of the Fed banks). I'm also applying to a handful of research institutes that focus on interesting areas.

I first sent out the 34 applications that required hard copies. A lot of the liberal arts colleges wanted hard copy applications which generally included a letter, cv, teaching evaluations, and my job market paper. Some also wanted a teaching statement, research statement, and graduate transcript. I printed everything out at home (so my printer needs a new toner cartridge) and sent them out priority or first class. All together, it only cost about $40 (plus the toner cartridge).

Then I filled out the web site applications. The ones that were on econjobmarket.org (started by our own John Rust) were fairly easy, although there wasn't always a place to put a cover letter. Maybe they didn't want letters. The applications that had their own web form to fill out was a bigger pain. They all seemed to have bought the same software package which had four to five separate pages to fill out and had mostly (but not completely) the same questions.

Finally, I'm sending out the applications that just want an e-mail with attachments. These are fairly easy, and I only have about 10 left. The one thing I keep trying (mostly successfully) not to screw up is the cover letter. So far I haven't (to my knowledge) sent a cover letter to one school with another school's name in it, but I may have said I was including something that the last school wanted and this school didn't. Hopefully, they won't notice.

With over 100 applications, and a fairly wide net, I'm hoping to get at least 10-15 interviews in January. We'll see if I can keep my fingers crossed until then.

Say JOE, Whatcha Know?

So, the October JOE (Job Openings for Economists) has been out for almost two weeks. The total is 432, down from 500+ last year. Still, a lot of those from last year's October listing were pulled in November and December, so it's hard to compare apples to apples. There are 190 full-time U.S. academic listings. Some are for more senior positions, but some of the junior listings are for two positions.

Looking through it, I've found plenty of jobs I'd love to have. I think there are about 75 I'll apply to and I'd be (fairly) happy at all of them. I've looked at the econ departments of a number of liberal acts colleges to see who they've hired recently. It's surprising how many of them have assistant professors from Yale, Princeton, Berkeley, even MIT and Harvard. My chances at those schools may be fairly low, but it still seems worth applying, especially if they want a good teacher.

There are also a number of Canadian schools hiring. I don't know much about the relative rankings of these schools so it's hard to gauge to whom I should apply and what my chances will be. Still, there are another 10-15 schools I think I'll apply to there. There are also 25-30 non-academic jobs I'd like working at and to which I'll apply, mainly in the federal governmnet. Putting it all together, that's a lot of cover letters to write. I guess you can't say "...I'd love working at [insert school]...I think I'd be a great fit at [school]'s department of [economics/business/public policy]...[city,state] is where I've always dreamed of living!" Probably wouldn't look too good.

Bryn Mawr Update

So I went to check out Bryn Mawr's web site in order to see what it said about open positions in the econ department after bemoaning the fact that the listing in the September JOE required at least 2 years of post-PhD experience. It turns out that the school lists an advanced assistant professor position (the one listed in the JOE) and an entry-level position (or maybe two). I don't encourage anybody else to apply to these attractive positions.

And it's no wonder. The department seems to consist of the chair, one other full professor, one associate professor, a visiting assistant professor, and a lecturer. Only five people! Maybe that's standard for a school of Bryn Mawr's size (it has 1,300 undergraduates). And I know that students can take classes at Haverford, but it still strikes me as a fairly small department.

Of course, that's one of the issues. If one is looking for a job at a liberal arts college it is encouraging to think of all the schools in all the states across the country. But if each school only has five faculty members then most will not be hiring in any given year. In that case, whether or not the first job you get out of graduate school is a good fit is a matter of a certain amount of luck. Perhaps even more so when you're looking for your first job in the middle of a recession.

September JOE

As we come to the end of September, I'm looking (anxiously) forward to the October JOE (that's Job Openings for Economists for those who don't know). The October JOE is the main source of job listings for newly-minted Econ PhDs and there is a certain amount of uncertainty as to how many openings there will be. Last year there were over 500 positions listed. Unfortunately, as the size of the current economic crisis became evident, many of these jobs were pulled and the job market tightened significantly. But before we see the larger and more important October JOE I thought I'd take a minute to look at the September issue.

Last year's September JOE had 182 listings of which 88 were full-time tenure or tenure-track academic positions in the U.S. and 59 were full-time non-academic. This year there are only 113 listings, a 38% decrease. Only 46 of these are full-time tenure or tenure-track U.S. academic jobs. That's down 47% from last year! That's um, not good. Non-academic full-time jobs were down to 29, slightly more than 50%.

There are a number of Canadian academic jobs (I love Canada!), but they all end with a disclaimer that Canadian citizens will be given preference. And one of the U.S. academic positions listed gave me pause. Bryn Mawr posted a listing for an assistant professor which looked great. After all, my grandmother, aunt, and cousin are all graduates. But BMC says that "applicants should have a minimum of two years post-Ph.D. teaching and/or research experience." Um, ok. I guess that puts me out since I expect to get my PhD in the Spring.

Now this type of requirement is fairly common in other fields. People go do post-docs or get adjunct positions for a couple years after they get their degree and then look for a tenure-track position after they've published. But economics has not usually had this type of requirement, I assume because of the extra demand from government and private industry. In fact, Bryn Mawr listed in 2008 (also in September) and only required that applicants expect their PhD at the time of appointment.

If this represents a trend it could be a problem for those of us finishing up in 2010. It's possible, given the soft job market last year that supply is higher this year than normal. If so, schools who are actually hiring (like Bryn Mawr), may feel that they're in a stronger position and can demand more (like experience) than they would usually be able to.

The October JOE should be out in ten days or so. We'll see.

Job Market Season

So, if all goes according to plan, I will be on the job market for newly-minted econonomics PhDs this year. We had our first job market meeting at school in which they told us to get our CVs and web sites done. I'm still supposed to get my CV edited, but you can see it here. My web site is up here. I've also added a brief teaching statement and results from two student surveys of classes I've taught at Maryland. I need to add a research statement and then I should be done with the peripheral materials.

Of course, the main thing I need to finish is my job market paper. It's coming along pretty well, but I still have a fair amount of work to do. I'm presenting it at our brown-bag lunch seminar in a few weeks and then I'll have about a month to finalize it.

The good news is that I've found some empirical evidence to support the main idea of the paper which is that people have loss averse preferences when making their education investment decision. I've found evidence of a quadratic function where education is the dependent variable and (log) average family income is the main explanatory variable. This shows that those with lower (and higher) family income will get more education than those with family income in the middle of the distribution.

There are a number of things I still have to do. I'm still working on the simulation, especially to match median income at each education level. I also need to simulate a basic model in which agents are not loss averse and simply have mean-reverting earning ability. This would be the main alternative explanation to my model. Hopefully this model will be unable to explain some of the moments in the data that my model can explain.

Once I'm done with all this I'll be ready to send it out to all the jobs I apply to, Assuming that anybody's hiring.

Draft of Bubbles Always Pop!

I've posted a draft of my brief paper on popping asset bubbles on my other web site. It can be found here. Comments are welcome.

Wait, nobody reads this blog.

Never mind.

Bubbles Always Pop!

That's the working title for the paper I'm working on as discussed in the last post. The key is not that the number investing in the risky asset depends on the growth rate of the risky asset but that it depends on the momentum of that asset. That is, how long has the asset been outperforming the risk-free bond? This attracts more investors until it stops outperforming the risk-free bond and then everybody tries to get out and the bubble pops.

Here's the abstract and the intro to the (very short) paper. I'll post the pdf when it's nearer to completion.

Abstract

This brief paper sets up a simple model in which investors can be ruled by “animal spirits” and bid up the price of a risky asset well above its fundamental value. The price of the asset eventually plateaus so that the annual return is less than could be earned in a risk-free bond. This lower return signals the end of the bubble and investors rush to the exit, pushing the price well below its fundamental value in one period. If model parameters remain the same, this cycle continues indefinitely with bubbles inflating and popping over and over again. A change in the parameter values allows the risky price of the asset to hover around its fundamental value. A bubble, at least in terms of this model, can be interpreted as an increase in the weight of irrational “animal spirits” as opposed to the rational value investors in the market. When the bubble pops, the irrational investors diminish in importance and the asset no longer experiences bubbles. There are a number of additional steps that need to be taken int he model in order to make it useful from a macroeconomic point of view.

1 Introduction

When Great Uncle Frank calls on that lazy Sunday morning and tells you he has a guaranteed investment opportunity, what do you do? You ask him some questions, and eventually, you realize that he invested early in a Ponzi scheme. And now you're at an ethical crossroads. After all, Great Uncle Frank earned fifty percent on his money in six months. You could use an extra five thousand dollars. Hell, who couldn't? Of course the ethical course is clear. Getting money in a Ponzi scheme isn't really different then mugging old ladies in the back alley. Either way, you've stollen money that doesn't belong to you. You explain to Great Uncle Frank that you can't invest in his “once in a lifetime” investment opportunity and tell him to give your love to Great Aunt Miriam.

Of course, homo economicus, that near relation of ours who fully developed in our great midwestern town of Chicago, is not familiar with ethical dilemmas. His only concern, when his Uncle Bernie calls with the same investment opportunity, is to figure out the likelihood that he can get in on the Ponzi scheme before it runs out of money and the last round of investors are left holding the bag. If he thinks the scheme will continue for at least another round, he's likely to invest, make some money, and then get out. Homo economicus is entirely rational and doesn't have to worry about Keynesian “animal spirits.” The rest of us are not so perfect and can get carried away with the thought of making a pile of money in an easy investment. If a friend or neighbor just made a bunch of money investing in a Ponzi scheme, we're likely to want to invest as well. If the asset is a stock or a house, then we have no ethical qualms and we can rush into the invesment with a clear conscience.

And an asset bubble is really no different than a Ponzi scheme, even if there's no postal reply coupons at the center of it. If I knowlingly buy an asset for a price above its long-run value and sell it to you for even more before the bubble bursts, then I've taken your money, as sure as if I was an early investor with Bernie Madoff and you were one of the ones holding the bag when the Feds arrived. The fact that it's not illegal may help me sleep better at night, but we're both just gamblers trying to make a buck before the final whistle blows. And when we see an asset that has outperformed others for an extended period of time (whether it's tulips, stocks, or houses) we want in as well. Who wouldn't? Even if we know the asset is overpriced, it's not completely irrational to invest if we don't think the bubble is going to burst anytime soon. As Charles Kindleberger said, “There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.”

As the bubble expands and the price pushes higher and higher, Cassandras warn that the prices won't keep on going up forever. Eventually they are proved correct and something triggers an exodus. It may be that risk-free bonds outperform the risky asset. It may be a scandal in the financing of the asset comes to life. It may be a panic that spreads through the market. Whatever it is, the bubble has popped and asset values head south much faster than they headed up as everybody wants to divest at once. After the bubble has popped the animal spirits of investors are tempered and are more likely to be replaced by the small voice in the back that was telling us it was all to good to be true in the first place.

This paper has its origin in a number of blog posts by Brad DeLong and Paul Krugman looking for a model that exhibits asset bubbles and also has those bubbles pop. In fact, the main setup for the model presented here comes from DeLong (2009). His model exhibits asset bubbles as investors randomly compare returns between the risky asset and the safe asset and switch to the asset that offers the higher return. In his model, however, there is no way for the bubble to pop. Instead the bubbles deflate slowly as the price of the risky asset passes its fundamental value before starting to inflate again. DeLong shows that his model is fairly sensitive to changes in the main parameter value.

The model here has investors in the risky asset pulled by two opposing forces. One, meant to represent irrational animal spirits, attracts more investors the longer the risky asset has outperformed the risk-free bond. The second, meant to capture the small voice that tells you the asset is overpriced, repels investors as its price gets farther from its fundamental value. The bubble pops when the risk-free asset outperforms the risky asset and nobody wants to hold the risky asset anymore.

Bubble Modeling

Brad DeLong has a (simple, according to him) model of the financial crisis. He does away with rational investors, has stochastic dividends, and has agents who compare rates of return (at random). I think we can probably get rid of these three assumptions and (maybe) write a more successful model. Here's what I would do.

Investors have the option to invest in a risky asset or a safe asset with return r. There is a "true" value of the risky asset, v, based on the (expected) fundamentals of the asset. This could be the discounted value of expected future dividends for a stock or the discounted value of the expected rent of a house.

Investors can calculate the true value of the asset, although it may be subject to shocks so that the current price of the asset may be above or below the long-run value at any given moment. Investors maximize per period (expected) profit. The key is that investors know that asset bubbles are possible. That is, the price of the risky asset can be above its long-run value for multiple periods?

Why is this? It's because investors are willing to invest in a Ponzi-like scheme. When prices start going up, investors assign some probability, a, that the price of the risky asset will continue on the same growth rate as the previous period, and a probability, (1-a), that the price will fall to its long run value (once the bubble bursts). As long as the probability they assign to prices going up is known and shared by all investors, it may be rational to continue to invest in the risky asset even when above its fundamental value.

The main question in the model, I believe, is how to model a, the expected probability that prices will continue to go up. I think it will work if a is a function of the past growth rate in the price of the risky asset and the distance between the current price of the risky asset and its fundamental value (although we may not need both). That is, a is decreasing in the distance between the current price and the fundamental value and is increasing in the past growth rates.

The model's dynamics come from heterogeneous risk preferences in investors. That is, investors have different cut-off points a* at which they are willing to invest in the risky asset. That is, more risk loving investors are willing to buy the asset with a lower a then are more risk averse agents. More risk averse agents will only be willing to buy the risky asset when a is high.

So what happens? A shock hits the asset's long-run value so that its current price is below the fundamental value (as in DeLong's model). This means that a is positive (but small) and less risk averse investors purchase the asset. As they purchase the asset the price of the risky asset goes up and a increases. This draws more investors into the asset and the price continues to go up. However, as the price gets farther and farther above the fundamental value, a starts first to increase more slowly and eventually to go down.

As soon as the growth rate of the risky asset price is negative, everybody assigns a value of a = 0 and sells the asset. Since everybody wants to sell at once, this may push the price of the asset below v. I think this should also push up the price of the riskless asset and so push down the interest rate, r. Once the asset falls to (or below) the fundamental value, the asset either stabilizes or even starts to rise.

The key is that everybody knows its an asset bubble. They are willing to invest in the risky asset because as long as a is high enough, the expected value of the risky asset is higher than the riskless asset. Investors maximize profit by buying the asset above its fundamental value simply because there's a high enough value that the price will keep going up. They're not at the last layer of the pyramid scheme.

It's not exactly true, of course, that investors are always aware they're in a bubble. But what is true is that once the bubble bursts everybody realizes that it was a bubble and tries to get out. This is easy for stocks but less easy for houses. Thus stock bubbles can burst in a week while housing bubbles may take longer to fully deflate.

Job Search Model

Went to a fairly interesting seminar last week. The presentation was on career switching, although it was really a career/job ladder model in which those who are more talented move up and those who are less talented move down. Matches the career switching data (at least in Denmark) although for me it raises the question of what the difference is between a job and a career. Successful engineers moving up to management (of other engineers) have switched careers in this model.

It seems to me that a model that is more successful in describing reality would have two dimensions. One dimension would be the "fit" of a job for a particular individual. That is, each individual has different interests and skills which will be matched differently by different (jobs? careers? occupations?) fields. Some will be math people, some medicine people, some construction people, etc. Young people just entering the labor force may have some idea what fits them best, but they learn a lot as they hold different jobs.

The second dimension would be a vertical dimension in which more capable people move up the ladder (in the field). The key would be that moving up the ladder would be a function both of overall ability (independent of field), but also the "fit" in the particular field.

If I went into the art field I might be allowed to clean the brushes, even if I have a reasonably high overall ability, because the field is such a bad fit for me. If I decided to teach math, I could probably rise to a semi-successful high school teacher. If I want to teach and research economics, perhaps I can rise a little higher because it's a better fit for me.

So how to do it? Well, each agent would have to have two describing statistics: field and ability. Let's say they're distributed between 0 and 1. The field could be a circle (i.e. it doesn't need to have a max and min). Say there are fields (each with one firm) distributed evenly around a Salope circle. Each has a ladder representing higher paying jobs in the field. The wage would then be a function both of the fit of the field and of ability.

Agents may or may not have any information about their field and ability when entering the labor market. After each job they learn more about each of those statistics, as do their employers. They (and their employers) have the option to move them up, move them down, keep them steady, or institute a search for a new field. If there's enough uncertainty and job search costs are high enough, most people will stay put. Those who have a good fit on the field but are on the margins in terms of ability will move up or down. Those who have a bad fit in the field will either quit or be fired.

This paper may have already been written. I feel like I've seen something like this, but I don't remember the model.

More on Housing

So apparently I'm not as original as I think. Nouriel Roubini has also suggested "breaking every mortgage contract."

Considering the fact that he's a lot smarter than I am, maybe we should take this idea seriously. But let's think about an asset other than houses to see if it clarifies the situation any.

Imagine that we all invest in gold. Whenever we want to save, we go to the goldsmith and buy a couple of nuggets. First, let's say we all pay cash for our gold. Now let's say there's a bubble in gold prices. I bought $50,000 worth of gold at the top of the bubble. But then the bubble burst, and now it's only worth $30,000.

There are really only two things that I can do. If I think the price is going to go back up, I can hold onto the gold and hope to sell it for more (than it's worth now) in the future. Or I can just sell it now and take the $20,000 loss. If it's clear that the gold only has an intrinsic value of $30,000, and I need the cash for whatever reason, then it makes sense to sell it now and realize I'm not the best precious metals investor in the world.

Now let's imagine that we all borrow the money to buy the gold. It's a loan backed by collateral, so that if we fail to make payments the bank comes and takes our nuggets. Maybe I bought the $50,000 worth of gold with $5,000 down and a $45,000 loan from my local bank. But now that gold is only worth $30,000 and I'm faced with a choice. I can keep paying the loan, or I can default. If I keep paying, then I will eventually pay much more for the gold than it is worth. If I default, the bank comes and takes my gold and I'm out $5,000. But in this case I'm out a lot less than if I had paid cash. The bank, on the other hand, now has $30,000 worth of gold that it can sell but faces a loss of $15,000 on the loan.

Now let's say the government steps in and "breaks every gold contract" so that the principal is reduced by however much the price has fallen. In our case, the price of gold has gone down by 40%. If the principal on the loan is reduced by this much, the new amount would be $27,000 and I would have $3,000 worth of "equity" in my gold. Now the bank will only go for this plan if the costs of seizing and selling the gold are larger than $3,000 ($30,000 - $27,000). Based on what I've read about the foreclosure process, it seems that costs are generally larger than 10% of the "true market value."

So as long as foreclosure costs are significant (larger than the average percent of the down payment), then the idea of reducing the principal on all mortgages will benefit everybody. Banks would prefer doing this only for mortgages with little to no equity on the original mortgage, but that doesn't seem like a politically feasible solution as it would benefit the least responsible borrowers.

The reason we need to do this is because we convinced ourselves that an asset that most people buy and all banks finance was worth more than it really was. The value was never there and now that we realize it, the only rational thing to do is rewrite all the loans that were based on the inflated value. The data to do this is out there. We can simply adjust every mortgage principal based on how much prices have fallen since the mortgage was written in that particular zip code.

Reducing the monthly payments for borrowers will only help people who plan on staying in their house for the entire length of the mortgage (then the difference between principal and interest is irrelevant). But for people who want or need to move, reducing the interest will have no effect. These people will still be faced with selling their house at some price less than their mortgage balance and either having to declare bankruptcy or coming up with the cash somehow.

The fact is, one of the main ways the country recovers from recession is for people who are unemployed or underemployed to move to areas that have jobs. If they are pinned to their house because they can't sell it for what they owe on their mortgage, then the recovery will take that much longer.

Remember, we had the same problem in the early stages of the Great Depression. In that case, the asset wasn't houses, but stocks. Individuals and banks were highly leveraged in their stock portfolios. When the stock market crashed and everybody received margin calls, the system blew up and thousands of banks went out of business over the next couple of years.

A Draft Solution to the Housing Crisis

The criticism leveled at the Obama administration's housing plan is that it does nothing to reduce the number of households that are (or will be) underwater (i.e. they owe more on their mortgage(s) then their houses are currently worth). It seems to me that there's an obvious reason that it doesn't do this. I can't see a lot of political support for reducing the principal owed by (especially subprime) many borrowers. I imagine there would be a lot of "Why should their mortgage principal be reduced because they paid too much for their house while mine stays the same because I (a) bought a smaller house and/or (b) put down a larger down payment so that even though my house has depreciated, I still have positive equity." And frankly, that's not a completely unreasonable opinion, right?

So what should we as a country do? What can we do? First, let's think about what happened during the housing bubble. Imagine there's a house with a true market value of $200,000 (i.e., the rent/buy ratio is around 1 at this price). Suppose it was bought 12 years ago at $200,000 by the Smiths. They lived in it for ten years and then sold it at the top of the market for $300,000 to the Johnsons. The Johnsons bought it with 5% down and a $285,000 mortgage. The mortgage was then packaged into a mortgage-backed security and sold to various investors.

The market has now corrected as the bubble has burst and the house is once again worth $200,000, leaving the Johnsons $85,000 under water. There's an $85,000 loss that has to be recognized by someone. It could be the Johnsons. The problem, of couse, is that most people who buy a $300,000 house don't have an extra $85,000 lying around. The only way they could end up paying the $85,000 is by paying off the mortgage, at least until the price got up to their mortgage balance. Another (market) option, is that the Johnsons walk away, mail the key to the bank who is then forced to foreclose and sell the house at a discount (probably significantly less than $200,000). The bond holders are then left holding the $85,000+ loss. We know they can swallow the loss because their asset simply has depreciated in value rather than creating a new liability (as it did for the Johnsons).

The problem with sticking the bond holders with the loss (as far as I understand it), is that most of these bond holders are large financial institutions. Reducing the value of their assets by a large amount (with lots of foreclosures) will put them under water (their assets will be less than their liabilities so that their capital will be negative or at least below the required amount for a bank to have) and they will be forced out of business or into receivership. If this happens to enough (or at least to large enough) banks, then the whole financial system seems likely to fail for the near future and we all lose. This is what happened in the Great Depression, combined with the fact that depositors lost their deposits when a bank closed.

So the losers are fairly clear: the Johnsons, the bond holders, and possibly everybody (represented here by the taxpayers).

The winners, in this case, are the Smiths, or are they? They received an extra $100,000 above the true market value when they sold their house. Of course, unless they were clever and decided to rent, they probably went and bought a $400,000 house that was really only worth $300,000 and have, therefore, lost that $100,000 they thought they made in the sale of their house.

When you look at it this way, you can see that there really are no winners here. Or if there are some, they are few and difficult to identify. For the most part our former selves were the winners and our current selves are the losers. The assets we thought we had have simply vanished because they were never truly there.

So what's the right policy? I have to agree with the critics of the Obama housing plan that point out that it doesn't do anything to solve the situation. The only way to truly solve the problem is to force the system to recognize all of the losses. The most fair way to do this is probably to write down ALL mortgages by however much real estate prices have fallen in that area (say by zip code) since the property was bought. This would involve trillions of dollars of loss for mortgage holders and MBS and derivative holders. However, for the most part, it's a loss that they've already recognized and may even be less. This would reduce foreclosures by getting everybody out from under water and would encourage investment in homes because people would no longer be facing losses. Reducing the principal and then allowing home owners to refinance at the current low rates would further help reduce foreclosures.

In our example, the Johnsons home depreciated by 1/3 from the time they bought it. Reducing their mortgage by 1/3 would drop it from $285,000 to $190,000. Their equity would have fallen from $15,000 to $10,000, but they would still have equity. Whoever owns the mortgage would face a loss of $95,000, but this is probably less than if the home went into foreclosure.

But what would happen for a "responsible" owner? Imagine the Miller family which bought a house for $250,000 with $50,000 down and a $200,000 mortgage. The house is now worth $220,000 meaning their equity has decreased from $50,000 to $30,000. In this case the value of their home has fallen by 12%. Reducing their mortgage principal by 12% would drop it to $176,000. Their equity would now be $44,000 (down $6,000 from the original but up $14,000 from current levels). The mortgage owner(s) would have seen its value drop $24,000.

There would be no direct cost to the taxpayer in this plan. The total cost to banks is hard for me to estimate. There's probably about $15 trillion worth of mortgage debt that would qualify. According to the Case-Shiller index, home prices are down almost 30% from their high, although they may have another 10-15 percentage points to go. That would mean that if everybody got their mortgage at the peak, the maximum write down of mortgage debt would be a little less than $5 trillion now or about $7 trillion if we wait for the bottom (we should probably only do this once). Of course, not everybody got their mortgage at the peak of the market, and regional markets have significant differences. The total write down would probably be between $3 and $5 trillion. It's a lot of money, but mortgage debt more than doubled between 2000 and 2007, so it's not a surprise.

Banks would probably fight this because it would reduce the value of the prime mortgages on their books that are unlikely to default. The question is, what would the net loss to banks be? They stand to gain something on subprime (and other) mortgages that will not now go into default. I would guess that the loss would be between $2 and $3 trillion. Unfortunately, that might put some of the larger banks under water (at least in terms of regulatory capital requirements). An injection of capital by the government for common shares would seem appropriate in this case as the government is forcing a reduction in the value of the banks assets.

Of course, that leaves the question of legality. This plan is probably not legal, and may even be unconstitutional. One option to force its acceptance would be to nationalize the major banks, take the write down, and then sell the banks to private investors. Hopefully, the banks would now be more attractive since the toxic assets currently on the books would have been mainly decontaminated.

Mortgage holders will be happy. Almost all will see an increase in their equity and a drop in the principal they owe on their mortgage. Renters will be pissed, so this would probably be a good time to eliminate the tax exemption for mortgage interest and give a one-time tax rebate to non-mortgage holders.

The plan should also help stabilize the real estate market by forcing home owners to recognize the fall in the value of their house. And it should help consumer spending by increasing the wealth of homeowners.

Endogenizing Sticky Prices in a Relationship Model

One of the main reasons that firms do not raise prices, according to survey data, is that they are worried about disrupting customer relationships. Yet I haven't seen a model that takes this seriously.

A successful model would have customers that buy one (or many goods) from a known retailer at some price p = (1+mu)*MC which is set by the retailer. The customers would have the option of buying from the retailer at price p or investing in a search at some some cost s to find a new retailer. The customer would have to form some expectation about the price other retailers are charging (some sort of information extraction problem).

The customer then is balancing the expected benefit of finding a lower price with the (known) cost of executing the search. The information available to the consumer might be some sort of productivity shock that affects the marginal cost for retailers in an idiosyncratic way.

The retailers, then, would face an idiosyncratic marginal cost (known only to them) and would choose the markup mu every period. The retailers would then balance the marginal benefit (or cost) from raising (or lowering) the price with the cost (or benefit) of losing (or gaining) customers. The intuition for sticky prices should be fairly clear. A small increase in marginal cost won't lead to a change in prices because it would lead to customers to leave and look for a new retailer. A small decrease in marginal cost won't lead to a drop in price because retailers would have nothing to gain.

There are other things that could (should) be considered in this type of model. Should retailers be able to advertise (gaining customers who are paying more) at some convex cost. This would add realism and would lead to price drops as well as price increases (I assume they wouldn't advertise price increases unless it represented a lower price compared to everybody else).

I could assume that customers have an idiosyncratic reservation price (i.e. they don't buy unless the price is less than their reservation price). Customers could only buy one unit so that retailers focus on gaining more customers rather than selling more to their current customers. The distribution of the reservation prices might be known so that retailers can form a conditional expectation of how much quantity would change if they changed their prices from p to p'.

Outline

Loss Aversion, Education, and Inter-Generational Income Mobility

1. Introduction

a. Fair playing field

b. Number of factors contributing to inequality

i) Education

ii) Innate ability

iii) Starting point

(1) Intergenerational mobility (or lack thereof)

c. How do parents contribute?

i) Financially

(1) Allows children to reduce losses in first (education) period

ii) Genetically

(1) IQ

(2) Other factors

iii) Setting reference level of consumption

(1) Level at which children will shoot when making education decisions

iv) Borrowing constraints

(1) Limits possible education for children from lower end of income distribution if related to parent income

(2) Increases loss in first (education) period for higher levels of education

d. Importance of loss aversion

i) Children from higher income families will take a loss in period one in order to reach reference consumption in period two

2. Model

a. Setup

i) Overlapping generations (3 periods)

ii) “Earnings ability” iid

iii) Education choice/wage determination

iv) Loss aversion (reference consumption)

v) Bequest motive (warm glow)

vi) Borrowing constraint

b. Loss Aversion

i) Weak vs. Strong

ii) Consumption/Savings patterns

c. Borrowing constraints

i) Weak (borrow up to cost of education)

ii) Strong (borrow up to some fraction of family income)

d. Bequest motive

3. Review of the data

a. Income distribution

i) By education level

b. Intergenerational correlations

i) Income

ii) Education

c. Educational attainment by family income

i) Mixed once controlling for parental education

d. Transition matrix for income quantiles

4. Simulations

a. Parameter values

b. Variables

c. Main results

i) Percent at each education level

ii) Distribution of income

iii) Correlation of inter-generational income

iv) Correlation of inter-generational education

v) Correlation of inter-generational consumption

vi) Correlation of inter-generational bequests

vii) Transition matrix for simulated income quantiles

d. Results without loss aversion, borrowing constraints, bequests

i) No habit formation

ii) Habit formation

iii) Add loss aversion

iv) Add borrowing constraints

v) Add bequests

vi) Show how much each adds individually and how they work together

5. Conclusion

a. Model shows three main ways that parent income can be transferred to child income

i) Loss aversion

ii) Borrowing constraints (when strong)

iii) Bequests

b. Work together to explain a significant portion of the inter-generational correlation of income

i) But not the only source

c. Potential policy implications

i) While these results may be individually utility maximizing, they are not socially optimal

(1) Would like people to maximize their lifetime resources (max GDP)

ii) Possible ways to do that:

(1) Make education financing available to all

(a) Include consumption allowance

(2) Inheritance tax

Gerrymandering: Good or Bad?

Before I forget the idea (which may have already been done), here's a possible way to model the effects of gerrymandering of congressional districts.

Imagine there is an area (state) which needs to be divided into N districts. Voters belong to one of two groups (R and D). Each sub area has a normally distributed percentage d of type D voters (and 1-d of R voters). If districts are assigned randomly, then the expected percentage of D voters in each district is simply d. However, if gerrymandering is allowed, then districts can be created with clear majorities of D and R voters. Will this be good or bad for voters? One way to measure welfare would be to measure the probability that a voter's representative would be in the same group. The higher the probability, the better off are the voters.

One other consideration, of course, is competition. The conventional wisdom is that voters are better off if seats are competitive because representatives will be more responsive to voter desires. However, even if a D or R always wins a particular district, there's no reason why (in this model) it has to be the same D or R. Competition at the primary level is still competition.

Loss Aversion and Human Capital

My current project is on loss aversion, education choice, and inter-generational income mobility. I will try to write the introduction tomorrow.

The basic idea is that people develop a reference level of consumption in their first period of life (known as childhood to non-economists). They then must make an education choice in the next period, facing both a direct cost and an opportunity cost.

Because agents are loss averse, they may choose a lower level of education than would maximize lifetime resources in order to avoid losses in the education period. In the final period they earn a wage that is determined by both their education level and their "earnings ability."

There are a number of questions that still need to be answered in the paper:

1. Is loss aversion necessary, or can I just use habit formation with a standard concave utility?
2. Can parents take into account the utility of children in making their decisions, or is it ok if they just have "warm-glow" altruism?
3. Should the direct cost of education be convex or should the opportunity cost be convex? Which is easier to model?
4. Can the model successfully replicate education choice, inter-generational correlation of income, and the overall income distribution, or is that asking too much?
5. If wages are stochastic, what is the effect on the education decision? With loss aversion we won't have certainty equivalence, right?
6. What is the result of using strong vs. weak loss aversion? What are the consumption implications of weak loss aversion?
   
7. Should utility depend both on the absolute level of consumption and the difference between current consumption and the reference level? Would that help or hurt the results?
8. How important is each aspect of the model? Loss aversion, habit formation, borrowing constraint, and bequests.

It will be fun to find out. Maybe.

Welcome to Drafty Economics

In order to make sure I write something everyday, I'm starting this blog. It will contain thoughts and drafts on (hopefully) original economics. And while it will contain much that is apocryphal, or at least wildly inaccurate, it will score over older, more pedestrian blogs in two important respects. First, it will be fascinating for those interested in how graduate students grope in the dark, trying fruitlessly to develop original theories in order to get a cushy academic job and, eventually, tenure. Second, well, actually, there is no second. I expect readership in the single digits. On a good day.