## Thursday, February 28, 2013

### Test Of The High?

Today the indices were up for most of the day but some late selling forced them to close in red.
Was it was a re-test and failure of the last high? I think it is still early to call today's action as failed re-test.
However, SPX is still above 1500 and DOW still above 14000. I would like to see indices making a lower low 1st and then re-test the 1530 level in SPX and fail there. Only time will tell whether the market will actually behave that way.

But what lead to the last hour selling? Was it fear of Sequestration or just regular pump and dump action?

But more than the red indices, I would like to draw your attention to Gold which again closed below 1600. I think the bounce in Gold is over short term and we will see some renewed selling. So those of you thinking about catching the falling knife, better be careful. However when the mood becomes totally negative on gold, that would be the time to go for it. We will have to wait a while longer for that to happen. Nothing much is happening anywhere else really. Equities will continue their up and down dance for a while more. Grains are still making a bottom before the rally. No much to do in Oil and Nat. Gas either. All in all, we are in the waiting mode. Our sell signal has been triggered but something else is holding us back from going short at this point of time. I am expecting some whipsaws in market action and better to avoid emotional and moral hazards. Folks normally get frustrated when there is not much action. We think we always have to buy or sell but in reality, we don't have to. Sometimes it is better to give up short term gain for longer term opportunities. This is one of those times. March subscription is still open for two more days, before the next Newsletter comes out on Sunday and if you would like to avoid walking in the dark, you are welcome to join the gang. ### Down a little; Up a little 4th Quarter GDP was revised up today from a dismal -0.1 percent to a dismal +0.1 percent, confirming the stagnation character of the American economy. All the fine rhetoric from the White House and its chorus of apologists cannot hide the fact that US economy is stuck in the mud. This should come as no surprise of course. Why should anyone expand their business or take on new employees in this environment? Heaven forbid that anyone should make a profit or try to get rich. That's the new sin. So, what is left is stagnation. An economy that rewards people for not working and punishes those who wish to employ capital is an economy that is going nowhere. Obama has managed to accomplish what few thought possible. He has shut down the mighty American economic engine. ## Wednesday, February 27, 2013 ### Bull vs Bear. Who Is Winning? Few days back I wrote that the bull may be wounded but not dead. Today's market action again proved my point. One day SPX down 2% and next day it is up almost another 2%! Go figure. The fact remains that upside is limited but Ben is not ready to accept defeat so quickly and easily. And as you know, there is no easy trade. When everyone is expecting the "Top", it remains in hiding. The market will kill the early bears and suck in the late bulls. And another new month is coming with new fund allocation. Why give up all the free money? But why every 10-15 point move up or down make such huge news? For one, the 24/7 news media is hungry for sound bites and dramatizes every small insignificant issues. But the more important thing which was point out by Josh Brown of The Reformed Broker is that, almost everyone has jumped in the options bandwagon and are playing with leverage. A 1% move has multiplier effect when combined with leverage. This is not investing. This is speculating. And speculation is anything but good for long term financial health of an individual investor. So where do we go from here? For one, I have avoided the urge / temptation to go short for now and have advised subscribers likewise. I am sure I will lose some of my subscribers with my constant call for caution and not having enough action. But the fact is we are making a top and direction is not clear. We have a sell signal and yet I am hesitant to take action based on the sell signal. And it is my policy that when in doubt, do not trade. I would shoot, only when all the ducks are lined up in a row. Sometimes give up short term opportunity for longer term clarity. Folks who have been in the market long enough know that we make 80% of the profits from 20% of the trades. Going back to the question, who is winning the battle of bull vs. bear, look the following picture for an answer: It is the TBTF Banksters who are winning. Yesterday Jamie Dimon told an analyst covering the bank to go F**K himself. The following is from Reuters: At a J.P. Morgan investor event this week Mike Mayo, an analyst at CLSA, who has been a critic of large banks and, at times, Dimon, asked if J.P. Morgan wasn't at a competitive disadvantage compared to more highly capitalized peers. (Here is a playback via Business Insider: link.reuters.com/fys36t) Mayo: I think what I hear UBS saying in the presentation is that if I'm an affluent customer I'll feel a lot better going to UBS if they have 13.5 (percent) capital ratio than another big bank with a 10 percent ratio. Do you agree with that? Dimon: You would go to UBS and not JPMorgan? Mayo: I didn't say that. That's their argument. Dimon: That's why I'm richer than you. This exchange shows what is wrong in the system and Jamie Dimon personifies the arrogance of the Banksters and how they game everything. In this environment, it is important that small investors start with "Return of Capital" not "Return on Capital" because the fat cats will steal everything otherwise. Avoid risk and everything else will follow. That's all for tonight. Good luck trading every one. ## Monday, February 25, 2013 ### Lessons from Hedge Fund Market Wizards: Steve Clark  Photo via marshfieldrodandgunclub.com "Remarkable performance consistency". These are the words Jack Schwager uses at the outset to describe the track record of Steve Clark's Omni Global Fund In his opening notes on Clark's event-driven hedge fund, Schwager points out that Omni Global has been profitable every year since its inception in 2001. This, of course, includes the panic year of 2008, during which Clark handily outperformed the Hedge Fund Research index of funds sharing this strategy. The combination of strong gains and moderate equity drawdowns and losing periods gave Omni Global an "extremely high Gain to Pain ratio", a return/risk measure favored by Hedge Fund Market Wizards author, Jack Schwager. In other words, he is very, very good. On to the interview lessons... 1. Steve Clark was "brutally honest" in his interview with Schwager. In the opening, Clark describes his background; raised in a council house on the outskirts of London, no father in sight, no university degree, and no initial trading experience. Clark was installing stereo systems when a friend told him about trading jobs in the City. Sometimes interest and motivation are more important than "pedigree". 2. He worked a series of back-office jobs and assistant roles before getting a shot at running a market-making book. He got his first chance to trade the book while filling in for a trader on holiday...during the week of the October 1987 crash. Trial by fire situation. 3. Steve learned a valuable lesson making prices on October 19, 1987: the price is where anyone is prepared to deal, and it can be anything. Steve found he had to quote prices so low until sell orders dried up. He still lost several million pounds on his book that day. 4. Eventually he became the most profitable trader in his group. Steve credits this shift to his ability to cut positions that were down or "wrong". He also traded around news to orientate himself on "the right side of the market". Plus, he was inexperienced and didn't have the fear that cripples people who've been in the business for a long time. 5. Traded on order flow info and screened for stocks making moves on big volume. He also used charts to see what happened when stocks reached certain levels in prior periods. Clark cautions that he is not a big believer in predictive chart analysis. 6. Clark left his market-making job at top-rated Warburg for a better salary offer from Lehman Brothers. He soon found that he couldn't make money at his new firm, having left behind an environment that was rich in order flow information. It was a shock to his ego and caused him to doubt his ability as a trader. It happens to the best of us. 7. Eventually he bounced back and over time developed contacts with trusted brokers. He used their order flow info to gauge near-term market sentiment on news events. If he was not aligned with momentum he would cut his position. Steve believes in buying on the way up. 8. Steve gives traders one key piece of advice: do more of what works and less of what doesn't. Dissect your P + L and see what works for you (types of trades, timing, etc.) and what doesn't. 9. Price is irrelevant, it's size that kills you. If you are too big in an illiquid position, there is no way out. 10. Clark discusses a period of professional ups and downs that begins after the initial seed money for his first hedge fund fell through. After seeding a small fund on a shoestring using his own money, he wound up closing shop and went back to work for others. Thus began a hard road which led to some contentious litigation and Clark's disillusionment with The City. 11. Set up his own fund in 2001 after a successful career move to First New York Securities. Despite his trading success, Clark says he is still waiting to find out "what I want to do when I grow up". A revealing section of the interview follows, in which Clark feels he has nothing to show for his trading career except money. "What have I accomplished?", he asks. It may be worthwhile to reflect on this issue. What are we in this for? Your values and your assessments of the pros and cons of a trading career may vary. 12. Back to trading. It's the size of your position rather than the price at which you put it on that determines your ability to keep the position. Trade within your emotional capacity. Don't take on a bigger position than you can handle. If you wake up thinking about a position, it's too big. 13. When everything lines up, you need to swing for the fences. However, if the position starts acting in a way you don't understand, you need to cut it because that is a sign you don't know what is going on. 14. Your job as a trader is to make the line [your equity curve] go from bottom left to top right. That's it. Don't get hung up on other supposed "mandates". Protect your capital and the direction of that equity line. . . . . That's it for this latest edition in our interview series. We'll have some new "Lessons from Hedge Fund Market Wizards" posts for you over the next few weeks. In the meantime, do pick up a copy of Hedge Fund Market Wizards to get the full color and detail of all these great trader interviews. You can revisit the earlier posts in our Hedge Fund Wizards series (it's like a Cliff's Notes of investing) here: We have some more great stuff in the works, so stay tuned to the Finance Trends blog feed and our Twitter updates for the latest on upcoming posts. Thanks for reading! ### March Subscription Is Now Open It is the Subscription renewal time again. How quickly a month pass! It was on 1st of Feb. when SPX reached 1513 and we went out of the market. Now it is morning of 25th Feb. and SPX is starting the day from 1515.60 Not much has changed in the last 3 weeks and we saved ourselves emotional trauma by waiting in the sideline. So is 49 a month worth for having an action plan in this market?
Many of our readers think so. It is less than a cup of coffee per day from your favourite coffee shop and yet provides you, the reader specific action points on various asset classes with at least two weekly updates, if not more.
Extract of some part of one of our old Newsletter is here for your review:

Equities:
The coming week, we have two indicators for sell signal:
• SPX closing below XXXX, DOW below XXXXX.
• VIX closing above XX.
When we see the Indices closing below those levels, we will know that we have seen the highs. From then on, it is a question of Indices making a lower high or re-testing the previous high and failing in the process.

....................................................................................................................
I think we have a good opportunity coming up and let us remain focused on that only, nothing else. We are not economists and at least I do not understand how it works. Just concentrate on making money with low risk.

PM Sector:
We have met our downside price target of Gold. Silver still has more to fall before it can find a bottom. While I am sure about a new all time high in gold but we may have to wait for 2014 for that to happen. The idea is to buy it when everyone hates it and I think we are reaching that point. Many of you may already be thinking that there is no future for gold. Main Stream Media (MSM) is writing about how Soros sold his gold. So we are getting there. However, if Gold closes below $1600, we will have still lower prices and that will remove all weak hands. So for now, we wait on the sideline with respect to PM. Only parts of the Newsletter. And the levels keep updating / changing to reflect the dynamics of the market price movement. Apart from Equities and PM, we cover Oil & Nat. Gas, Copper (sometimes), Grains & soft commodities and treasuries. Are we always right? Nobody is or can be and we are no exception. But we make every effort to reduce risk and shoot only when when we think all the ducks are lined up. And I try to explain that we do not have to be always invested (Only Wall St. wants you to be 100% invested 100% of the time) and cash is a position. I quote from Josh Brown: "Guys talking about being all-in or all-out can and will change their opinions quickly. This is what they should be doing as professional, full-time speculators. But are you a full-time speculator? If someone can and frequently does go from fully invested to all cash to fully invested over the course of a few days, is there any particular reason that you should be paying attention to them? Will they personally be calling you to give you the second half of their trade? Well, most of you don't realize this so when someone says "ALL IN" or "ALL OUT", it gets you talking, thinking, retweeting, sharing etc. So if you think caution is your style and you value your savings, want to grow it in a low risk manner, may be you should give it a try. Click on the "Donate" Button above and pay$ 49. In the subject line mention Subscription for "March" and you are all set.

I look forward to hearing from you soon.

## Friday, February 22, 2013

Everyone knows, except Obama, that the entitlements are $70 trillion in the hole from an actuarial point of view. This means that, in finite time, they will run out of money. So that, it is very, very clear that future generations will get nothing at all from social security and medicare regardless of the amount that they pay in. Unless something is done. This we know (except for Obama, of course, who seems to know nothing). All of this means that sooner or later, social security and medicare will be fixed. Running out of money is a fix. That does solve the problem. A simple solution is to move out the age of eligibility for medicare (and index it). Do the same for social security. Means test both programs. Raise medicaid eligibility requirements. Doing these things would mean that social security and medicare will never run out of money. So, a simple fix, can make things work. If we do it now. Delay means that when you do act, the actions must be much, more draconian. By postponing action, even for only a single year, the size of the cuts and the postponement of eligibility must be far greater than what would be necessary if we acted today. This is the Obama "delay" tax. The longer you postpone dealing with the problem, the worse is the plight of future seniors. Either Obama doesn't know this (which is probable, because he isn't very focused on real issues) or he knows it and simply doesn't care. ## Thursday, February 21, 2013 ### The First Warning Shot. We heard the first boom. Intra-day, SPX went below 1500 but closed above at the end. While we saw a breach in the up-trend it will be wrong to say that the bull is dead. Wounded yes, dead? No. Those who are thinking of shorting the market now, should do well to keep the fate of this guy in mind. This was the 1st meaningful pull-back in many moons and at this point of time, is just a healthy correction.I think we will see a bounce very soon, may be as soon as tomorrow. Only when it makes lower high, we can think of an intermediate term top. Just like last time. When the indices made few lower highs and there were reversals of reversals of reversals, we did see meaning-full correction. It will follow similar path this time around and prudent traders / investors should wait for price confirmation. Subscribers know the level to watch for and when the sell signal will be triggered. They also get mid-week and end of the week update, which help us to remain on the right side of the market without front running. Other risk assets are getting slaughtered as well. Oil had a flash crash yesterday but for now I think it has found a bottom. But there is no such respite for precious metals. We have been out of it for a while and waiting in the sideline for the right time to get long. But we may have to wait for a while till everyone gives up on gold and all gold bugs fly away. Some other interesting trades are developing in the soft commodities/ grains / Nat.Gas and we will have some action there soon. All in all, end of Feb./ early March promises to be interesting in contrast to the last 3 weeks which has been a boring kind of market. Hope you all are doing great and wish you all best of luck trading. ## Tuesday, February 19, 2013 ### Two cents on the minimum wage Once upon a time, the minimum wage, like free trade, was a basic test of whether you were awake in the first week of econ 1. We put a horizontal line in a supply and demand graph. Minimum wages increase unemployment of poor people. It's back of course. I won't review here the debate over Card and Kruger's provocative results, diff in diff estimators, empirical work without theory (is there really no substitution to capital or high skilled labor? Is the price elasticity really zero?) and so on. This is all low-hanging fruit. (See Greg Mankiw, who asks if$9 why not $20, David Henderson's nice post with great quotes from Paul Krugman on just how bad minimum wages were before evil Republicans didn't like them, the Becker-Posner Blog, and Ed Glaeser, noting how minimum wages are hidden taxing and spending and better ways to achieve the same goals, and this clever Steve Chapman oped asking, why not fix prices lower instead?.) Let's presume for the sake of discussion that a rise in the minimum wage would indeed not much change the demand for labor, the costs would just be passed on in the form of somewhat higher prices, with little decline in output -- as usual in non-economics, assume that all elasticities vanish. It still strikes me, that like much of the current policy discussion, we're asking the wrong question. The question is not "is this great" or "is this terrible" but "does this have anything to do with current problems?" The fiddling while Rome burns is worse here than the belief in minor economic magic. President Obama's state of the Union Address was to me, an interesting peek into the Administration's thinking, and a revealing piece of political rhetoric (I mean that in the good sense of "rhetoric," i.e. "what arguments we use to persuade people") ...today, a full-time worker making the minimum wage earns$14,500 a year. Even with the tax relief we’ve put in place, a family with two kids that earns the minimum wage still lives below the poverty line. That’s wrong....

Tonight, let’s declare that in the wealthiest nation on Earth, no one who works full-time should have to live in poverty, and raise the federal minimum wage to $9.00 an hour. This single step would raise the incomes of millions of working families. It could mean the difference between groceries or the food bank; rent or eviction; scraping by or finally getting ahead. For businesses across the country, it would mean customers with more money in their pockets.... What caught my eye is the "family with two kids," "...millions of working families." It paints a grim picture: mom, dad, two kids, trying to survive one wage earner's full-time minimum-wage job. My thought: What planet do the president's advisers live on? Come take a look, say, at the south side of Chicago, where I grew up and live, and where President Obama spent many formative years as a community organizer and so knows it even better. Is the first-order problem of these neighborhoods that its residents live in intact families with two kids, one full-time wage earner, trying to live on the wages from a full-time minimum wage job, but having a tough time making ends meet? Is there anyone like this? The tragedy of the neighborhoods around where I live, and President Obama used to live, is the vast number of people with no job at all. How does raising the minimum wage for the few who have a minimum-wage job help the vast majority who have no job at all? Minimum wages are about teenagers and young adults, most still living at home. It's about the "dating" phase of work-force attachment, where people learn the skills and habits, and make connections by which they can move up to better jobs when they are ready to have families. "Families" is an interesting word as well. Marriage among lower-income Americans is rare, as President Obama made clear when he came back to talk to students at Hyde Park High school and made some controversial remarks about the absence of fathers. For example in zip code 60619, just south of the University, there are "4,967 married couples with children, and 12,745 single-parent households (2,655 men, 10,090 women)." Here's the marital status chart. What "family" means in this speech is, by and large, a single woman with children. I'm not starting a Murphy Brown argument, but it is an interesting use of the word. I wonder how many of the Republican ears in the audience listened to "working families" and heard "single women with children and no father in sight?" More worthy of our sympathy, indeed, but a very different picture of what kind of policies might actually work. And even then, the modern Scrooge ("are there no workhouses?") might ask, "Is there no earned-income tax credit? Is there no home heating subsidy? Are there no food stamps? Is there no schip or medicaid? Have they not applied for social security disability? Are there no section 8 housing vouchers?" The point is not to be heartless -- government programs or not, life on the lower end of America's economic and social spectrum is pretty awful. The point is, if we seriously want to address the problems of the "working poor," if we want policies that actually work rather than spew a lot of TV time and make us feel good, let us paint a vaguely realistic picture of what their life is like. Absolutely nobody (except perhaps illegal aliens) is trying to support a family on$14,500 from a full time minimum wage job, period.  The actual economic life of the "working poor" is a welter of government programs, transitory employment, and a lot of illegal activity

And, one huge problem facing  people who do work full time and earn minimum wage is the astounding marginal tax rates that our various social programs imply.  In fact, much of the raise from $7.25 to$9.00 will be taken away. Even more of a raise to $20 an hour will be taken away. The structure of our programs that are supposed to help people are instead trapping them. (Previous posts here and here.) Yes indeed, let us help families to "finally get ahead!" Let us talk about lousy schools, incentive-destroying social programs, horrendous violence, life-destroying incarceration, and the war on drugs run amok. The minimum wage may slightly help the few who can get such jobs, and put such entry-level jobs slightly more out of reach for many others. But it's just irrelevant to the real, first-order problems such families face. The final line also caught my eye: "For businesses across the country, it would mean customers with more money in their pockets." I wonder who signed off on that one. Even if the Administration's theory works, it is exactly the same as a tax on sales of local businesses (i.e. cost passed on as higher prices) to subsidize employment. This is an interesting harbinger of things to come in the politics of budgets: Passing a national sales tax on businesses that employ minimum wage workers, to fund an on-budget subsidy of those workers' wages, would obviously go nowhere politically, and would count on the budget. But forcing businesses to do it, though economically equivalent, makes it looks as if the government is not taxing and spending as much as it is. And of course, that tax comes out of the very pockets it's going back in. Back to Greg Mankiw's question about how much the wage should be: on this theory there is no limit! If you pay them$20, then customers have $20 more to spend. If you pay them$50, then they have $50 more to spend. Now we really have crossed the line, from serious economics, to fiddling while Rome burns, to believing in magic. ### Bloomberg TV on debt and magic I did a short interview on Bloomberg TV this morning. Nothing new for readers of this blog, but fun anyway. Coffee just starting to kick in at 6:15 AM. As always, walking home I figured out 10 better ways to answer. ## Monday, February 18, 2013 ### Links: Popular posts and new trading insights Some Presidents' Day reading and insights to guide us into the coming week. Recently popular posts on Finance Trends: 1. Trading psychologists: Overcoming your fear of pulling the trigger 2. Global macro trading: Lessons from Market Wizard, Colm O'Shea. 3. Lessons from Market Wizard, Ray Dalio. - "Markets teach you that you have to be an independent thinker." 4. Lauren Templeton shares investing lessons from Sir John Templeton. Real wisdom on markets, behavioral finance, and life here. 5. Jim Rogers on Street Smarts and outsized investing returns. Rogers says the 4,200 percent returns he and Soros achieved at Quantum Fund are replicable, if you are passionate and work hard enough. Items of interest (markets, trading, and insights) from around the web: 1. Excellent Q+A with trader, Brian Shannon: Better Trading With Multiple Timeframes. 2. Joe Fahmy on The Greatest Trading Book Ever. 3. Napoleon Hill's Think and Grow Rich (e-book). 4. On the Invariant Nature of Investor Returns: "We were irrational then and we're irrational now.". 5. Q+A with Chris Kacher and Gil Morales: why they trade like William O'Neil. Thanks for reading. Check back soon (via RSS and/or Twitter), we'll have a new post in our "Lessons from Hedge Fund Market Wizards" series to share with you and more. Photo credit: George Washington via Newport Buzz. ### Risk Reward Ratio Readers sometimes ask me why am I more in cash and less in the market. My answer is that it always has to do with the "Risk Reward Ratio". Take the current situation for e.g. When the media and ZH was screaming danger in last December (ZH is always screaming wolf anyway) I was telling readers to get bullish. We were long for the whole month of January and went to cash when SPX moved close to our price target of 1510. And for the last 3 weeks we have turned patient bear and yet not shorted the market. The reason we are not being long equities here can be explained in the following long term (monthly) SPX chart. Assuming SPX keeps going up as everyone in Wall St and all talking heads in CNBC are saying, the upside in my view is limited to 1550 which is 2% up from here. It may take another 2 weeks and market does not correct, just to kill all the bears. But on the other hand, should there be a correction (Not the end of the world, mind you) the long term support is a 1300 level, if 1400 does not hold. At 1400, that is 8% correction and at 1300, that is 15% correction. So at best we have 8% / 2% =$ 4 risk and at worst 15% /2% = $7.5 risk. In other word, to go long here hoping to make$ 1, we will be risking $4 to$ 7.5. Is it worth it?
Just to break even on risk reward ratio, we need another 8% upside from here which is 1641 in SPX. I think that is bit far fetched. And although Ben has promised unlimited money, let us see what happens with the Sequestration thingy coming up in March.

Mind you, I am not suggesting that the world as we know it, is about to end. Simply because I do not know how economy works and what will be the unintended consequences. I just know how not to take unnecessary risk or at least I try not to.

But I get the feeling that I am in that Jeep and the Volcano has already exploded and all the ash is bearing down. So better run or be in cash to take advantage of a better entry later.
Now you know why I am in Cash.

### Joe Stiglitz and Inequality

Joe Stiglitz has penned an interesting article on the growing inequality of measured income in the United States.  The facts that he uses, of course, are subject to the usual limitations.  If you ignore everything the government does and all employee benefits, then you get one answer.  If you include government spending and employee benefits you get an entirely different answer.  But, lay that aside for the moment, because, I think, Stiglitz is on to something.  There is growing inequality of opportunity in America, but not for the reasons Stiglitz is implying.

It is no wonder that wealthy liberals are at the forefront of the call for reduced inequality.  They know that their policies will solidify their exalted status in society. They are not at risk.

The simplest example can be read in today's editorial in the NY Times in support of raising the national minimum wage from $7.25 per hour to$ 9.00 per hour.  That kind of policy won't hurt the liberal elite, protected with incomes far, far above these numbers.  This kind of policy -- outlawing jobs for folks with limited skills -- only hurts those who might have trouble affording a copy of the NY Times, not those writing their editorials.

Minimum wage laws are one of the many reasons that inequality is growing in the United States.  Entitlement programs, welfare programs and the takeover of public schools by teacher unions are other reasons for the growing inequality.  I doubt that many of the editorial writers for the NY Times send their own children to public schools or need access to welfare programs of entitlement programs, so, by all means, make them available to others.

Providing government largesse for those less fortunate inevitably increases the number of those less fortunate.  Outlawing jobs for those with limited skills is cruel and makes things far worse.  Stiglitz is right.  Inequality is growing.  But the reason is that government is growing.  Growing government puts lower income citizens in the penalty box and makes it difficult for them to ever escape.  That is what causes growing inequality.

It is interesting that Stiglitz thinks America was much more a land of opportunity one hundred years ago.  That was a time that predated minimum wage laws, teachers unions, social security, medicare, medicaid and welfare programs.  That was a time when a real land of opportunity existed because government played a much more limited role.

## Sunday, February 17, 2013

### Surprising candor at NYT on health care

The New York Times published a surprisingly sensible piece on health care on Sunday, "The health care benefits that cut your pay" by David Goldhill. A sample

We manage health care as if our needs were always urgent and unpredictable, ignoring how deeply this industry is integrated into our lives, with a vast amount of care now devoted to treating ongoing, chronic conditions.

Our system takes resources from all of us, pools the cost of certainties disguised as risks, extracts enormous costs of administration and complexity and then returns — to almost all of us — a fraction of the money we’ve put in.

Try to imagine what homeowners’ insurance would look like if we expected everyone’s house to burn down and then added coverage for each homeowner’s utility bills and furniture wear-and-tear. This would be insanely expensive without meaningfully reducing anyone’s risk. That, in short, is how health insurance works.

...Traditional health experts may repackage their ideas, but they are never discouraged by past failure. So the new Accountable Care Organizations are a reinvention of H.M.O.’s. The Independent Payment Advisory Board is the new Medicare Payment Advisory Commission, or MedPAC. Bundled payments are the new Prospective Payment System.

We often see some early benefit from the introduction of new ideas, but over time such initiatives are always subjugated by our system’s nefarious economic incentives. Implement cost control reforms and watch providers circumvent new rules and guidelines. Reduce reimbursement rates for procedures, and witness providers expand the definition of required services. Convert fee-for-service reimbursements into bundled payments, and soon more severe diagnoses are given. Attempt to use government buying power, and see providers turn to lobbyists to keep prices up. We are approaching a half-century of fighting this losing battle

...

Here’s a completely different idea, one that might actually work. Let’s give every American health insurance, but only for truly rare, major and unpredictable illnesses. In other words, let’s cover everyone but not everything. It would take a generation to transition fully to such a system, but eventually the most routine and expected medical treatments, from checkups and minor illnesses all the way to common chronic conditions and expected end-of-life care, would be funded from our individual health savings; only the most major needs — for example, cancer, stroke and trauma — would be paid out of insurance.

Defining insurable events more narrowly and enabling Americans to use the premium savings to build health savings would reduce the distortions inherent in our insurance approach. Most importantly, it will also compel providers to compete on the basis of price, quality and service, as they meet the one force that creates real incentives for good performance, innovation and safety: the consumer.
Sheer poetry, in few words accomplishing what took me many pages of "After the ACA."  Newspapers often publish contrary views to show they are balanced (or so a WSJ editor once told me when I complained!) But that this can even get aired at the Times is pretty remarkable.

## Thursday, February 14, 2013

### Teflon Market, Patient Bear.

Or its Deja Vu'

Its 2012 all over again. In the morning, the futures were down and markets opened lower but by mid-day BTFD crowd came in and helped push SPX in tiny green. Most likely tomorrow will be tiny red. Historically, Feb OpEx, which is tomorrow is green. So we will see who wins, red or green. But it does not change anything. And while we are on the sideline, some will short the market out of sheer boredom, only to have emotional trauma and lose money. Some will go long thinking this is the beginning of new bull run and shares will never correct because Ben will have their back. They will also lose big time. Its all about timing.
Timing says, do not front run, shut out the noise and the Zen moment will come.

I know subscribers are getting impatient for lack of action, but we start with the premise that 1st goal is not to lose money. Rest will follow.

So folks, no new nugget of wisdom or fancy charts to share. Just chill till the appropriate signal comes.

## Wednesday, February 13, 2013

### Round Two

The President enjoys a good fight.  The only question is will there be an opponent.  Reality, of course, is one major opponent.  But, the Presidents seems adept at ignoring reality.

The State of the Union speech last night was the Hugo Chavez plan for the US -- more body slams to the private sector, more money to be wasted on government and government's pals.  As for the poor, raise the minimum wage.  One wonders why Obama did not advocate a \$ 100 per hour minimum wage.  Using his logic, that should solve the problem of poverty in one grand stroke.

As for the hopes of the unemployed and underemployed, forget it.  This President is not bothered by slack economic growth and growing numbers of folks disappearing from the work force.  Just expand medicaid and food stamps.  That should do it.

As for the national debt.  Hey!  That's one area where we lead the world.  Let's maintain that lead!

Meanwhile, the war on capitalism continues unabated.  Tax rich people!!  That seems to be the main mantra of this White House.

So, what's the future.  It isn't good.

## Monday, February 11, 2013

### Dairy Of A Reluctant Bear.

It has been a while I posted in the blog. But the fact is, there has not been much to write home about.
We were long for the whole month of January and when SPX started flirting with 1510, we exit all long positions and have been in the sideline since then.
The indices have been chopping and churning and grinding higher very slowly. In the process, killing all bears and convincing everyone else to BTFD
Sentiments are at all time high:
And indices are in the overbought territory.
However, overbought can remain overbought for a long time, till no one is left to sell and everyone is a buyer. When we start hearing about SPX 1600, we will know that the gig is up.

So we are not front running. Subscribers know the levels to watch and when the sell signal will trigger. Knowing those critical levels have helped us to avoid the whipsaws. We are watching VIX very closely and that is another of our indicators.

We have also stayed away from commodities including PMs and while we did not short it, we fully anticipated the sell off in gold and silver. Now we are waiting for the sell signal in oil and Nat. Gas. There is no play in grains or soft commodities either.

All in all, we are practising patience and keeping our emotional health in good shape. Not to mention preserving our capital as well.

Hope you all are having fun in this BTFD market and although I have turned into a reluctant bear, I am now a patient bear waiting for the fish to land in my mouth.

## Sunday, February 10, 2013

### The Snow Storm Disaster

As three feet of snow blanket Boston, the Administration tries to push their "climate change" agenda, as if anything of substance could result from that.  There is no scientific evidence that weather patterns are changing materially, but that doesn't keep the Obama folks from pointing to every weather-related problem as more evidence of climate change.

One wonders why the infrastructure in America is not built up to withstand these storms and help the public resist them.  The answer?  There is no money left.  The liberal agenda, mainly the entitlements, have not only taken top priority, but will eventually absorb more than any possible tax revenues could ever provide.

One of the many downsides of the entitlement world is much, much slower economic growth.  Entitlements destroy private savings, reduce and eliminate work incentives, and make personal responsibility a remnant of antiquity.  A record number of Americans now live off of social security disability payments and that trend is only in its infancy.

Once the government promises to care for our every need, it loses the ability to provide basic services -- such as protection from natural disasters.  Why was there no protective flood wall in New Orleans to protect its citizens from Katrina?  Why?  Because the money that should have been available was drained off for entitlements and social services.  Why aren't there widespread use of generators in the Northeast so that citizens don't have to huddle without power for days in subzero weather?  Why?  Because who can afford generators with public service costs, including health care, spiraling out of control.  Government services aren't cheap.  Check out the post office.

Today, the government increasingly determines the priorities of what goods and services will be provided to the American public.  Infrastructure, generally, is a loser.  Gradually, but certainly, the historic role of government to provides roads, courts and national defense will wither away.  It is no accident that sequestration strikes hardest at the defense department.  In time, America will lose the ability to defend itself militarily.  That seems to be Obama's plan.

So, don't be surprised if, increasingly, Americans are buffeted by natural disasters that they are unprepared for, foreign wars that they are unprepared for, and infrastructure that is simply corroding away as more and more Americans become wards of the state.

## Friday, February 8, 2013

### Jim Rogers on Street Smarts and outsized investing returns

Jim Rogers has a new book out called Street Smarts and he's out talking about it, along with a few other favored subjects.

Here are a few highlights from his recent interview with Open Currency

1. Asked about Germany's repatriation of gold from American vaults, Rogers says they're right to do it and he's surprised they haven't done it sooner. Recently, the Federal Reserve refused the Germans an audit of their own gold, and according to Rogers "it's clear some of that gold has been lent out, or something, as it will take 7 or 8 years to move the gold."

2. Nearly all governments are printing money, for the first time in recorded history. All major banks are "printing" and debasing their currencies, which brings us to Rogers' favorite safe haven - hard assets.

3. We are destroying all the people who save and invest. People are getting wiped out because interest rates are zero and below the rate of inflation. Those who borrowed huge amounts of money and went bust are being bailed out at the expense of those who saved. This is disastrous for society.

4. Is it possible for this generation's investors to replicate Quantum Fund's investment returns of 4,200% over 10 years? Rogers says such returns are entirely possible for those who work hard and are great investors. Of course not everyone will do it, but "there's gotta be someone who is smart enough and ambitious and driven enough" to achieve that.

5. His new book, Street Smarts, contains much of what Jim has learned over the years and reflects on many of the things he has done. Jim's thought processes, mistakes, and successes are shared, along with his thoughts on how the world will look over the next 10-20+ years.

I've just received a review copy of Rogers' latest book, and I look forward to reading it. Look for a follow-up post on Street Smarts in the near future. Until then, you'll find a whole lot more from Jim Rogers in the posts below.

Related posts:

.

## Wednesday, February 6, 2013

### What's holding back the US economy?

This is a video I did with Steve Davis and Amir Sufi, moderated by Hal Weitzman, part of the new Chicago Booth "The Big Question" series. Youtube link here. I'm actually a lot calmer through most of it than I appear in the cover shot.

## Tuesday, February 5, 2013

### Told You So.

I have been out from 5.30 AM in the morning and is back at 11.30 PM at night. Have been busy with multiple meetings throughout the day and have not had a chance to see what is happening in the market.
Now that I see how the market played out during the day, I find that SPX was up 15.58 points.
And I can just laugh , shake my head and say that I told you so.
Let me know how are doing in this backing and filling market.

## Monday, February 4, 2013

### In The Chop Zone

Indices sold off today by 1% or more.
Understandably bears are jubilant and bulls are giving it a shrug.

However do keep in mind, in Wall St. there is no bull or bear, only Weasels.

If you have read last few posts, you know that my upside target was 1510 in SPX and while we briefly crossed it last Friday, we have been moving in 10-15 points range. The 15 points sell off has not done any damage yet. The market is still on buy signal. That does not mean we have to buy. That simply means we are not going to short, yet.

The story is same with Gold and Silver. Moving in a range.
Same with Crude.

We went for skiing last weekend and after coming back we see that nothing has changed. So we have decided to wait outside the ring and watch the show.

Subscribers know what level to watch for the sell signal and when not to front run. While we do expect February to be a great month we also know when not to jump and this is one of those times. In all likelihood  those who shorted the market today will be disappointed tomorrow and those who go long tomorrow will be disappointed the day after. There is no play in commodity either.

Therefore , dear reader, let me repeat the old and tired formula: Cash is King

## Sunday, February 3, 2013

### Three views of consumption and the slow economy

I'm still digesting New-Keynesian models. As part of that effort, today I offer some thoughts on how economists come to such different views of the current situation and desirable policies. It's a nice story, in the end. Real economists, unlike much of the commentary and blogging world, come to different conclusions by using much the same model, but making different assumptions and simplifications, each of which we can look at and evaluate, and hopefully come to some consensus.

The economy is not doing well. The black line in the graph shows log consumption. (The units are percent increase in consumption since 2002.) After trending up steadily at close to 3% per year through the previous decade, consumption -- along with output and everything else -- took a dive, totaling 10% loss relative to the red trendline. And consumption has been stuck there ever since.

So, the big questions: why, and what might be done about it?

All current macroeconomic theories start with the same basic story: when interest rates are higher, people consume less today, save, and then consume more in the future. Higher real interest rates mean higher consumption growth. In equations,

(c represents log consumption, i is the interest rate, pi is inflation, rho and gamma are parameters. Rho is a "discount rate" capturing how much people prefer the present to the future, and gamma captures how strongly people react to interest rate changes. I simplified, leaving out uncertainty.)

We build on this insight in different ways.

I. New Keynesians

Integrating forward, today's consumption reflects all expected future interest rates, and where we think consumption will be in the far-off future

This is the central equation of the new-Keynesian model and world-view. (For example, this is Johannes Wieland's equation 2, see my last post. I have taken out growth or trend, so these represent deviations from a steady growth path.)

The green line in the graph presents the New-Keynesian diagnosis of the current situation. New-Keynesians assume consumption will return to trend, so the last term in the equation is zero. In the graph, they anchor future consumption at the green dot. Then, a too-high interest rate means too-high consumption growth, which drives the level of today's consumption down.  (For example,  Ivan Werning's figure 3, discussed in an earlier post here.)

Why is the interest rate too high? The "zero lower bound" is to blame. The Fed cannot lower nominal interest rates (i) below zero. So if the inflation and discount rate terms (pi and rho) require a strongly negative nominal rate, the real rate will be stuck at a big positive number.

From this one equation and graph, you can make sense of lots and lots of new-Keynesian analysis and policy advice.

The level of today's consumption depends on the whole string of future interest rates, not just today's interest rate. So, if people expect the interest rate in 2014 to be lower, that is every bit as effective in raising today's consumption as would be lowering today's rate. Hence, "open mouth operations," "forward guidance," and "managing expectations."  If the Fed by just talking can persuade people it will hold interest rates low for a longer periods, when they are expecting rates to rise above zero, that expectation will "stimulate" today's consumption. If promises don't help, perhaps announcing a new "rule" which if followed would lead to lower rates for longer will help to change expectations.

In this equation, more inflation lowers the real interest rate too. So, anything that boosts inflation is a good thing. Boosting inflation isn't primarily about a Phillips curve, direct "monetary stimulus," encouraging investment, and so on. It's a way to lower real interest rates inside the integral and shift consumption from the future to the present.

Once again, increasing expected future inflation would be just as effective as increasing current inflation. Hence, calls for the Fed to announce a higher inflation target, or at least announce that it will tolerate more inflation before beginning to raise rates, as it has.

Fiscal stimulus, and many of the other seemingly magical properties of new-Keynesian models (see  last post) follow from the idea that inflation is good. Fiscal stimulus raises inflation. Broken windows, hurricanes, pointless public works projects, temporarily lowering the economy's productive capacity, all raise inflation (how is in other equations of the model), which lowers interest rates.

I'm not sold on this story, as you probably guessed, for a variety of reasons.

New Keynesian models are a bit fuzzy on just why interest rates have to be so low -- why the "natural rate" is sharply negative and why zero interest rates aren't enough. Many of the formal models assume that consumer's discount rate (rho) has declined sharply, beyond the capacity of the interest rate to follow it. If rho goes to, say -5%, with our 2% inflation, then even a zero nominal interest rate is like a 3% real interest rate. (These are deviations from trend, so one might not need actually negative discount rates to hit the zero bound. But even adding growth, it's hard to avoid the need for a negative natural rate to cause a problem of this size.)

Now, a spontaneous outbreak of thrift, to the point of valuing the future a lot more than the present, seems a bit of a strained diagnosis for the fundamental trouble of the US economy. That a bit more thrift is a great danger to the economy, rather than the long awaited return to normal after decades of debt-financed consumption, seems strained as well.

To be fair, all the papers I've read say clearly that they regard the decline in the discount rate rho as a stand-in for some more complex process involving the financial crisis. For example, a more precise version of my first equation adds a "precautionary saving" term. When people are very uncertain about the future, they save more, just as if they had become much more patient. In equations,

This story seems possible for 2008 and 2009, in the depths of the financial crisis and recession. But I'm less convinced that it describes our current moment. Just look at the graph. Our state is one of steady but sclerotic growth, not one of great consumption volatility.

New-Keynesian introductions have something more complex in mind, involving the "frictions" of the financial crisis, and lots of models in this spirit add explicit financial frictions. That too seems to me a useful line to pursue to understand the onset of the recession and the financial crisis. But that too is really not our question. The  "frictions" of the financial crisis -- capital constraints at banks and financial intermediaries,  or the run in the shadow banking system -- passed quite a while ago, and the models with frictions are by and large not being used to address the current moment.

The question before us is not really why consumption fell so drastically in 2008 and 2009. The question is, why did consumption get stuck at so low a level starting in 2010? For this question, it's much harder for me to understand what a strongly negative discount rate means.

This question and controversy is much like those surrounding the Great Depression. The controversy there has not been about why the stock market crash and recession happened in the first place. (Though perhaps it should, as we really don't know much about that process.) The controversy is, why did the US get stuck so low for so long? Was it bad monetary policy (Friedman and Schwartz), bad microeconomic policy, war on capital, and high marginal tax rates (Cole, Ohanian, Prescott, etc.), or inadequate fiscal stimulus (Keynesians)?

Many new-Keynesian models (such as Ivan Werning's) generate the high real interest rate by predicting strong deflation. Yes, if inflation (pi) were negative 10% in (2), then a zero interest rate would be a 10% positive real rate. But our inflation has been positive throughout. Our zero interest rate has meant a negative 1.5% to 2.5% real rate all along. Deflation simply did not happen. Moreover, the other ingredient in new-Keynesian modeling -- the Phillips curve -- says that a big output gap should be accompanied by some action on inflation, not a steady 2%.  The Phillips curve part of the model suggests that "potential" dropped, not that current output is far below that potential.

I graphed the green line to 2010, a good date for supposing the crisis is over and we entered the period of sclerotic growth rather than swift return to trend. We've had some time since 2010. Again, the new-Keynesian model generates a low consumption level by saying that we have too-strong consumption growth. But we don't have strong consumption growth. Equation (2) does not produce a steadily depressed level of consumption, with (if anything) weaker than normal growth. I guess you could argue for a constant sequence of unexpected negative shocks, so that each quarter, people are expecting the big consumption growth which just ends up not happening. But you can see how strained that argument is. It would be much more appealing to refer to a model and analysis that describes slumponomics directly.  (Update: I just found Kathryn Dominguez and Matt Shaprio on a sequence of negative shocks.)

And, you might be exploding a bit at the economic logic of it all. How can it be that all we need to do is to decide how much to consume, and the output just magically appears? Doesn't consumption have to be limited a bit by income?

Well, the new-Keynesian models are coherent on this subject. The simple models have no capital; output is produced by more or less labor each period. The logical structure of the models, is, roughly, that you first decide how much you want to consume, then you'll work hard enough to make the required income. (This isn't a behavioral assumption, it's the equilibrium outcome of sticky prices and monopolistic competition.)

That's why fiscal stimulus works at all. You might think that if you have to pay taxes to the goverment, which buys output to throw it away, you'll have to consume less.  (Again, stimulus in these models is Ricardian so the same whether from taxed or borrowed money, and stimulus does not depend on the government doing anything useful with the output.) But if consumption is determined first by the above equation, then you just work harder to pay taxes and make the stuff the government wants to throw away. That gives us a multiplier of one, not zero, and then inflation kicks in to raise desired consumption and give us a larger multiplier. (Roughly! Again, I'm trying to explain the core simplest idea, not to fairly describe all the complexities of the models.)

The very simple new-Keynesian model also does not have investment or capital stock. Output is produced as you need it. That's why consumption "demand" immediately means changes in output. I've always wondered why buying a car is good (consumption) but buying a forklift is bad (investment) in new-Keynesian models. You just can't ask that question in the very simplified model here -- there is no investment. Now, real quantitative new-Keynesian models do have investment and capital (with adjustment costs and other wedges). But as far as I can tell, the same basic conclusions emerge from models with capital, so the intuition must be as here, in which consumption is everything.

II Permanent income

An alternative view asks, what about the second term on the right hand side of the basic equation (2)?  What if nothing's terribly wrong with the intertemporal allocation of consumption, but the long-run productive capacity of the economy has declined?

There is certainly an abundant litany of such complaints. What if all the over regulation (Obamacare, Dodd-Frank, EPA "crucifixions," etc.), sand in the gears, disincentives of social programs, crony capitalism, policy uncertainty, high and prospectively much higher marginal tax rates, and other litany of complaints, have permanently reduced the productive capacity of the US economy, or, worse, its long run growth rate? Then we are not returning to trend. The trend has shifted down.

If so, the trouble is in the second term on the right hand side of the basic equation (2). And this basic equation has a dramatic and important lesson for us: Long-run ("supply") will depress today's consumption every bit as much as expected future interest rates ("demand") effects do. And improving the long-run "supply" effects can have a direct "stimulative" effect on consumption today.

I italicized, because I think this is an underappreciated consequence of the common world-view of all modern macroeconomics, both new-Keynesian and not, embodied in (2). The old-Keynesian view was,  take care of the short run now, because helping the long run only helps in the long run. You hear this over and over in policy circles. More stimulus now, and then talk about "structural reform" once the economy has recovered. Equation (2) denies that separation:  Improving the long run improves the present.

I drew the blue line to reflect this view of matters. For an equation, we can turn to our old friend the permanent income model

Here W represents wealth (capital stock), r is the real rate r = i - pi, and y represents the stream of expected future income. This is an extremely oversimplified version of the standard stochastic growth model at the heart of... well, I don't know what to call us anymore. "Neoclassical?" "Anybody left who is a bit suspicous of the new-Keynesian juggernaut?"

The difference is really one of emphasis, not deep economics. (3) also derives from (1), but with a different set of auxiliary assumptions. The real interest rate is constant at r. There is capital W, and investment freely adds or subtracts from capital. Labor's product y is fixed rather than produced.

Again, this model is, like (2), extremely simplified. Yes, interest rates do vary, and it's easy enough to add that to the model.  Similarly, new-Keynesians know there is capital and investment.  We're outlining basic stories today, not constructing completely realistic, but often obscure and complex, models.

In this equation, the level of consumption shifts up and down along with expectations of permanent income. So, if you get news that the productive efficiency of the economy is permanently 10% lower, consumption drops 10%, and then goes on at the previous growth rate. As, by picking 2010 as the decision date, my graph suggests.

Like the new-Keynesians,  I won't be that specific here about just why consumption fell so drastically in the financial crisis.  The permanent income model does suggest that we look for changes in permanent income to explain the fall, rather than (only) a rise in discount rates or real interest rates, i.e. the desired intertemporal allocation of consumption.  From this perspective, consumers realized in fall 2008, that this recession was going to last forever rather than bounce back quickly, and they adjusted consumption downward accordingly. They were right. Just how they knew, when all the Government's forecasters thought we would quickly bounce back, is an interesting question.  Surely, my litany of free-marketer's complaints did not obvioulsy get suddenly worse in October 2008, just coincident with a run in the shadow banking system.  Well, maybe not so surely. Maybe consumers thought, we're in a horrible banking crisis, and our government is likely to prolong this one with ham-handed policies just like they did in the 1930s. But that's pretty speculative. And I do think (just as speculatively) there was a run in the shadow banking system, effective risk aversion spiked, and the financial crisis was more than just a signal of bad policy to come.

But all that is a topic for another day. The question is why consumption (and output) remain so low for so long after the crisis, when whatever outside-the-model chaos is over. The permanent income view suggests the problem is a poor long-term level, poor long-term prospects for the productive capacity of the economy, not too high growth, to an unchanged long-term level.

In this view, the Fed largely wasting its time with all its QEs and promises about future interest rates. The right policy answer is to forget about stimulating and fine tuning. Fix the long-run growth problem and the short run will take care of itself, much faster than you might have thought. This isn't the Fed's job. For Europe, do the "structural reforms" now and you'll start growing now in anticipation of their effect.

Moreover, in the underlying stochastic growth model, a rise in real interest rates is a good thing. Yes, we can get on the new-Keynesian green trajectory. What does that is a rise in the marginal product of capital, which raises interest rates, attracts investment, and leads to greater output. In that model, consumption is (very roughly) anchored at its position today, and increased interest rates raise future consumption, not the other way around. Of course, in the stochastic growth model, the Fed can't raise interest rates all on its own --  a higher marginal product of capital comes from greater efficiency or better technology. Still, it encapsulates the comments you read here and there that maybe the conventional sign is wrong -- maybe higher interest rates are desirable, as a sign of a good thing, not as a cause of a bad thing. There is always supply and demand in economics, and two sides to every question.

Which view is right? To my eyes, consumption seems stuck on a lower trend line, not growing sharply. Real interest rates are already negative -- we do not have deflation -- and I find it hard to believe that the discount rate and marginal product of capital are negative 5% or worse. The very large discount rate shock needed for the new-Keynesian story is pretty nebulous. The shocks to long-run productivity are staring us in the face.

I wish, of course, for more serious structural investigation to separate the two stories. I haven't seen a serious attempt to look at the structure of the US economy and measure a sharp negative "natural rate." (I welcome pointers from commenters.) I would welcome a quantitative assessment of how much the level of GDP is depressed from my litany of free-market complaints. With trillions of dollars of GDP, and potentially trillions of wasted stimulus at stake, you'd think we could do better.

I want to emphasize, this is not a fight between models. This is the same model, with different emphasis, and different simplifications. There is nothing in the new-Keynesian modeling paradigm that forbids one to ask the question, what if the long-run productivity of the economy has sunk and high real rates are not the problem? The models were developed to talk about other things, to talk about historical "cycles" defined as deviations from "trend." Nothing but old habits prohibits one from asking the opposite questions.

III. Old Keynesians

A traditional view of consumption has been conspicuously absent so far, the textbook old-Keynesian consumption function

Consumption depends on today's income through the "marginal propensity to consume" mpc.

Modern new-Keynesian models are utterly different from this traditional view. Lots of people, especially in policy, commentary, and blogging circles, like to wave their hands over the equations of new Keynesian models and claim they provide formal cover for traditional old-Keynesian intuition, with all the optimization, budget constraints, and market clearing conditions that the old-Keynesian analysis never really got right taken care of. A quick look at our equations and the underlying logic shows that this is absolutely not the case.

Consider how lowering interest rates is supposed to help. In the old Keynesian model, investment I = I(r) responds to lower interest rates, output and income Y = C + I + G, so rising investment raises income, which raises consumption in (4), which raises income some more, and so on. By contrast, the simple new-Keynesian model needs no investment, and interest rates simply rearrange consumption demand over time.

Similarly, consider how raising government spending is supposed to help. In the old Keynesian model,  raising G in Y = C + I + G raises Y, which raises consumption C by (4), which raises Y some more, and so on. In the new-Keynesian model, the big multiplier comes because raising government spending raises inflation, which lowers interest rates, and once again brings consumption forward in time.

Old-Keynesians spent two generations fighting against the intertemporal view of consumption embodied in my first two equations, and now at the heart of the new-Keynesian model, in favor of the last equation. They said consumers were "liquidity constrained," or "rule of thumb," their expectations (if they had any) "adaptive," either too stupid to look forward in time or unable to do so.

I must confess a little sympathy to some of these views. A long long time ago I wrote a paper on "near-rationality" criticizing excessive zeal in the application of equation (1). Really, if the Fed today raises interest rates to 12% (annual rate) for a month, would everybody's consumption fall one percent today, so that it could rise one percentage point over the next month? Or is the relation between consumption and interest rates one of those looser relations that yes, applies roughly, for large sustained changes, and over long time periods, but not necessarily instantly?

In any case, a look at (1) and its application in (2) tells us that Friedman won more than he could possibly have imagined. Intertemporal optimization is now not the heretical pariah suggesting a low marginal propensity to consume and low multiplier, but it is the heart of the model. The Lucas-Sargent-Prescott revolution pervades new-Keynesian models as much as their more classical counterparts. Consumers are forward-looking. Expectations matter. No self-respecting mid 1970s Keynesian would have said that Fed pronouncements about what interest rates were going to be in 2016 -- or how the future unemployment rate would condtion that choice -- would have the slightest effect at all on today's consumption. Consumers are myopic, he would say. Expectations are adaptive.

But as a result, the new-Keynesian model really has nothing to do with the old-Keynesian intuition.

IV. Bottom line

Enough history of thought, though. The relevant choice today is between the first two alternatives. Are we in a situation where the long run is just fine, but the zero bound is forcing us to have too high interest rates, so consumption growth is too high and the level is depressed? Or are we in a situation that consumers doubt the long-run productive capacity of the economy, and are consuming little today because they expect to consume little tomorrow and little 10 years from now?

The answer matters: whether the economy can be stimulated merely by more solemn promises from the Fed about future interest rates and inflation, by broken-window interventions that reduce supply today to engender some inflation, or whether the economy must be stimulated today by ignoring short-run stimulus, fixing the long run, and counting on the permanent income model to increase consumption, and the present value model (q theory) to increase investment today.

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P.S. It's 2013. Why is displaying math in html so hard?! The people who developed the internet are all nerd engineers who took calculus! I'm back to  pasting in png files to show equations. I tried mathjax, but it only seems to work on traditional screens, not in mobile, rss, etc. Suggestions welcome.

P.P.S. Martin Boulanger and Absalon below asked if maybe consumption wasn't growing unsustainably before the crash. Here's a longer view of the first graph, with my 2000-2007 trend line.
Or, even go back to 1945.
A big boom in the 2000's does not stick out from the consumption data. If anything, it was a little weaker than usual.

Also, yes, this is total consumption. Nondurable and services does not look much different. I started to break out the components but the post was getting too long.