Andy Xie, who some of you may recognize as formerly an economist for Morgan Stanley, writes that the stock market rally of recent months comes from investors getting tired of fear. Given the poor fundamentals this argument is at least plausible.
Regardless of what investors or speculators say to justify their punting, the real driving force is the return of animal spirit. After living in fear for more than a year, they just couldn't sit around any longer. So they decided to inch back. The resulting market appreciation emboldened more people. All sorts of theories began to surface to justify the market trend. Now that the rising trend has been around for three months globally and seven months in China, even the most timid have been unable to resist. They're jumping in, in droves.
Fear drove the market too far down after greed drove it too far up. Now fear fatigue has set in and investors have gotten tired of sitting on the sidelines.
Xie also believes that foreign buying of US Treasury bonds will decline and therefore Treasury interest rates will return to historic patterns of being about 2.5% above inflation.
The 10-year Treasury yield historically averages about 6 percent, with about 3.5 percent inflation and a real yield of 2.5 percent. This reflects the preferences of marginal buyers in the United States. Foreign central banks have pushed down the yield requirement substantially over the past seven years. If marginal buyers become American again, as I believe, Treasury yields will surge even higher from current levels.
So shy away from longer term bonds right now. You'll be able to earn much better yields if you wait.
If Xie is correct then there are some bigger consequences in store. First off, government debt servicing costs will soar and therefore the US government (as well as state and local governments) will have less money to spend on services and will be looking much harder at ways to raise taxes.
Higher interest rates will raise the cost of capital for the private sector too. But I'm not so sure about the impacts on private sector growth. If the national savings rate continues to rise then households might have more money available to invest.
On the plus side, net additions to household debt began to slow in 2007, and since the third quarter of last year liabilities have shrunk by $421 billion. For the first time ever, households have paid off more debt than they took on for two quarters in a row.
On the other hand, the Chinese might feel compelled to continue to buy Treasuries. The high savings rate in China might be driven by selective abortion of female fetuses and the resulting greater competition to attract wives.
In 2007, Chinese household savings as a share of disposable income was 30%, up from 16% in 1990. One possible reason for the jump in savings: The dearth of women is making China’s marriage market extremely competitive, and families with boys are accumulating wealth to make their sons more attractive matches.
Selective abortion increased savings in China, drove Chinese to buy more American bonds, and then this helped cause the real estate and debt bubble in the United States.
While the high savings rate in China has global impact, existing explanations are incomplete. This paper proposes a competitive saving motive as a new explanation: as the country experiences a rising sex ratio imbalance, the increased competition in the marriage market has induced the Chinese, especially parents with a son, to postpone consumption in favor of wealth accumulation. The pressure on savings spills over to other households through higher costs of house purchases. Both cross-regional and household-level evidence supports this hypothesis. This factor can potentially account for about half of the actual increase in the household savings rate during 1990-2007.
This has implications that go beyond China since selective abortion for sex selection is practiced in Vietnam, India, and other countries.
In a study examining the relationship between pay raises, expectations, and performance, University of California, Berkeley's Haas School of Business Assistant Professor Alexandre Mas found that police performance declined sharply when officers lost in arbitration over their wages.
Mas studied 383 final offer arbitration cases involving compensation disputes between New Jersey police unions between 1978 and 1996. The cases provided a unique opportunity to test how expectations about pay and actual pay affect productivity. In final offer arbitration, the two sides submit offers to an arbitrator and the arbitrator is allowed to choose only one side's offer in a binding settlement, thus creating a wedge between the pay police received and the amount they demanded. Mas then matched the arbitration data to monthly measures of police performance by jurisdiction.
Mas found that per capita number of arrests were 12 percent higher in the months following arbitration when arbitrators ruled in favor of police officers compared with when they ruled against them. His findings are outlined in an article titled "Pay, Reference Points, and Police Performance" in the latest issue (August 2006) of the Quarterly Journal of Economics.
"Losing arbitration affects productivity, even when the stakes are small," says Mas, a member of the Haas School's Economic Analysis and Policy Group. "For employers in any organization, the results imply that it's really important to manage worker expectations when considering wage policy."
Productivity dropped when the police lost at arbitration. But productivity rose when police won at arbitration.
Mas found that when arbitrators ruled in favor of the union, police forces on average made 5 more arrests per month per 100,000 capita after arbitration than before arbitration. But when unions lost in arbitration, he found police officers averaged 6.8 fewer arrests per month per 100,000 capita after arbitration compared with before arbitration.
Officers did not appear to alter enforcement in murder and rape cases, but did make fewer arrests for assault, robberies, and property crimes if they lost arbitration.
In addition, Mas found that the magnitude of a union's arbitration loss was strongly correlated to how much the arrests declined.
I see a problem in all this: If the police productivity rose after a win for how long did the productivity stay higher? Ditto on the drop. After all, if the productivity stayes high eventually another wage negotation will happen. At that point my guess is the odds seem to be against yet another rise in productivity after yet another arbitration win. Maybe the productivity boost is short-lived until workers become accustomed to their higher salaries. Do disappointed workers stay demoralized longer on the job than happy workers stay more productive?
People respond to incentives. How to structure pay incentives for police to boost their productivity in a sustained way? Simply rewarding a higher arrest rate could backfire in the form of more arrests that aren't justified. Or police could put more time into easy arrests of criminals who commit less important forms of crime. Incentives could be structured to reward lower rates of crimes reported. But police then would become incentized to write up fewer crime reports than they hear about.