Bubble or Dodd-Frank headwind?

Noah Smith and Tyler Cowen recently had a debate on Bloomberg View (to which they are both contributors) about the wisdom of watering down Dodd-Frank.

Smith wanted to defend Dodd-Frank, while Cowen argued that the legislation is roughly pointless, beyond its provision that banks fund with (ed note: not retain!) more capital.

Smith and Cowen seemed almost to agree that it might be best to impose tougher restrictions at the top of the cycle, rather than when the economy is still struggling and policy makers are trying to stimulate demand.

But Smith placed more emphasis on the idea that political considerations require that regulation be put in place while memories of the recent crisis are still fresh, while Cowen pointed out that being too early might needlessly restrain growth, particularly if the regulations are ill designed, as in the case of Dodd-Frank.

I am not competent to join that debate, but there were a couple, possibly-unreflected assumptions that I would like to weigh in on.

First, fwiw, I have given up agitating for more stimulus to aggregate demand growth, because the economy is near full employment and – more to the point – away from liquidity trap. Any exogenous force putting upward pressure on nominal demand – be it fiscal stimulus, deregulation or whatever – is likely to be offset by the Fed.  You don’t need to be an ISLMic fundamentalist to see this.

We can argue about whether that would be right or wrong (I pick right), but I think it is pretty obvious that it will happen. So, practically, if you want to argue that neutering Dodd-Frank will speed growth, then you will have to lean on the supply-side, rather than the demand-side, impact. If deregulation were to speed innovation and productivity advance, then that would be good — and a point to Cowen. But if it were (ex-ante) just to push up equity prices and lift consumer spending growth, then probably that would just provoke the Fed.

Second, it is pretty easy to get confused about the position of risk premia when you read the press.  Is there a bubble — even if a small one — in risk assets because of President Trompe?  Or are risk premia too wide because of Dodd-Frank? You gotta pick one, I think.

As I read them, high yield spreads are on the tight side, although perhaps they should be, given the lower underlying volatility in the business cycle.


The equity market is tougher. What I would call the equity spread, which is just the Shillerized operating earnings * yield less the 10-year Treasury real yield, looks a bit wide. But if you very crudely adjust that for the fact that much of the decline of the real Treasury yield may be due to slower potential growth, then the spread looks less attractive.

Very roughly speaking, and with low conviction, it seems to me that equities are roughly fairly priced to deliver the low returns consistent with slow growth and low economic volatility.  It is not obvious to me that there is an excessive risk premium here that needs fixing. When people say risk premium, they may really mean supply-side growth headwind.  It is easy to confuse those two issues, I guess.

screen-shot-2017-02-08-at-9-31-47-amPricing data are current and economic data are estimated to the current period as required to exploit that. The rough proxy of the equity premium is just the equity spread plus the gap between estimated potential growth and its full-sample average. In the current environment, that adjustment is downward. My rough proxy is correlated with underlying economic volatility, which is intuitive, but the relationship there is loose, not rigorously estimated, and certainly not a timing indicator.

As for Trump, obviously I think he is a total disaster. My fear that he would spark a constitutional crisis is already being borne out.  It is now not so much shrill and ridiculous as consensus. I tried to make sure I did not underestimate how horrible this guy would be, but failed.

It is just that you can’t necessarily hedge out your Trump risk by getting out of equities.  My worry is as much that the equity market stops as that it goes down.  If you are blowed to smithereens it does not matter if you own equities, Treasuries, gold or even Bitcoins.  It is only in the really bad but not extinction level event that having gotten out of equities might help.

I concede that is a risk. Krugman, for example, worries about a situation in which Trompe does something really bad, but there still exist people to lose money in equities.

* In calculating the Shillerized operating earnings yield, I discount operating earnings by 10% so that they have the same historical average as GAAP earnings. This is similar to just using GAAP earnings, but it nets out the fact that we have until recently had two major write-down episode within the rolling 10-year Shiller window. This issue is now becoming less relevant. For more on this, I would go to Philosophical Economics.