The American magazine has been running a series of profiles of the newest crop of bright, young economists. Their latest profilee is Raj Chetty, associate professor of Econ at Berkeley (although now on loan to Stanford’s Hoover Institution).
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Raj Chetty |
Raj began his promising econ career by proposing and investigating – at a wee age – an intriguing thesis: in some situations, the demand curve for capital might be upward sloping –
Raj Chetty, now 28, was a sophomore at Harvard University when he came up with the theory that higher interest rates sometimes lead to higher investment. It was a counterintuitive idea. Usually, companies invest less when rates rise because the higher rates increase the cost of capital. But Chetty found that some companies, in fact, invest more because they want to get revenue-generating projects off the ground sooner, rather than later, in order to pay down that costly capital more quickly.
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p>Put another way – when money is more expensive, and the time crunch is on, firms actually accelerate investments in certain, less risky, faster time-to-revenue projects. It’s sort of a “Sorry boys, the first bank payment is due next next week, so stop planning a coast to coast franchise, and start building the first, local Bombay Palace right now….” And building costs more (in the short run) than planning….
Or, as Chetty’s abstract 
more formally describes the scenario –
This paper studies the effect of interest rates on investment in an environment where firms make irreversible investments with uncertain pay-offs. In this setting, changes in the interest rate affect both the cost of capital and the cost of delaying investment to acquire information. These two forces combine to generate an aggregate investment demand curve that is a backward-bending function of the interest rate. At low rates, increasing the interest rate raises investment by increasing the cost of delay.
I’m a bit more of a capitalist than an economist so Raj’s result more than passes my smell test. Businesses – particularly startups – understand & internalize the value of “hustle” in a way economists – particularly macro – haven’t quite worked into all of their models. And under the right conditions, hustle burns more capital than not.
(FWIW, Austrian’s do tend to credit the “hustle”; however the motive isn’t just the “desire to spend now” but rather, the broader “lets discover if Bombay Palace can work now” with spending being an outcome instead of the goal; Raj’s paper focuses more the former but does have some sympathy with the latter).
“Yes Virginia, lowering dividend taxes forced corporations to be less profligate” — Raj Chetty (sorta, but not quite)
Raj describes his overall research direction as –
…focused on theoretical and empirical issues in the design of tax and social insurance programs. My broad objective has been to analyze new models of economic behavior that better match empirical evidence (e.g. models of risk preferences or corporate behavior), and study the implications of these models for government policy. My work can be grouped into two categories: (1) risk preferences and social insurance and (2) behavioral responses to taxation.
Towards that end, some of his interesting research papers include –
- Impact of the 2003 dividend tax cut — Although decried as a classic “tax cut for the rich”, empirical data collected by Raj on the 2003 dividend tax cut shows that it, on net, squeezed money out of firms, forced them to spend less $$$ on big boss perks, and return more $$$ to shareholder grandma’s as dividend payments.
- Experiments in Tax Salience — How aware is the consumer of retail sales taxes on a day to day basis? Through simple retail experiments, Raj demonstrates that the answer is – not very. The implication limits the efficacy of tax policy as a form of social engineering.
- Liquidity Effects vs. Unemployment Insurance — What’s the right amount of unemployment insurance (welfare, etc.) to achieve humanitarian ends without overly incenting folks to hang out on the dole? One structural answer, Raj proposes, can be found in looking at illiquid assets and liabilities held by individuals & how they affect incentives. This other paper has some interesting quantitative data on how much incremental severance packages and the like “slow down” the rate of new job discovery.
The paper I most laud, however, was written very early in his career, back in September, 2001 (sheesh, homey was just 22 back then!). The paper explores Milton Friedman’s classic critique of monetary policy that, due to the intrinsic non-linearity of the system even attempts at counter-cyclical policy can reduce, rather than improve stability. Why this one? Well, Chetty notes comments received from
Martin Feldstein, Benjamin Friedman, Milton Friedman, Greg Mankiw, and Arnold Zellner
1 Bates Medal Laureate + 1 Nobel Laureate + 2 former members of the Council of Economic Advsiors – not bad company to keep. And thus someone SM will certainly keep an eye on. And perhaps the more interesting question, given the non-trivial overlap between Raj’s demographic and ours, does he keep an eye on us? 
[related – SM’ers might like The American’s earlier profile Roland Fryer who tackles issues in race, culture, and economics – all hot buttons here]
Vinod,
Come on, I’m sure you could’ve put together a better analogy than that. The extra spending doesn’t have anything to do with fixed rate loans. Variable rate loans, however, such as libor+50 or ARMs, become more expensive as interest rates rise. Many old loans, therefore, are subject to interest rate risk. Interest rates also are perceived to have momentum, whether or not they actually do. What this means is, if you’re being crippled under the rising interest for an old 30yr variable-rate loan, you’re better off taking a high-interest short-term loan that can provide positive ROI and pay off the longer-term debts that carry huge interest rate risk. (IR risk goes up with longer maturity dates).
Every time I think I had enough of SM cuz it’s getting too predictive, a post like this comes along and changes my mind. Granted, it won’t get as many responses as, say, Padma’s Ramadan Avial, but hey, who says quality and quantity always go hand-in-hand.
You tell ’em Democrats, Raj. While you are at it, educate them as to how tax cuts actually increase net tax receipts.
Looks like Raj’s a rising star…
M. Nam
Sic, In a different scenario I think that is the problem with the current sub prime mess, where a lot of these loans are locked in ARMs which are usually the structure you mention (LIBOR+200 bps)and refinancing them at higher rate fixed rate structures is not possible, coupled with loss in property values it lead to higher default rates blowing up the MBS. It is simplistic to assume that higher rate loans will lead to increased capital spending. The problem currently is to secure financing for all the deals announced earlier this year. It will be interesting to see how to First Data and Hilton deals’s financing ultimately shapes up.
I followed the link from Marginal Revolution yesterday. Super impressive guy. I like that the guy is biased towards empirical tests. So many conventional hypotheses are laid to rest when the rubber meets the road. I wish him the best, and hopes he keeps his ear to the ground even after the success and big-money-advisor-jobs.
Predictive of what, Moornam? Anyway, I predict that this will NOT be a sleepy thread because the topic is really interesting.
Why should the rate of new job discovery be the way we determine the success of unemployment insurance? Why not look at the type of jobs people get? Whether they are retrained into a field with an income that provides a high level of well-being? People who have incremental packages might be going to school. He seems like the kind of economist who is fixated on easily measurable outcomes rather than meaningful ones, but I haven’t read his work. There are lot’s of other promising young South Asian economists like Sanjay Reddy.
I think he meant predictable.
Although, this was hardly the reason the Repubs gave for the tax cuts. And yes, companies did increase dividends, but the shareholder grandmas who got them were, on average, very rich grandmas to begin with. I myself haven’t met a tax cut that I didn’t like, but its important to highlight the actual mechanisms that make them work, rather than party-line rhetoric.
There’s also the phenomenon of path dependency (en.wikipedia.org) to keep in mind, which is synonymous with irreversibility that smack middle in the title of Chetty’s paper “Interest Rates, Irreversibility, and Backward-Bending Investment”. One example of path-dependency is the following: You know as a fact, say from the gods, that IBM will be at twice its current price in a year’s time. Of course, you could buy its shares and in a year be handsomely rewarded. But you’re greedier, and so you buy on margin. The gods failed to mention that before a year, in just six months, the price will actually fall to 10% of its value before rebounding. Now you’re screwed because you’re getting margin calls at the nadir, forced to liquidate at the most inopportune time, despite knowing that if you just held on a little longer, you’d be wildly wealthy. The recent credit-crunch and prevailing quant meltdown was in fact a textbook scenario of path-dependency. Multi-strategy hedge funds got squeezed on their credit desks, forced to unwind their most liquid assets: u.s. equity, pushing the prices away from fair value by 0.5%. However, a lot of quant models are high-volume (20x levered) low-margin, so a 0.5% inefficiency can invert a +0.25% return to -0.25% return, causing them to get margin calls (remember, 20x levered…) and in turn pushing prices further away from fair value and causing a spiral of greater price inefficiency and greater correlated liquidation. At the peak, prices were pushed 2.5% off from the expected value, a 20-30 sigma move.
During periods of rising interest rates, issuers of variable-rate debt instruments are similarly struck by path-dependency and irreversibility. Namely, for whatever amount the company has in long-term debt obligation, there’s an associated debt service which is the amount of the debt that needs to paid off in the near-horizon, which is usually the next couple coupon payments for bonds. If this cash outflow is expected to eventually supercede cash inflow, then the comany’s debt service coverage ratio is in deep shit. The company has two choices, either admit it sucks and give up, or believe that it is profitable in the long-term, such as the previous example of holding on to IBM at 10% of the purchase value knowing through divine insight that it will rebound to twice the purchase value. If the former, then bankruptcy is the course of action. If it’s the latter, then the company needs to take out additional loans to ease short-term cash-flow problems while mounting up larger long-term debt (through instruments such as zero-coupon convertible bonds). AMD, for example, did this with by issuing $1.5bn senior convertibles.
My previous posts are plagued by typos, but such is life.
plagued with*
You get the point.
Sic,
I think # 9 is very interesting, do you work in Finance?
id be more amused if he doesnt…
Puliogre,
You are right and that is why I asked the question.
Some perceptive comments from stt; just quickly, the idea of an upward shaping demand curve is not new (some would even say its old hat). Plenty of critics of mainstream economics have suggested it. Also see Veblen’s brilliant series of articles (written in the early 20th century) about allied issues (the guy was actually close to three quarter of a century ahead of his contemporaries).
Oh by the way, i forgot to add that Veblen’s “Why Economics is not an Evolutionary science” contains a general statement and explanation for upward sloping demand curves in general (and not just for capital).
Whooops! economic mumbo-jumbo again. Chetty has even less of a clue about current spending habits of businesses than Fed economists. For all he knows, Ben Bernanke is right – they’re not a problem at all…but merely a reflection of the fact that Desis, bless their hearts, save too much. And because of all their savings flooding into the United States, even the most repulsive shack on either coast is floating up to such a high price that would have caused shock and alarm 10 years ago. Who complains about that?
So stop whining about high rates and go out and buy a new car. Get rich in real estate! Donald Trump will tell you how. He says he’s getting a million dollars a pop just to tell young mogul-hopefuls his secrets. Save yourself the money. We can tell you the secret. Buy in hot areas. With no money down and minimum monthly payments. Borrow as much as you can. Then, be very, very lucky. As long as prices continue to go up you’ll be rich…and George Bush and Ben Bernanke will be geniuses.
You know what else is predictable? You insulting my posts and indirectly by doing so, those who enjoy them. SM would suck if all we did was either econ OR celebrity stuff; the magic is in the mix, because there’s something for everyone.
I’m thrilled that you aren’t the arbiter of quality, that wait– what’s that? We let the markets decide. 200+ comments on a thread about Padma? Their definition of quality is just as legitimate as yours.
Also, I didn’t write the Ramadan post and AFAIK, you don’t have beef with Amardeep, so you hurling that bit in wasn’t very nice.
Mumbo-jumbo notwithstanding, are you saying Bernanke is wrong? All I got from your post was sarcasm. Do you have an alternative idea? And you conclude that “Chetty has even less of a clue” – is that conclusion from the articles posted or do you know him personally?
Yes – me having to clarify “That’s not what I meant”, yet again…
Yes – it would. And that’s my point. Do you read everything in a newspaper? Or do you enjoy specific portions only? Do you totally ignore some pages? I do. Is my evaluation that the pages I read are quality material an insult to those other pages? I don’t think so.
“Boring” topics like economics almost always get very little attention as compared to OJ Simpson – that’s a fact of life. Some of us are allowed to think that economics affects all of us a lot more than whan Padma does, hence judging for ourselves what’s quality and what’s trash. Others may make their own judgements that are totally opposite to mine.
Have I said that everything you blog is useless? Don’t I try to contribute to your caption posts – which btw is another reason for me to come to SM.
Enough said.
Can we please get back to regularly scheduled programming? sst…?
M. Nam
Anna, I enjoy many of the posts here and I didn’t feel insulted by MoorNam’s comment.
Both comments duly noted and appreciated, though Amit, you don’t have my history with MoorNam. 😉 Sorry for distracting, back to pondering Econ, k thx bi
Ooh, gossip!! Dirty laundry!!! Do tell. 🙂 🙂 (I kid.)
brown,
Exactly. In fact, many gasped with horror as the public ate up cheap mortgages in the aftermath of the Nasdaq/DJIA Q4’00-Q1’03 freefalls. The debt was often structured as 5-years fixed-rate and variable then on. Cries of a housing bubble in the works were shouted, but the joke about how economists “called twenty of the past two recessions” means economists are overly pessimistic and as such their warnings are taken with a pinch of salt. Fast-forward to 2007 and you have many of the 2002 and older mortgages now in their variable leg, and a good portion of those are by homebuyers who did not spend enough time analyzing their expected cashflow situation. Moornam might jest how they probably have spent a little too much time reading about anthropomorphized idlis and dosas singing to each other about Kerala in one of Anna’s diary-style stories. It will take until 2010 for the last of the uber-cheap mortgages to convert to the variable rate leg. Economics is much like an ecosystem, and just as how the extinction of a single species of flower can cascade to endangering larger mammals, small perturbations in the intertwined economic systems can lead to massive liquidation. The system has to be imperfect and fail now and then to remind us how likely mishaps are; and unless we’re frequently reminded, our readiness would atrophy and when the postponed mishap strikes, we’re screwed.
“Best to bow and not break.”
Raj describes his overall research direction as ” My broad objective has been to analyze new models of economic behavior that better match empirical evidence …”
BETTER match empirical evidence, as in better than the models proposed by other economists? There are two things that do not become an economist – arrogance and certainty.
I think what you meant to say was that those qualities were not becoming in an economist. What exactly do you mean by that? That by aspiring to describe new economic models to better fit his interpretation (kindly remember, this is what academics are paid to do–come up with their own interpretations of data/primary materials–which usually entails doing some original research of their own–and perhaps suggest models that better fit this interpretation) of the data, he is somehow usurping the august and hallowed positions of the big names in the academy? This seems to be a specious argument.
I have learned so much from the posters at SepiaMutiny. There seems to be a group of very academic know it all types on here that respond to blogs like this one and I always learn a lot from it.
When the blog is really academic I usually refrain from posting because I either don’t know enough about the topic and my comments will be stupid compared to other posters or I can’t add anything relevant to the discussion. It’s not because the topic is “boring.”
And I guess this is the reason that blogs like this one don’t get as many comments.
26 “I think what you meant to say was that those qualities were not becoming in an economist.”
Was there a problem with my grammar in, “There are two things that do not become an economist…”?
I am not worried about keeping the big names of economics in business. But for someone to make a claim of empiricism in a discipline that is nothing if not empirical is like a musician claiming proudly that he sings in tune.
Is his last name pronounced “Shet-ty?” Because if it is I might giggle for about 4 or 5 hours.
Interesting that his last name is “Chetty” because I am Tamil and Chettiar. Does having the last name Chetty make him Chettiar too? He looks north Indian and I’m not sure if they have a Chettiar Caste. Aside from Tamils I know that there are Telegu Chettiars too.
I dont think so. I would aver that it is fine. But then English is not my first language. Not even my second 🙂
Vinod – bloody interesting post.
I take it that the data is US centric. In any case a very interesting hypothesis.
just to be clear Floridian and MD, that sentence just read very awkwardly (IMO). I know i’m not the stylistic guru here nor a crafter of particularly succinct sentences but it just felt a bit off.
Thankfully, this man’s audience is not limited to the Democrats. However I found this, to be of greater significance that defending tax policy that Bush couldn’t have conceivably come up with himself:
M. Nam, not the case when people use their tax credit to pay down debt, as most (non-upper class) Americans did, as opposed to fueling consumption or investment (vis-a-vis savings), in 2003.
brown, a lot of the subprime disaster, in my opinion, had more to do with the loan-shark like quality of brokers who offered loans to individuals who had no idea of what they were actually signing up for. I’m totally with you on the ARM aspect of the mess, but I don’t know if we can really apply Chetty’s argument given that he’s talking about capital investments, not equity investments. In general there’s a lot of ridiculous behavior in the credit market that encourages spending money that people don’t have.
On that note (and in line with the Veblen comments), I’d like to throw in Veblen’s Theory of the Leisure Class as an explanation for consumer behavior.
Floridian, I didn’t find his statement insulting. I think his research position is neither arrogant nor offensive. Many of the models produced in economics are NOT firmly rooted in empirical data. Granted, you can cherry-pick your data and draw a regression through anything, but I think his position was more of a statement on his disciplinary outlook (effectively using microeconomic data to create new models). The goal in that case is not to provide predictive, all-encompassing models, but to create models that are generally applicable within a subfield (e.g. U.S. finance, capital investments, tax systems).
Isn’t Chetty effectively arguing that the opportunity cost of time-discounting does not always outweigh the interest rate? Maybe my understanding is just more simplistic/inaccurate 🙂
The new Greenspan book sounds interesting. As for chetty, even the bombay palace example was over my head.
“Impact of the 2003 dividend tax cut — Although decried as a classic “tax cut for the richâ€, empirical data collected by Raj on the 2003 dividend tax cut shows that it, on net, squeezed money out of firms, forced them to spend less $$$ on big boss perks, and return more $$$ to shareholder grandma’s as dividend payments.”
What are shareholder grandmas? That’s really arguing at an emotional level. These are probably rich people to begin with. Income inequality is higher now than any time since the gilded age.
Neither do I. Floridian’s interpretation seems like reading a bit too much into it.
Floridian, are you saying that economists do not study abstract theory? (If your answer is no, then his point with that sentence in his research statemtn might be that he is a bit more on the applied side of the spectrum…)
Re comment #28 by Floridian:
I will have to go with comment #37 by random, Floridian. (Going off on a tangent: there are people in the hard sciences who will justifiably take issue with your assertion that economics is “nothing if not empirical”; a hard-core experimental chemist, for instance, might get quite a chuckle out of it.)
So what could Chetty’s “. . . better match empirical evidence” mean. Let’s look at how economic models are crafted. A model mathematically encodes certain assumptions in such a way that that the empirical data is predicted by it. However, a model is no good if it is so complex that one cannot determine how it evolves in time. Therefore, models are kept faily simple, and aspects of the empirical data are often: a) declared as lying outside the regime of the model; OR b) shown to be a “small perturbation” to the model. Not infrequently, a model turns out to be a bad fit with the data because a shoddy job was done in establishing (b), or — more commonly — because, in the absence of the analytical tools that would make a complex model grow legs and run, the economist opted for a simpler model.
From the few economists I’ve been talking to, I infer that the use of modern mathematics is seeing a minor renaissance in economics. This has conferred on economists greater technical power to eschew option (a) and grapple with more complex models. The complexity confers a better match with empirical data . . . and I think this is the sense in which the phrase “better match” is meant.
The 7-page appendix to the paper Vinod linked to illustrates a part of my point. It is still not very hard, but it is a sea change from the cognitive style of economics papers from the 1980’s.
FROM OUR FRIEND, WIKIPEDIA:
“Fields of science are commonly classified along two major lines:
(e.g. inserted by Floridian)
These groupings are empirical sciences, which means the knowledge must be based on observable phenomena and capable of being experimented for its validity by other researchers working under the same conditions.[4]
Mathematics, which is sometimes classified within a third group of science called formal science, has both similarities and differences with the natural and social sciences.[3] It is similar to empirical sciences in that it involves an objective, careful and systematic study of an area of knowledge; it is different because of its method of verifying its knowledge, using a priori rather than empirical methods.”
Sorry I lost the link in my effort to copy-and-paste. In a nutshell, I see empirical and a priori methods as the two extremes with economics using the former. Sometimes I even question if economics is indeed a science, social or not. Having spent most of my life in marketing, I have been humbled by many outcomes that did not follow the proven empirical theories of consumer behavior. Since economists eat from the same plate, I would think that marketing’s frequent non-replicability, a horribly unscientific condition, applies to them as it does to us lowly marketers.
Again, neither my remark on empiricism nor non-replicability is meant to be a criticism of economics.
From comment #39
Thanks, Floridian, for the above observation and the further contextualisation in your comment. The sense in which many economists, and most sales-and-marketing “theorists” use the word “empirical” is what provoked my parenthetical comment in #38. The disconnect between theory and real-life outcomes that you’ve witnessed are, of course, largely a result of the sheer complexity that economics tries to model and/or explain, and of the fact that social experiments are difficult. But these disconnects occasionally make me wonder if economists need to acquire more sophistication in how they use their data sets (after all, empiricism is a lot more than the mere acquisition of data points a la the “research” of the gentlemen-naturalists). When one looks at the severe hypothesis-testing that biologists typically perform nowadays, economics sometimes feels like it is stuck in the gentlemen-naturalists’ era of empirical science.
I think Chetty is very aware of all this, but I don’t think his “. . . better match empirical evidence” is an immodest declaration that he is an empiricist and others are not (as you seemed to interpret it), OR that he has found a way of turning economics into a hard-empirical discipline such as, say, experimental chemistry. I think those words are merely a gloss of his methodological outlook.
it’s pleasantly ironic that Kahneman and Tversky, who won the most deserving of Nobel’s, were brilliant in unraveling some of the disconnect, making economics more accountable and creating space for more empirical approaches; but, in doing so, their results were simultaneously and decidedly falsifiable. that is the peculiar essence of economics- more math on top of a disconnect is rubbish; more math on top of a ‘connect’ is good. but does more math reveal the disconnect? sometimes.
in my experience, the quants at hedge funds are the best practitioners in highly mathy, yet reality-based outlook on markets. they aren’t married to the fantasy of efficient market theories or gaussian distribution of market returns.
to add to what nvm said, i think that the basic problem is that very little is known about “huaman nature”, but to the extent something is known, it is at the level of common sense. as the statistician david freedman has pointed out (see his “statistics and shoe leather”; jstor search), mere verbal arguments backed up with careful descriptive statistics (in other words, the ability to perceive “natural experiments” when one presents itself) can achieve way more than cleverly formulated mathematical models and outlandish statistical assumptions.
Yeah, I’m with ups @36 on this one. This seems like a combination of a strawman and some general misdirection. As far as I remember, no one argued that the dividend tax cuts would result in increased executive compensation (except insofar as they have a lot of stock and thus receive more in dividends) [there’s the straw man]. Instead, my understanding was that it would do exactly what Chetty discovered: return more money to people in the form of dividends. The question is: who was getting the dividends? If most of the dividend earners were rich, this still amounts to a tax cut for the rich, regardless of how many of them are also grandmas [there’s the misdirection].
NvM @ #41:
I agree. And I like the cautious “sometimes”.
Again, I agree. However, I must mention that it was rather depressing to look at the literature from the early days of quantitative finance (lot of it of non-math-dept origin); especially its accent on gaussian distribution of market returns! I mean – something as mutually-non-independent as a slew of sell orders in a small span of time was approached from a law-of-large-numbers perspective back in those days!!
What I remember about the dividend tax: It is double taxation since it is paid from after tax earnings of the company.
Removal of the dividend tax would: Lift stock prices – since the “yield” is now higher. This could be classified as a tax-cut for the rich since it increases the company owners net-worth. More companies increase dividend or start paying a dividend – this effect is probably easy to check. Stable, large companies paying a dividend were known as “widow-orphan” stocks. Maybe, the grandma part is a reference to pocketing dividend from these companies.