Fischer Black started from a model of efficient markets with diversified investors. However, there is nondiversifiable risk in the economy, there will be times when you get a bad draw. At those times, the value of physical and human capital will fall.
Tyler Cowen says that we are poorer than we thought we were. He says that this means that our estimate of future earnings has fallen. This sounds like a drop in the value of physical and human capital.
I think that it is impossible for people to diversify effectively with respect to human capital. So I will not be talking about a perfectly Black-like world. But I would like to elaborate on the Black-Cowen model, using lawyers as an example.I get a sense that the Recalculation is affecting lawyers. There seems to be an excess supply. Large firms laid off lawyers. New law school graduates are having more difficulty landing jobs than they did a few years ago.
My guess is that salaries for lawyers in the private sector will decline over the next five years. Government salaries will remain elevated, so that the quality of lawyers attracted to government will tend to rise.
On average, lawyers must be reducing their estimates of future earnings. Nonetheless, many young people may be applying to law school, perhaps even more than usual. However, that in turn may reflect a perception that the value of an unadorned BA has fallen even more than that of law degree.
In some sense, the market value of the asset of a law degree has declined. This may be due to the fact that lawyers did a lot of the work in processing the complex financial transactions of the mortgage credit boom, and the demand for that work has declined. Or it may reflect the fact that companies are developing fewer new capabilities and products (what I call the Minsky-Jones economy), and thus they only need whatever lawyers are required to maintain current operations.
Suppose that when Recalculation is complete, we will have restored full employment with fewer lawyers and more physical therapists. The return on investment in a physical therapy degree will be as high as that on a legal degree, for people of equal ability (if one may speak of equal ability in this context). This comes from a drop in the return on a law degree and an increase in the return on a physical therapy degree.
The point of the Black-Cowen model, as I interpret it, is that the people with existing law degrees take significant capital losses. People with existing physical therapy degrees enjoy capital gains, but they do not have to be nearly enough to offset the losses of the lawyers. Thus, on average, we are poorer than we thought we were.
I still want to think about Ricardian non-equivalence in this model. That is, if government runs a deficit and people do not assign themselves the liability to repay this debt in the future, then the government can make people feel richer than they are. In fact, the government does not have to run a deficit today in order to do that. By promising to take care of all of my health care after age 65, government can make me feel very rich today. But if we get to the point where government cannot keep that promise, then lots of people will suddenly discover that they are not as rich as they thought they were.
READER COMMENTS
Philo
May 30 2010 at 12:26pm
“By promising to take care of all of my health care after age 65, government can make me feel very rich today.” If you believe the promise; but, in fact, you don’t!
The trend to government spending suggests to me, an old person (“senior citizen”), not that I am poorer than I had thought, but that my children and grandchildren are poorer than I, and they, had thought. (I expect government debt to weigh on them, not on me.)
Tyler Cowen
May 30 2010 at 12:34pm
I like this post very much, I would just note the complications arising from the greater “consumer surplus” of those who hire lawyers. There may for instance be an “even longer run” in which big dividends are forthcoming, but it takes us a while to realize that.
Rebecca Burlingame
May 30 2010 at 1:15pm
Perhaps economies are moving into times of aggregate need of the sort which are not as easy to profit from. After all, there was always more money left over from processes of production, than most service-based economies. And a lot of those financial instruments that once sold so easily, were actually intended for people to be able to pay for the service economy needs they knew they’d had to tap into as they got older.
GU
May 30 2010 at 3:36pm
Recent law grad here, who did well at a highly ranked school yet is jobless. You are correct that the Recalculation is affecting lawyers. I wouldn’t care were it not for the crushing debt-load I took out that made good sense 3-4 years ago when I was deciding whether to go to law school.
John Fisher
May 31 2010 at 8:26am
How does the ability of the legal profession to create more demand (new laws and regulations) as well as impose some restrictions on supply (law school and the bar) enter into this?
GU
May 31 2010 at 11:19pm
Law school and the bar impose virtually no restriction on the supply of lawyers (at least people who are competent enough to be lawyers). Law has not been restricting the supply of lawyers à la Med schools.
One major way the legal profession creates demand is by convincing (usually unsophisticated) people that they can sue a large entity or government as part of a class action, without paying a dime (the lawyer takes the case on a contingency fee). This is what happens when you let too many people become lawyers.
Peter
Jun 1 2010 at 2:42am
“Tyler Cowen says that we are poorer than we thought we were.”
If there is a recalculation happening then I think that must necessarily be true because all sorts of assets will now be less valued than previously. A house that there is no one to live in is not much different to a law degree nobody wants to hire.
fundamentalist
Jun 1 2010 at 9:13am
In nomimanl dollars terms we are poorer. Monetary pumping by the Feds inflated salaries, which are nothing but the price of labor. So projecting those inflated salaries into the future gave us a false sense of wealth. But that’s the whole point of the Feds’ monetary pumping, isn’t it? The Fed wants everyone to think they’re getting wealthier as prices and wages rise so we’ll spend more. The Feds depend upon this illusion in order for their monetary policies to work. But the bust always comes, and prices retrace and we are left with less wealth.
And a lot of savings was wasted during the boom but only realized in the bust. So yes, we have less wealth than when the depression began.
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