Monday, April 13, 2015

New Solutions to Old Problems

There was an interesting exchange over the last couple of days between two of my favorite bloggers; Frances Coppola, aka Femina Spectabilis, and Brad DeLong, aka Distinguitur Oeconomicarum. Frances delivered a talk at my alma mater,  Manchester University, on the need to use non-linear models and to recognize the importance of multiple equilibria. Brava! Brad Delong, over at Equitable Growth, takes umbrage at Frances’ charge and rushes to the defense of his former teacher, Olivier Blanchard, aka Nobilis Vir. 

Here is Frances at full tilt

… some of the most influential people in macroeconomics have spent their lives developing theories and models that have been shown to be at best inadequate and at worst dangerously wrong. Olivier Blanchard’s call for policymakers to set policy in such a way that linear models will still work should be seen for what it is – the desperate cry of an aging economist who discovers that the foundations upon which he has built his career are made of sand. He is far from alone.

Perhaps a little harsh. But Frances has a point here Olivier. It's one that was made sometime ago by my emeritus colleague Axel Leijonhufud who referred to what he called corridor effects. Using Axel’s metaphor, Olivier is simply calling for policy makers to keep the economy in the corridor. And who could disagree with that?

Not Brad DeLong for sure, who is supportive of this position. And Brad has a prescription for what it means... long as you can keep the economy on the upward-sloping rather than the flat part of the LM curve, linear models should be good enough for practical purposes. And the government has mighty fiscal policy and credit policy tools at its disposal that it can use to keep high-quality bonds, even short-term bonds, from going to par. 
Quite! The key in this paragraph is the call for policy makers to use  ‘credit policy tools’ in normal times as an additional component of stabilization policy. What might that involve? In my view, central banks and treasuries must recognize their responsibility to counteract the wild swings in asset markets that are the root cause of financial crises.

Horror! Surely, we should leave the allocation of financial capital to those who know best. The decisions of billions of people, freely contracting in markets, can surely make better choices that a cadre of appointed mandarins who purport to understand the economy  better than the markets. Not so. As I argued in the Guardian last year,
The ratio of the stock market price to cyclically adjusted earnings, the PE ratio, is a highly persistent, volatile process. It has been as low as 5 in the 1920s and as high as 45 in the 1990s. When the PE ratio is above its long run average, an investor can profit from selling the market short. When it is below its long run average, a winning strategy is to borrow money and invest it in shares. But although that is sound investment advice in theory, in the real world there is no private investor with a long enough horizon and deep enough pockets to make those trades. As Keynes famously said: "Markets can remain irrational for longer than you can remain solvent."
What can possibly go wrong with private markets? Quoting again from my Guardian op Ed,
Economic theory teaches us that free trade in markets leads to efficient allocations. But a precondition of that doctrine is that everyone who is affected by trade is free to participate in the market. That condition does not hold in the context of the financial markets. We cannot buy insurance over the state of the world into which we are born.
The problem of excess financial volatility is one that cannot be solved by any individual; but it can be solved by government. The Treasury has the power to make commitments on behalf of future generations. The FPC, by exercising that power on behalf of the Treasury, can make trades in the financial markets that capitalise on the inefficient boom-bust financial cycles that are the source of so much human misery. In this way, the FPC will at the same time stabilise volatility in the market and promote financial stability.
There is a growing awareness that free trade in the financial markets does not lead to Pareto efficient outcomes. And, as we have learned only too painfully; pain on Wall Street leads to pain on Main Street. Monetary policy cannot ensure financial stability and stable prices with only one instrument. We must manage the risk composition of the central bank’s balance sheet as well as its size.


  1. It sounds like you are advocating the central bank do something like sell the market whenever the cyclically adjusted PE ratio is much above 16, and buy whenever it is much below.

    Envision a world with that policy and a group of savvy investors who foresee earnings are going to rise next year, for reasons less mechanical than cyclical recovery but perhaps no harder to fathom than great new technology being adopted. They bid the market up to 17. The central bank then sells short at that price, I suppose to a point determined by the ability of the private investors to borrow and buy.

    In the event, the savvy investors are right, and earning rise next year so that the price at which the central bank bought is only 12 times earnings. But they can't let the market fall that far; the policy is to buy at 15 times time earnings, which is (15x17)/12=21.25 the previous year's earnings. So 4.25 times the previous year's earnings per share, multiplied by as many shares as the hedge funds can force the banks to short, gets handed out to super-rich operators who have done little of value.

    Why does that prospect not bother you?

    1. My preferred rule is to buy the market when unemployment is judged to be too high; and sell when it is too low. That recommendation is based on two papers here and here .

      Most of the volatility in the return to holding the market arises, not from variations in dividends, but from variations in share prices. There is little doubt that a central bank has the ability to control the average share price of the market as a whole. The right question to ask is; would stabilizing the price of paper assets leads to stability in the real economy or, as some would claim, is the causation in the opposite direction.

      Your concern, that the policy I advocate would enrich savvy investors, is predicted on the assumption that the central bank is unable to dictate the market price.

  2. Actually, my concern is that the central bank can dictate the market price; but I don't see how they can do it without redistributing wealth. I assumed in that example that they use a simple and publicly known rule, which seems to me to invite manipulation. Use of a vague and secret process opens its own can of worms, obviously, unless the bankers are saints.

    I agree that whether stabilizing paper prices stabilizes the real economy is at least as important as whether it helps the shrewd to rob us. But I see the two as quite closely linked. Both dangers emerge because, if a central bank stabilizes share prices, it almost necessarily decouples those prices from forecasts of profits.

    In the two papers you mention -- which are fascinating and at least 1/5 persuasive -- the share prices are already decoupled from sensible beliefs, so there is not a lot of scope for harm. But the other 4/5 of me worries. And even if the real markets are dominated by the spirits of mad animals, would it not make more sense just to ban equities entirely? Or, at least, to reclassify them as casino games, get them out of the regulated pension funds and such? Because if they aren't reflecting well-formed expectations, what purpose do they serve that is not better served by inflation-indexed bonds and roulette?

    1. Michael
      Any fiscal policy (and this is a fiscal policy) may redistribute wealth. In this case, the redistribution is Pareto improving.

      Share prices are already decoupled from forecasts of profits. They are mainly connected with forecasts of other peoples' forecasts of profits. Or worse; they are caused by our forecasts of the forecasts of other people's forecasts .... and so on ad infinitum

      Ban equities? Absolutely not. The more assets that are traded, the better. The prices that market participants are willing to pay for those assets reflects their well-formed expectations of the prices they can be sold for in the future. Providing stability in the resale price is a way of anchoring expectations.

    2. Thanks for your thoughts, Roger. I stand by with mind open.

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  4. It seems to me as if a significant amount of instability is actually caused by the central bank due to the tools it uses.

    Lowering rates or asset purchases to stimulate the economy contributes to bubbles and also to financialization because the financial sector underpins create creation and other financial activities which increase as a result of lowering rates.

    It must be superior to stimulate by employing tools which don't lower the interest rate or lower it less and don’t require asset purchases. Helicopter drops of central bank emoney (hel-e's) would maintain a higher rate because they stimulate through higher monetary wealth of recipients not lower a rate. A higher comparative rate would also prevail because the central bank would not purchase bonds in expanding money (lowering the demand for bonds) and money would be expanded into central bank depository accounts and not increase loanable funds.

    Regulations are essential but they need to be coupled with monetary policy tools which don’t grow financial excess.

    1. I agree with much of this. Instability can certainly be exacerbated by bad policy. And yes, regulation and monetary policy go hand in hand.

  5. Hi Roger. You write,

    “We cannot buy insurance over the state of the world into which we are born.”

    Two quick points. You construe the sentence above as being a necessary condition of “efficient allocations,” which, of course, it is. In addition, a variation of this requirement has also been incorporated within a theory of equity, or fairness, by Ronald Dworkin in “Equality of What?” (1981), which you might find interesting.

    Your last sentence identifies one of many “Arrow-Debreu conditions” that aren’t satisfied in the economies in which we actually conduct our business. I just finished reading one of Robert Lucas’ New Classical Manifestos (1980) and was surprised at how easily he brings Arrow-Debreu to his aide.

    Kenneth Arrow, himself, characterized the real-world macroeconomy as one of disequilibrium (1995), and has mocked real business cycle explanations of the Great and Lesser Depressions (March 2005). And Frank Hahn, who co-authored “General Competitive Analysis” with Arrow, thought Arrow-Debreu should be regarded as a compendium of the stringent conditions that must be satisfied if there are to be no “Keynesian problems.”

    p.s. In connection with your recent discussion with David Andolfatto on involuntary unemployment, here’s Arrow’s response to a Minnesota Fed question in 1995: “I don't believe that unemployment is all voluntary, by anticipation of future wage movements or this sort of thing. I know you can modify the models by taking into account the indivisibilities, but I don't really think that people are voluntarily unemployed. When a job is offered, not so much today but say a few years ago, you would have had many applicants for it--people who do not seem to be conspicuously differently qualified than those who are now working” (1995).

  6. Hi Greg
    Yes, the general equilibrium theorists of Ken Arrow's generation were appalled at the assumption of continuous market clearing. Thanks for the Arrow quote.

    1. Roger,

      I’m interested in what *you* think of Arrow and Hahn’s arguments against New Classical economics. From my amateur point of view, two essential aspects of Arrow-Debreu are: 1) contingent commodities that cover every imaginable state of nature open to public view; and 2) a conception of equilibrium that involves a single moment of “decision” in which market participants make commitments, once and for all time, to exchange goods and services, contingent upon states of nature over an infinite future.

      You draw on this conception in pointing out that we can’t insure against the circumstances of our birth, Arrow drew on it in writing about the deficiencies of the market for health insurance, Hahn drew on it in pointing to the lack of a single moment of decision in real-world markets and the need for a theory of sequence economies and disequilibrium adjustments, etc., etc. In other words, the Arrow-Debreu construction is used as a kind of ideal model in terms of which the operation of real-world markets, which fail to meet one or another of the A-D requirements, can be analyzed (as in the foregoing examples).

      Lucas, by contrast, seems to hold that the A-D “contingent claim equilibrium” can be interpreted in terms of “spot markets” and rational expectations over the prices that will prevail in these markets in the near and far future. And this construction, in turn, Lucas regards as a useful model of real-world markets, which are assumed to clear.

      Now this application of A-D has seemed preposterous to many economists well-versed the A-D conception of GE. What is your view?

    2. Greg
      I'm not in the 'preposterous camp'. I'm on record as praising Lucas for rational expectations, complete securities markets and markets always in equilibrium. But a couple of tweaks to the underlying structure allows models in that class to generate Keynesian conclusion. The absence of complete participation allows animal spirits to influence allocations. And the absence of complete factor markets allows animal spirits to influence the unemployment rate. When there is a continuum of Pareto inefficient steady state unemployment rates, equilibrium, rational expectations and market clearing in the sense of a search market, do not seem such bad assumptions.

    3. Very good. I think I've got it. Thanks for taking the time to respond!


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