The paper constructs a formal mathematical model to capture the idea that free trade in capital markets does not lead to optimal outcomes. We would all be better off if national governments were to regulate the capital markets through counter cyclical trades of debt for equity.
In a second new working paper, "The Theory of Unconventional Monetary Policy" coauthored with Pawel Zabczyk of the Bank of England, we show how those regulations would work in a simple two-period general equilibrium model. As Ben Bernanke said in the aftermath of the Great Recession; "Quantitative Easing works in practice but not in theory". We show in this paper why it works in theory.
In my single-authored paper, I extend the two-period model to an infinite horizon and I show that it captures two features of real world capital markets. Price-earnings ratios are excessively volatile and equity earns a substantial premium over three month treasuries. These two features are related and they both follow from the inability of the unborn to trade in the financial markets.
Ever since Adam Smith, economists have sought to explain why market systems provide outcomes that improve our lives. If I have a good that you want and you have a good that I want, we should be allowed to exchange one good for the other. The power of that idea was demonstrated most recently by the growth of China as 1.5 billion Chinese were pulled from poverty by the move from social planning to a market economy.
The benefit of free exchange is captured by economists in the theory of general equilibrium. That theory, developed by Walras and Pareto in the nineteenth century, was atemporal. The market takes place at a single point in time. In modern macroeconomics, exchange takes place in a sequence of markets and the trades we make are with people we may never have met. Each human being is connected with every other human being on the planet. From the urban centers of London, Paris, Tokyo and New York to remote areas like the Brazilian rain forest and the Australian outback; we are connected by free trade in markets. And through free trade in the capital markets, we are connected with people who are not yet born.
The most important idea to emerge from Adam Smith is, in the immortal words of Gordon Gekko, that ‘greed is good’. Selfish behavior by greedy people seeking to improve their own lives will, inevitably, improve the lives of everyone else on the planet. That idea is encapsulated in the first welfare theorem of economics which asserts that ‘every competitive equilibrium is Pareto optimal’. I assert that the first welfare theorem, when applied to the financial markets, is wrong.
Macroeconomists often assume that all trades can be described ‘as if’ they were made by a representative family with superhuman perception of future prices. That assumption works well if our goal is to explain savings behavior. It works very badly when applied to financial data. There are two dimensions in which it fails that economists have labeled the excess volatility puzzle and the equity premium puzzle. My new working paper shows that both of these puzzles are explained by the fact that we are unable to participate in financial markets that open before we are born.
The fact that we cannot insure over the state we are born into allows for non-fundamental shocks to influence asset prices simply because people believe that it will be so. I believe that a substantial component of the fluctuations we see in aggregate asset prices are caused by non-fundamental events. They are self-fulfilling prophecies and we would all be better off if these fluctuations were eliminated by treasury or central bank intervention.
This paper, and my joint paper with Pawel, provide a foundation for the argument I make in my new book ‘Prosperity for All’; namely that treasuries and/or central banks should intervene in the asset markets to smooth out inefficient fluctuations in PE ratios.
 This paper is the latest in a series of working papers. Farmer and Zabcyck builds on Farmer (September 2012) and my single-authored paper builds on Farmer (2002a, 2002b), Farmer (September 2012), Farmer, Venditti and Nourry (December 2012), and Farmer (2014, 2015). The connections between these papers are explained here.