Somebody at the PBC blinked

In a recent post I made this comment about China’s decision to intervene in its own stock market.

China is holding more than $1.2 trillion dollars of U.S. government debt. If the Bank were to tap those funds to stabilize the Chinese stock market it could not simultaneously maintain an exchange rate peg. If China goes that route, look out for upheaval in the foreign exchange markets.

Chinese policy makers are now learning that lesson. The Peoples Bank of China (PBC) has allowed the Renminbi to tumble by more than 3% in the last few days. The ride may not yet be over.

What’s happening and why? It's my guess that there are investors on the margin who are pulling money out of the Chinese market and moving it into the world capital markets. Those investors are betting against the valuation that the PBC is putting on domestic assets. The outflow of funds  puts downward pressure on the RMB and if the PBC were to maintain its previous parity they would be obliged to sell their holdings of dollar denominated assets to support the currency.

The PBC blinked! But that's a good thing. They’ve chosen a domestic target over an exchange rate target and to make that work, the world needs to keep buying Chinese goods.

I have advocated a policy of Treasury and Central Bank intervention to stabilize domestic asset markets. What we are seeing in the Chinese case is that this policy is inconsistent with a fixed exchange rate.

Playing Chess with the Devil

I love this quote (with my amendments for economists)  from the NY Times article about Terrence Tao. 

The true work of the mathematician economist is not experienced until the later parts of graduate school, when the student is challenged to create knowledge in the form of a novel proof piece of research. It is common to fill page after page with an attempt, the seasons turning, only to arrive precisely where you began, empty-handed — or to realize that a subtle flaw of logic doomed the whole enterprise from its outset. The steady state of mathematical economic research is to be completely stuck.

It is a process that Charles Fefferman of Princeton, himself a onetime math prodigy turned Fields medalist, likens to ‘‘playing chess with the devil.’’ The rules of the devil’s game are special, though: The devil is vastly superior at chess, but, Fefferman explained, you may take back as many moves as you like, and the devil may not. You play a first game, and, of course, ‘‘he crushes you.’’ So you take back moves and try something different, and he crushes you again, ‘‘in much the same way.’’ If you are sufficiently wily, you will eventually discover a move that forces the devil to shift strategy; you still lose, but — aha! — you have your first clue.

That's pretty much how I feel about research. Another analogy is that research is like solving a Rubik's Cube: You're about to put the last piece in place and you find you have to go back 25 moves and start over.

Why the Belief Function Matters

A debate on the monetary transmission mechanism was recently reignited on the blogs with a post by Noah Smith, posts from Nick Rowe and Brad De-Long and a response to Noah from John Cochrane. This was all triggered by a set of slides prepared by Michael Woodford and Maria Garcia Schmidt for a Riksbank Conference in June 2015. A good starting point is the summary here back in 2014 by John Cochrane. 

The question: If the Fed raises the interest rate will it cause more or less inflation? The answer is complex and the topics that must be dealt with in formulating that answer are at the heart of monetary economics. 

In my own work, I emphasize two central points.

1. Monetary rational expectations models always have multiple equilibria.

2. The right way to deal with this is by explicitly modeling how people form beliefs using a concept that I call the belief function.

Flash back to 1968. Rational expectations was not part of our vocabulary but economists still needed to model the passage of time. The standard approach was the temporary equilibrium model that John Hicks developed in Value and Capital.

In the temporary equilibrium model, time proceeds in a sequence of weeks. Each week, people meet in a market. They bring goods to market to trade. They also bring money and bonds. The crucial point of temporary equilibrium theory is that the future price is different from our belief of the future price. To complete a model of this kind, we must add an equation to explain how beliefs are determined. I call this equation, the belief function.

Now jump forward to 1972. Robert Lucas wrote an influential paper that changed the way we think about monetary economics. Lucas was concerned that a variable called expectations was floating around in our models and that this variable had the potential to influence outcomes through its impact on the beliefs of people. That was messy and it was inconsistent with Lucas’ intuition that prices and quantities should be pinned down by fundamentals: preferences, endowments and technology. He suggested that we model the future price as a random variable with a probability distribution.

How do the people  deal with this possibility? They must form subjective beliefs about what will happen. Instead of forming a point belief about the future price, they form a complete subjective probability distribution. Now comes the coup de grace. Lucas argued that, if people live in a stationary world where the same events are repeated again and again, that rational people will come to learn the true distribution.

Lucas argued that, although we may not know the future exactly: we do know the exact probability distribution of future events.
Following the work of John Muth, he called this idea, rational expectations.

Rational expectations is a powerful idea. If expectations are rational, then we do not need to know how people form their beliefs. The belief function that was so important in temporary equilibrium theory can be relegated to the dustbin of history. We don’t care how people form beliefs because whatever mechanism they use, that mechanism must be right on average. Who can argue with that?

That is a clever argument. But it suffers from a fatal flaw. General equilibrium models of money do not have a unique equilibrium. They have many. This problem was first identified by the English economist Frank Hahn, and despite the best attempts of the rational expectations school to ignore the problem: it reappears with a alarming regularity. Rational expectations economists who deny an independent role for beliefs are playing a game of whack a mole.

More recently, the multiplicity problem arose in a paper by Jess Benhabib, Stephanie Schmitt-Grohé and Martín Uribe (BSU). In new-Keynesian models with rational expectations, the central bank sets the interest rate in response to inflation using a response function that is called a Taylor Rule.  If the Fed chooses a rule that is aggressive in response to inflation, the New-Keynesians thought that the equilibrium would be unique. BSU showed that they are wrong.

This is not an esoteric point. It is at the core of the question that I pose at the beginning of this post: If the Fed raises the interest rate will it cause more or less inflation?  And it is a point that policy makers are well aware of as this piece by Fed President Jim Bullard makes clear.

What is the solution? It is one thing to recognize that the world is random, and quite another to assume that we have perfect knowledge. If we place our agents in models where many different things can happen, we must model the process by which they form beliefs. I made this argument in my 1993 book, the Macroeconomics of Self-Fulfilling Prophecies   where I referred to the mechanism that selects an equilibrium in a rational expectations model as a belief function. It is time to embrace the idea that the belief function matters. 

Fasten your seat belts; the ride is about to get choppy.

Chinese policy makers are concerned with the dramatic recent falls in the value of the Chinese Stock Market. They are right to be concerned. Although we can, and should, allow financial markets to allocate capital across sectors, the market as a whole is a creature of sentiment. And U.S. experience suggests that market crashes often precede deep recessions.

Today, the Peoples Bank of China was given the authority to purchase shares in the Chinese Stock Market. This is a bold experiment; but it is not unprecedented. In 1998, in the midst of the Asian Financial Crisis, the Hong Kong Monetary Authority engaged in a similar exercise. That intervention was large and successful and was the beginning of the end of the Asian crisis.

Chinese stocks are not dramatically overvalued and prospects for growth have recently picked up. I have advocated in the past for  the policy that the Peoples Bank is now engaged in. But the devil is in the details.

Stock market intervention could unfold in two ways. A purchase of shares by the central bank might be financed by money creation (Quantitative Easing). Or it might be accomplished by swapping short-term debt for risky securities (Qualitative Easing). Chinese interest rates, at 4.8%, are still in positive territory although inflation is currently at 1.2% and falling if official statistics are to believed. That leaves room for purchase of shares financed by money creation and it is an option that I would not rule out.

Buying stocks through money creation is not the only avenue. The Peoples Bank also has the option to purchases shares without increasing the monetary base through swaps of shares, either for foreign exchange or through domestic government borrowing.

China is holding more than $1.2 trillion dollars of U.S. government debt. If the Bank were to tap those funds to stabilize the Chinese stock market it could not simultaneously maintain an exchange rate peg. If China goes that route, look out for upheaval in the foreign exchange markets.

An alternative strategy would be to issue domestic debt and use it to purchase stocks. That would leave the Bank with liabilities, short-term debt, offset by assets, shares in the Chinese stock market.

It would be a mistake to bet against a Central Bank that is committed to dampening market volatility and a national treasury that is backed by the present value of future tax revenues. But an intervention of the magnitude that China is now contemplating cannot fail to spill over into world financial markets. Fasten your seat belts; the ride is about to get choppy.

Behavioural Economics is Rational After All

There are some deep and interesting issues involved in the debate over behavioural economics. Greg Hill posted a comment on my previous blog where he says:

Now, you really have to ask yourself whether the kind of rationality involved in [Thaler's idea of a nudge], where a minimal change in cost results in a significant change of behavior, is same kind of rationality Lucas and Sargent have in mind.

That led me to explain my views a little further.

The most interesting issue [with behavioural economics] is whether we should continue to accept the neoclassical assumption that preferences are fixed. Let's go with that assumption for a moment.

If preferences are fixed, then we face a second question. What form do they take? For a long time, macroeconomists assumed that people maximize the discounted present value of a time and state separable von Neumann Morgenstern expected utility function. The narrow version of behavioural economics asserts that this assumption is wrong; but people are still utility maximizers.

Finance economists seeking to reconcile macroeconomics with finance theory have already taken up that challenge (see the survey here on Exotic Preferences in Macroeconomics). The dominant view in finance theory is that people maximize the present discounted value of a subclass of preferences first formalized by Epstein and Zin. These preferences drop one of the key assumptions of Von-Neumann Morgenstern; that the date at which information is revealed is irrelevant. There are also more radical possibilities. The original version of the Epstein Zin utility function also allows for dropping a more fundamental assumption, called the independence axiom.

My point here, is that neoclassical economics can absorb the criticisms of the behaviourists without a major shift in its underlying assumptions. The 'anomalies' pointed out by psychologists are completely consistent with maximizing behaviour, as long as we do not impose any assumptions on the form of the utility function defined over goods that are dated and indexed by state of nature.

There is a deeper, more fundamental critique. If we assert that the form of the utility function is influenced by 'persuasion', then we lose the intellectual foundation for much of welfare economics. That is a much more interesting project that requires us to rethink what we mean by individualism.

Greg also asks

“can we understand all the failures of classical macroeconomics without giving up both rational choice and the premise that all markets clear?” If anyone can make a persuasive case for the “yes” answer, I believe you can."

My response. Yes we can and should maintain rational choice, rational expectations and market clearing: but that requires a radical change in the way we define equilibrium. As I have done here.