Don't Trust the Markets

In a week when the Vix is at a seven-year high and the markets are back to the trading range of the summer of 2017, now seems like a good time to revisit the theme of market efficiency. Here is a link to the pre-publication version of an academic paper I published this year in the Review of Economic Dynamics.

The paper is a formal model of an argument I’ve been making for a while.  Although it’s not possible for the average punter to make a buck in the financial markets we should definitely NOT trust the financial markets to do a good job allocating capital intertemporally. As Richard Thaler explained in his review of Justin Fox’s book The Myth of the Rational Market, the efficient markets hypothesis (EMH) has two components. 

The first, ‘no free lunch’ asserts that unless you have inside information, it is impossible to outperform the market except through dumb luck. That is almost certainly correct, although even that part of the EMH is disputed by some.

The second, ‘the price is right’, asserts that the financial markets allocate capital efficiently over time. Efficiently, here, means that there is no intervention by government that could make us all better off. That, despite the protestations of radical free-marketeers, is almost certainly wrong.  My paper explains why.

The financial markets facilitate trade with people not yet born. If you buy a stock and sell it twenty years later, there is a good chance the buyer wasn’t alive when you made the purchase. When you buy the stock for the long-run, you are betting that the buyer, twenty years from now, will pay more than you did. And the buyer is making the same forecast about the whims of some other buyer in the yet more distant future. This never-ending chain of market trades leads to the possibility that self-fulfilling prophecies lead to inefficient cycles of booms and crashes.

For the cognoscenti, here is the abstract from my paper

“This paper constructs a general equilibrium model where asset price fluctuations are caused by random shocks to beliefs about the future price level that reallocate consumption across generations. In this model, asset prices are volatile, and price-earnings ratios are persistent, even though there is no fundamental uncertainty and financial markets are sequentially complete. I show that the model can explain a substantial risk premium while generating smooth time series for consumption. In my model, asset price fluctuations are Pareto inefficient and there is a role for treasury or central bank intervention to stabilize asset price volatility. ”

Have fun trading everyone and I wish you all a very  happy 2019. 

Conference at the Bank of England

Last year I co-organized a highly successful conference at the Bank of England on Economics and Psychology. You can find links to videos from most of the conference presenters here. This year I am co-organizing a second conference with the title, "Economics and Psychology: New Ways of Thinking about economic policy". The conference will take place on Monday July 9th and Tuesday July 10th. We have a tremendous line-up of papers with topics ranging from economic theory, economic and psychology experiments to behavioral economics and economic policy.

The conference will open with a keynote address from Seppo Honkapohja, former Deputy Governor of the Bank of Finland and closed by Vítor Constâncio, former Deputy Governor of the ECB. It promises to be an exciting event.  There is a limited number of spots for non-participants so, if you would like to attend, please send an email to Michelle Scott at the Bank of England. We welcome requests from academics, journalists and particularly from graduate students in economics and psychology. Space is limited so please don't wait too long to apply.

I am especially grateful to the Economics Department at the University of Warwick, the Bank of England, the Centre for Macroeconomics and the National Institute of Economics and Social Research for supporting both conferences. 

Lend Me Your Ears: Friedman and The Role of Financial Policy

I was invited by Matías Vernengo, Co-Editor of the Review of Keynesian Economics, to write a paper, 'The Role of Financial Policy' in honour of the 50th anniversary of Friedman's Presidential Address to the American Economic Association. The Review will be publishing a special edition later this year and I am honoured to be writing in the distinguished company of many fine economists. 

Invited contributors that I am aware of include Brad DeLong, James Forder, Robert Gordon, David Laidler, Rober Pollin, Louis-Philippe Rochon, Sergio Rossi, Antonell Stirati, Servaas Storm and Nathan Perri.  

I opened my essay with a quote from Shakespeare's play, Julius Caesar.

Friends, Romans, countrymen, lend me your ears; I come to bury Caesar, not to praise him.
The evil that men do lives after them;
The good is oft interred with their bones;
So let it be with Caesar.

Opening an essay to honour the work of a great man by quoting from Marc Anthony’s words at Julius Caesar’s funeral, may appear to some to be a boorish opening gambit. But I do not mean disrespect. Milton Friedman was one of the greatest economists, if not the greatest economist, of the twentieth century. Friedman’s views of the appropriate role of monetary policy have become accepted wisdom and they form the core belief of every practicing central banker in the world today. That does not make them right. I come to bury some, but not all, of Friedman’s ideas. And as for Friedman himself, unlike Marc Anthony, I come to praise him.

My praise is for the influence of Friedman's ideas on the operation of monetary policy. Although his advocacy of a money supply rule was a failure in practice, his focus on rules evolved into the adoption of inflation targeting, implemented by interest rate control, that was a pillar of monetary policy in the last thirty years and was, arguably, responsible for the long period of economic stability that we refer to as the Great Moderation.

My critique of Friedman is of his insistence on the free market as a self-stabilizing system. The  Great Recession is just the latest example of the failure of that idea. Friedman was the greatest monetary economist of his generation. But the natural rate hypothesis, introduced in his 1968 Presidential Address, was a spectacular failure and we are only now digging out of the rubble of the New-Keynesian edifice that was constructed on this concept.

My solution, discussed in this essay, is to supplement inflation targeting with a new kind of financial policy that institutionalizes the role of the central bank as the lender of last resort.

Taming the Lion

In the nineteenth and early twentieth centuries the business cycle was a wild ride. Part of the damage inflicted by financial crises was caused by price instability. That problem was successfully solved in the 1980s when the Fed adopted inflation targeting. The success proved chimeric.  My last post argued for a second policy, designed to stabilize the stock market. This policy, in combination with an inflation targeting rule, would effectively dampen financial cycles. 

My previous post provoked a number of responses on Twitter that I will respond to here.  Sanjay Mittai, @sanjmitt asked;

"What about stabilizing employment? Or are workers to be regarded as trash as long as the stock market is doing OK?"

My proposal to stabilize the stock market is based on two research papers, here, and here,  in which I show that there has been a strong and stable connection between the stock market and the unemployment rate in six decades of US data. Stock market crashes, when they are sustained for six months or more, lead to recessions. Persistent bull markets lead to unsustainably low unemployment rates and the creation of unsustainably high levels of capital creation. The euphoria always eventually comes to a painful end for the average worker when the market crashes and he or she is out of a job.

The proposal, explained in my book Prosperity for All, is to stabilize the asset markets with the ultimate goal of maintaining full employment. Part of my argument is aimed at my fellow economists. I explain why financial markets do not work well, even when everyone alive today can trade assets contingent on every conceivable future event. And part of my argument is aimed at my fellow citizens. I seek support to create an institution that is not aimed to improve the lives of the rich and powerful: it is aimed to improve the lives of all of us.

A second point was raised by John the Blind, @Athena_Alithis who is concerned that low volatility is the calm before a future storm. Here is John;

By stabilising the stock market, the system becomes more unstable and risky. Less vol means higher leverage and larger risk portfolios building up as ‘what could possibly be wrong.’

To which I respond: The world we live in today is not the same world that our Mothers and Fathers inhabited. It is not the world that our Grandmothers and our Grandfathers inhabited. It has evolved in ways that none of us, even ten years ago, could have foreseen. The institutions that we built to tame financial cycles have been, at least partially, successful. That success is evidenced by a fall in the frequency of financial panics which occurred far more often in the nineteenth and early twentieth centuries.

We achieved increased stability by creating new institutions like the Federal Reserve System which learned successfully to manage price stability for more than three decades from 1980 through 2007, a period we now call the ‘Great Moderation’. That stability was not an illusion. It was a creation of improved monetary management. It ended in 2008 because the tool we had used to manage markets, control of the short rate of interest, hit zero and could be lowered no further.

The Great Recession was a large natural experiment that we can, and should, learn from. The lesson is not that we must tear up existing institutions and go back to the Gold Standard. It is that we must develop new institutions. By managing the short rate of interest we tamed the lion of inflation. By managing the risk composition of the average market portfolio we can tame the lion of unemployment and help to bring Prosperity for All.

Bulls and Bears: Why central banks should stabilize the stock market

My paper, Pricing Assets in a Perpetual Youth Model was recently published in the Review of Economic Dynamics. The paper uses mathematics to make a point.  But the idea is simple and worth explaining in English.  

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. 

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 explains why markets, most of the time, work well. So why doesn't that idea apply also to the financial markets?

The answer is simple. For markets to work well, everyone affected by price movements must be able to trade in those markets. The first welfare theorem does not apply to the financial markets because not everyone is alive to participate in them.  We cannot trade in markets that open before we are born.

I show in my published paper that the fact that we cannot insure over the state we are born into can explain why markets are so volatile. Markets go up and markets go down simply because people become enthused with waves of optimism or waves of pessimism. Most, if not all, stock markets movements are caused by contagious waves of self-fulfilling prophecies and we would all be better off if they were eliminated by treasury or central bank intervention.