Central Bank Equity Purchases: An Idea Whose Time has Come

Writing in the Financial Times last week, BlackRock executive, Rick Rieder, urged the ECB to purchase equities in an attempt to stimulate growth in the Eurozone. Merryn Somerset Webb, disagrees. While Merryn is correct to point out that BlackRock stands to benefit from a policy that would increase equity prices in the Eurozone, that is not a reason to dismiss an idea whose time has come.

Critics of central bank intervention argue that central bank equity purchases ‘distort price signals’? That assumes that private agents interacting in markets are able to accurately divine what is in the best interests of society. In reality, market participants are often captured by waves of optimism or pessimism that are themselves the prime cause of capital misallocations. 

The asset markets are remarkably efficient at allocating capital across industries. They are much less efficient at allocating capital across time. Most of the people we will trade with in the financial markets are not yet born as the shares we buy today derive their value from the actions of our children and our grandchildren. The arguments that economists have provided to explain Adam Smiths’s ‘invisible hand’, rely on the ability of people to trade with each other. As I show in my book Prosperity for All, those arguments break down when applied to the capital markets as a direct consequence of the fact that the unborn cannot buy shares.

Theoretical and empirical research conducted by teams I have led at UCLA, the University of Warwick, NIESR, and the research network, Rebuilding Macroeconomics housed at NIESR, all points in the same direction. The capital markets are socially inefficient. 

The policy implication of our research is that central banks should adopt a policy of active asset price stabilization through targeting the price of an index fund. This policy would be a complement to the traditional monetary policy of interest rate control.

Since the time of Walter Bagheot, economists have recognized a role for central banks in maintaining financial stability. The direct control of the price of an index fund of European share prices would provide an effective way of implementing this financial policy in the European context.

The Future of Macroeconomics

In May of 2018, I was privileged to be invited to participate in an ECB colloquium on the Future of Central Banking and Macroeconomics in honour of Vítor Constâncio. Here is a video of my ten minute discussion of a paper by John Muellbauer.

This discussion reflects my thinking on many topics including hysteresis, multiple equilibria and the need for a fundamental shift in direction for the future of macroeconomics and macroeconomic policy.

I have also included a link to the full conference progamme, with videos, here.

Why the Indeterminacy Agenda Matters in the Real World

In a couple of weeks, I will be presenting two lectures at the 20th edition of the Axel Leijonhufvud Summer School in Trento Italy. I’ve also just completed a piece for the Oxford Research Encyclopedia of Economics and Finance on the Indeterminacy Agenda in Macroeconomics. That article is available here as an NBER paper or as an ungated piece directly from my website here. The article shows how far the indeterminacy agenda has advanced modern macroeconomics and explains its relevance for economic policy.

In the article, I draw a distinction between dynamic indeterminacy and steady-state indeterminacy. Dynamic indeterminacy is the idea that, in DSGE models, there frequently are not enough initial conditions to pin down the solution to the dynamic path that characterizes a dynamic equilibrium. Jess Benhabib and I surveyed that literature back in 1999 in an article for the Handbook of Macroeconomics. The working paper version is available here. That literature was important, but it did not fulfill its original promise: to act as a micro foundation to Keynesian economics.

The dynamic indeterminacy literature introduced the idea that ‘animal spirits’ can act an independent driver of business cycles. But it missed completely the idea of involuntary unemployment as a steady state equilibrium.

In a new literature on steady-state indeterminacy, I have introduced a version of search theory that is distinct from the work for which Diamond, Mortensen and Pissarides won the Nobel Prize in 2010. I call their work, and the work that evolved from it, Classical Search Theory. In my alternative, Keynesian Search Theory, explained in my 2016 book Prosperity for All, I drop the idea that the wage is determined by bargaining and I replace it with employment that is determined in the asset markets by the animal spirits of investors. Along with a series of co-authors, we have written a series of papers explaining that idea which you can find linked here. Some of these articles are theoretical: others show the relevance of the idea of steady-state indeterminacy to the real world. These ideas have important implications for the policies we must put in place to head off and combat the next Great Recession.

As I say in the closing section of The Indeterminacy Agenda in Macroeconomics, in a review of the empirical evidence that Giovanni Nicolò and I present here and here, “It takes a model to beat a model. And the indeterminacy agenda wins the day by a decisive margin.”

Replacing the Phillips Curve: I showed you my macro model. Now show me your macro model.

Peter Dixon wrote a nice piece about my work …

To which I responded ….

David Glasner weighs in with the view that the Phillips Curve is not a structural relationship.

Here is my response.

And Stephen Williamson and Jorge Miranda-Pinto tell us that they have not been teaching the Phillips Curve as a structural equation for some time.

What are macroeconomists currently teaching their students? Time to teach a credible alternative to the NK Phillips Curve.

Here is me responding to David Glasner …

In the following tweet, David responds using the language of the outdated IS-LM model.

As I explain below …, this is not a good answer.

David sees IS-LM as a ‘convenience’ …

I want more. I want to see what’s under the hood. This is what’s under my hood … the IS-LM-NAC model and how to use it ….

There are many unemployment rates for any r*

Eric Lonergan has a new blog post in which he draws attention to the importance of the asset markets in business cycle dynamics. While there is much to like in that post, I find parts of Eric’s argument misleading. Here is Eric:

“This leads us to the how [stet] the equity market determines the ‘neutral policy rate’. I have argued in the past that we need to get away from the idea of some magic level of the interest rate that somehow brings inflation to 2% and the economy to full employment.”

Eric is even clearer in his tweets in which he asserts that "stock prices determine r*”. I disagree for the reason I outlined on page 195 of Prosperity for All. The stock price is a stock. r* is the ratio of a stock to a flow. If r* is 5% (for example) the (real) stock price could be 100 bushels of corn and earnings could be 5 bushels of corn or the stock price could be 200 bushels of corn and earnings could be 10 bushels of corn. Both cases would lead to a value for r* of 5%.

If there are 100 people in the economy and it takes one person to harvest a bushel of corn, the first case would correspond to an unemployment rate of 5% and the second case would correspond to an unemployment rate of 10%.

In a second passage, Eric points out that recessions are typically preceded by stock market falls.

“Stock markets are a measure of recession risk. They are not predictors of recessions, as such. Paul Samuelson famously quipped that the stock market has predicted seven of the last three recessions – or words to that effect. But the joke is only partly insightful. Yes, there is excess volatility in stock prices for a host of reasons, but the probability of recession fluctuates, so stock prices should fluctuate with these probabilities. In that sense, the stock market should ‘predict’ more recessions than actually occur.”

Here Eric and I agree. But I would go further. Persistent drops in the stock market are not simply indicators of a future recession: they are causes of a future recession. This is demonstrably true in the sense of Granger Causality, as a I show here. And the word ‘persistent’ is important in this statement. A one-day crash that comes back a week later has no impact on the unemployment rate. A one day crash in the stock market that persists for three months does have an impact.

To get beyond Granger Causality, one needs a theory of how stock market crashes, triggered by a loss of confidence, so called animal spirits, can generate a causal chain that increases unemployment. I have developed such a theory here. This theory explains why ANY unemployment rate can be consistent with an equilibrium in which no market participant has an incentive to change his or her behavior. And it explains why there is no correspondence between r*, the so called natural rate of interest, and u*, the socially optimal rate of unemployment.