Archive for the 'Efficient Market Hypothesis' Category

What Do Stock Prices Tell Us about the Economy?

Stock prices (as measured by the S&P 500) in 2017 rose by over 20%, an impressive amount, and what is most impressive about it is perhaps that this rise prices came after eight previous years of steady increases.

Here are the annual year-on-year and cumulative changes in the S&P500 since 2009.

2009              21.1%              21.1%*

2010              12.0%              33.1%*

2011              -0.0%               33.1%*

2012              12.2%               45.3%*

2013              25.9%               71.2%*

2014              10.8%               82.0%*

2015              -0.7%                81.3%*

2016             9.1%                   90.4%*            (4.5%)**          (85.9%)***

2017             17.7%                 108.1%*          (22.3%)****

2018 (YTD)    2.0%                  110.1%*           (24.3%)****

* cumulative increase since the end of 2008

** increase from end of 2015 to November 8, 2016

*** cumulative increase from end of 2008 to November 8, 2016

**** cumulative increase since November 8, 2016

So, from the end of 2008 until the start of 2017, approximately coinciding with Obama’s two terms as President, the S&P 500 rose in every year except 2011 and 2015, when the index was essentially unchanged, and rose by more than 10% in five of the eight years (twice by more than 20%), with stock prices nearly doubling during the Obama Presidency.

But what does the doubling of stock prices under Obama really tell us about the well-being of the American economy, and, even more importantly, about the well-being of the American public during those years? Is there any correlation between the performance of the stock market and the well-being of actual people? Does the doubling of stock prices under Obama mean that most Americans were better off at the end of his Presidency than they were at the start of it?

My answer to these questions is a definite — though not very resounding — yes, because we know that the US economy at the end of 2008 was in the middle of the sharpest downturn since the Great Depression. Output was contracting, employment was falling, and the financial system was on the verge of collapse, with stock prices down almost 50% from where they had been at the end of August, and nearly 60% from the previous all-time high reached in 2007. In 2016, after seven years of slow but steady growth, employment and output had recovered and surpassed their previous peaks, though only by small amounts. But the recovery, although disappointingly slow, was real.

That improvement was reflected, albeit with a lag, in changes in median household and median personal income between 2008 and 2016.

2009                    -0.7%                   -0.7%

2010                    -2.6%                    -3.3%

2011                     -1.6%                    -4.9%

2012                    -0.1%                    -5.0%

2013                      3.5%                    -1.5%

2014                    -1.5%                     -3.0%

2015                     5.1%                       2.0%

2016                      3.1%                      5.1%

But it’s also striking how weak the correlation was between rapidly rising stock prices and rising median incomes in the Obama years. Given a tepid real recovery from the Little Depression, what accounts for the associated roaring recovery in stock prices? Well, for one thing, much of the improvement in the stock market was simply recovering losses in stock valuations during the downturn. Stock prices having fallen further than incomes in the Little Depression, it’s not surprising that the recovery in stocks was steeper than the recovery in incomes. It took four years for the S&P 500 to reach its pre-Depression peak, so, normalized to their pre-Depression peaks, the correlation between stock prices and median incomes is not as weak as it seems when comparing year-on-year percentage changes.

But considering the improvement in stock prices under Obama in historical context also makes the improvement in stock prices under Obama seem less remarkable than it does when viewed without taking the previous downturn into account. Stock prices simply returned (more or less) to the path that, one might have expected them to follow by extrapolating their past performance. Nevertheless, even if we take into account that, during the Little Depression, stocks prices fell more sharply than real incomes, stocks have clearly outperformed the real economy during the recovery, real output and income having failed to return to the growth path that it had been tracking before the 2008 downturn.

Why have stocks outperformed the real economy? The answer to that question is a straightforward application of the basic theory of asset valuation, according to which the value of real assets – machines, buildings, land — and financial assets — stocks and bonds — reflects the discounted expected future income streams associated with those assets. In particular, stock prices represent the discounted present value of the expected future cash flows (dividends or stock buy-backs) from firms to their shareholders. So, if the economy has “recovered” (more or less) from the 2008-09 downturn, the expected future cash flows from firms have presumably – and on average — surpassed the cash flows that had been expected before the downturn.

But the weakness in the recovery suggests that the increase in expected cash flows can’t fully account for the increase in stock prices. Why did stock prices rise by more than the likely increase in expected cash flows? The basic theory of asset valuation tells us that the remainder of the increase in stock prices can be attributed to the decline of real interest rates since the 2008 downturn to historically low levels.

Of course, to say that the increase in stock prices is attributable to the decline in real interest rates just raises a different question: what accounts for the decline in real interest rates? The answer, derived from Irving Fisher, is basically that if perceived opportunities for future investment and growth are diminished, the willingness of people to trade future for present income also tends to diminish. What the rate of interest represents in the Fisherian framework is the rate at which people are willing to trade future for present income – i.e., the premium (discount) that is placed on present (future) income.

The Fisherian view is totally at odds with the view that the real interest rate is – or can be — controlled by the monetary authority. According to the latter view, the reason that real interest rates since the 2008 downturn have been at historically low levels is that the Federal Reserve has forced interest rates down to those levels by flooding the economy with huge quantities of printed money. There is a certain sense in which that view has a small element of truth: had the Fed adopted a different set of policy goals concerning inflation and nominal GDP, real interest rates might have risen to more “normal” levels. But given the overall policy framework within which it was operating, the Fed had only minimal control over the real rate of interest.

The essential idea is that in the Fisherian view the real rate of interest is not a single price determined in a single market; it is a distillation of the entire intertemporal structure of price relationships simultaneously determined in the myriad of individual markets in which transactions for present and future delivery are continuously being agreed upon. To imagine that the Fed, or any monetary authority, could control or even modestly influence this almost incomprehensibly complicated structure of price relationships according to its wishes is simply delusional.

If the decline in real interest rates after the 2008 downturn reflected generally reduced optimism about future economic growth, then the increase in stock prices actually reflected declining optimism by most people about their future well-being compared to their pre-downturn expectations. That loss of optimism might have been, at least in part, self-fulfilling insofar as it discouraged potentially worthwhile – i.e., profitable — investments that would have been undertaken had expectations been more optimistic.

Nevertheless, the near doubling of stock prices during the Obama administration did coincide with a not insignificant improvement in the well-being of most Americans. Most Americans were substantially better off at the end of 2016, after about seven years of slow but steady economic growth, than they were at the end of 2008 when total output and employment were contracting at the fastest rate since the Great Depression. But to use the increase in stock prices as a quantitative measure of the improvement in their well-being would be misleading.

I would also mention as an aside that a favorite faux-populist talking point of Obama and Fed critics used to be that rising stock prices during the Obama years revealed the bias of the elitist Fed Governors appointed by Obama in favor of the wealthy owners of corporate stock, and their callous disregard of the small savers who leave their retirement funds in bank savings accounts earning minimal interest and of workers whose wage increases barely kept up with inflation. But this refrain of critics – and I am thinking especially of the Wall Street Journal editorial page – who excoriated the Obama administration and the Fed for trying to raise stock prices by keeping interest rates at abnormally low levels now unblushingly celebrate record-high stock prices as proof that tax cuts mostly benefiting corporations and their stockholders signal the start of a new golden age of accelerating growth.

So the next question to consider is what can we infer about the well-being of Americans and the American economy from the increase in stock prices since November 8, 2016? For purposes of this mental exercise, let me stipulate that the rise in stock prices since the moment when it became clear who had been elected President by the voters on November 8, 2016 was attributable to the policies that the new administration was expected to adopt.

Because interest rates have risen along with stock prices since November 8, 2016, increased stock prices must reflect investors’ growing optimism about the future cash flows to be distributed by corporations to shareholders. So, our question can be restated as follows: which policies — actual or expected — of the new administration could account for the growing optimism of investors since the election? Here are five policy categories to consider: (1) regulation, (2) taxes, (3) international trade, (4) foreign affairs, (5) macroeconomic and monetary policies.

The negative reaction of stock prices to the announcement last week that tariffs will be imposed on steel and aluminum imports suggests that hopes for protectionist trade policies were not the main cause of rising investor optimism since November 2016. And presumably investor hopes for rising corporate cash flows to shareholders were not buoyed up by increasing tensions on the Korean peninsula and various belligerent statements by Administration officials about possible military responses to North Korean provocations.

Macroeconomic and monetary policies being primarily the responsibility of the Federal Reserve, the most important macroeconomic decision made by the new Administration to date was appointing Jay Powell to succeed Janet Yellen as Fed Chair. But this appointment was seen as a decision to keep Fed monetary policy more or less unchanged from what it was under Yellen, so one could hardly ascribe increased investor optimism to a decision not to change the macroeconomic and monetary policies that had been in place for at least the previous four years.

That leaves us with anticipated or actual changes in regulatory and tax policies as reasons for increased optimism about future cash flows from corporations to their shareholders. The two relevant questions to ask about anticipated or actual changes in regulatory and tax policies are: (1) could such changes have raised investor optimism, thereby raising stock prices, and (2), if so, would rising stock prices reflect enhanced well-being on the part of the American economy and the American people?

Briefly, the main idea for regulatory reform that the Administration wants to pursue is to require that whenever an agency adopts a new regulation, it should simultaneously eliminate two old ones. Supposedly such a requirement – sometimes called a regulatory budget – is to limit the total amount of regulation that the government can impose on the economy, the theory being that new regulations would not be adopted unless they were likely to be really effective.

But agencies are already required to show that regulations pass some cost-benefit test before imposing new regulations. So it’s not clear that the economy would be better off if new regulations, which can now be adopted only if they are expected to generate benefits exceeding the costs associated with their adoption, cannot be adopted unless two other regulations are eliminated. Presumably, underlying the new regulatory approach is a theory of bureaucratic behavior positing that the benefits of new regulations are systematically overestimated and their costs systematically underestimated by bureaucrats.

I’m not going to argue the merits of the underlying theory, but obviously it is possible that the new regulatory approach would result in increased profits for businesses that will have fewer regulatory burdens imposed upon them, thereby increasing the value of ownership shares in those firms. So, it’s possible that the new regulatory approach adopted by the Administration is causing stock prices to rise, presumably by more than they would have risen under the old simple cost-benefit regulatory approach that was followed by the Obama Administration.

But even if the new regulatory approach has caused stock prices to rise, it’s not clear that increasing stock valuations represent a net increase in the well-being of the American economy and the American people. If regulations that are costly to the economy in general are eliminated, the benefits of fewer regulations would accrue not just to the businesses whose profits rise as a result; eliminating inefficient regulations would also benefit the rest of the economy by freeing up resources to produce goods and services whose value to consumers would the benefits foregone when regulations were eliminated. But it’s also possible, that regulations are providing benefits greater than the costs of implementing and enforcing them.

If eliminating regulations leads to increased pollution or sickness or consumer fraud, and the value of those foregone benefits exceeds the costs of those regulations, it will not be corporations and their shareholders that suffer; it will be the general public that will bear the burden of their elimination. While corporations increase the cash flows paid to shareholders, members of the public will suffer more-than-offsetting reductions in well-being by being exposed to increased pollution, suffering increased illness and injury, or suffering added fraud and other consumer harms.

Since 1970, when the federal government took serious measures to limit air and water pollution, air and water quality have improved greatly in most of the US. Those improvements, for the most part, have probably not been reflected in stock prices, because environmental improvements, mostly affecting common-property resources, can’t be easily capitalized, though, some of those improvements have likely been reflected in increasing land values in cities and neighborhoods where air and water quality have improved. Foregoing pollution-reducing regulations might actually have led to increased stock prices for many corporations burdened by those regulations, but the US as a whole, and its inhabitants, would not have been better off without those regulations than they are with them.

So, rising stock prices are not necessarily a good indicator of whether the new regulatory approach of the Administration is benefiting or harming the American economy and the American public. Market valuations convey a lot of important information, but there is also a lot of important information that is not conveyed in stock prices.

As for taxes, it is straightforward that reducing corporate-tax liability increases funds available to be paid directly to shareholders as dividends and share buy-backs, or indirectly through investments expected to increase cash flows to shareholders in the more distant future. Does an increase in stock prices caused by a reduction in corporate-tax liability imply any enhancement in the well-being of the American economy and the American people

The answer, as a first approximation, is no. A reduction in corporate tax liability implies a reduction in the tax liability of shareholders, and that reduction is immediately capitalized into the value of shares. Increased stock prices simply reflect the expected reduction in shareholder tax liability.

Of course, reducing the tax burden on shareholders may improve economic performance, causing an increase in corporate cash flows to shareholders exceeding the reduction in shareholder tax liabilities. But it is unlikely that the difference between the increase in cash flows to shareholders and the reduction in shareholder tax liabilities would be more than a few percent of the total reduction in corporate tax liability, so that any increase in economic performance resulting from a reduction in corporate tax liability would account for only a small fraction of the increase in stock prices.

The good thing about the corporate-income tax is that it is so easy to collect, and that it is so hard to tell who really bears the tax burden: shareholders, workers or consumers. That’s why governments like taxing corporations. But the really bad thing about the corporate-income tax is that it is so hard to tell who really bears the burden of the corporate tax, shareholders, workers or consumers.

Because it is so hard to tell who bears the burden of the tax, people just think that “corporations” pay the tax, but “corporations” aren’t people, and they don’t really pay taxes, they are just the conduit for a lot of unidentified people to pay unknown amounts of tax. As Adam Winkler has just explained in this article and in an important new book, It is a travesty that the Supreme Court was hoodwinked in the latter part of the nineteenth century into accepting the notion that corporations are Constitutional persons with essentially the same rights as actual persons – indeed, with far greater rights than human beings belonging to disfavored racial or ethnic categories.

As I wrote years ago in one of my early posts on this blog, there are some very good arguments for abolishing the corporate income tax altogether, as Hyman Minsky argued. Forcing corporations to distribute their profits to shareholders would diminish the incentives for corporate empire building, thereby making venture capital more available to start-ups and small businesses. Such a reform might turn out to be an important democratizing and decentralizing change in the way that modern capitalism operates. But even if that were so, it would not mean that the effects of a reduction in the corporate tax rate could be properly measured by looking that resulting change in corporate stock prices.

Before closing this excessively long post, I will just remark that although I have been using the basic theory of asset pricing that underlies the efficient market hypothesis (EMH), adopting that theory of asset pricing does not imply that I accept the EMH. What separates me from the EMH is the assumption that there is a single unique equilibrium toward which the economy is tending at any moment in time, and that the expectations of market participants are unbiased and efficient estimates of the equilibrium price vector toward which the price system is moving. I reject all of those assumptions about the existence and uniqueness of an equilibrium price vector. If there is no equilibrium price vector toward which the economy is tending, the idea that expectations are governed by some objective equilibrium which is already there to be discovered is erroneous; expectations create their own reality and equilibrium is itself determined by expectations. When the existence of equilibrium depends on expectations, it becomes impossible to assign any meaning to the term “efficient market.”

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What’s Wrong with EMH?

Scott Sumner wrote a post commenting on my previous post about Paul Krugman’s column in the New York Times last Friday. I found Krugman’s column really interesting in his ability to pack so much real economic content into an 800-word column written to help non-economists understand recent fluctuations in the stock market. Part of what I was doing in my post was to offer my own criticism of the efficient market hypothesis (EMH) of which Krugman is probably not an enthusiastic adherent either. Nevertheless, both Krugman and I recognize that EMH serves as a useful way to discipline how we think about fluctuating stock prices.

Here is a passage of Krugman’s that I commented on:

But why are long-term interest rates so low? As I argued in my last column, the answer is basically weakness in investment spending, despite low short-term interest rates, which suggests that those rates will have to stay low for a long time.

My comment was:

Again, this seems inexactly worded. Weakness in investment spending is a symptom not a cause, so we are back to where we started from. At the margin, there are no attractive investment opportunities.

Scott had this to say about my comment:

David is certainly right that Krugman’s statement is “inexactly worded”, but I’m also a bit confused by his criticism. Certainly “weakness in investment spending” is not a “symptom” of low interest rates, which is how his comment reads in context.  Rather I think David meant that the shift in the investment schedule is a symptom of a low level of AD, which is a very reasonable argument, and one he develops later in the post.  But that’s just a quibble about wording.  More substantively, I’m persuaded by Krugman’s argument that weak investment is about more than just AD; the modern information economy (with, I would add, a slowgrowing working age population) just doesn’t generate as much investment spending as before, even at full employment.

Just to be clear, what I was trying to say was that investment spending is determined by “fundamentals,” i.e., expectations about future conditions (including what demand for firms’ output will be, what competing firms are planning to do, what cost conditions will be, and a whole range of other considerations. It is the combination of all those real and psychological factors that determines the projected returns from undertaking an investment, and those expected returns must be compared with the cost of capital to reach a final decision about which projects will be undertaken, thereby giving rise to actual investment spending. So I certainly did not mean to say that weakness in investment spending is a symptom of low interest rates. I meant that it is a symptom of the entire economic environment that, depending on the level of interest rates, makes specific investment projects seem attractive or unattractive. Actually, I don’t think that there is any real disagreement between Scott and me on this particular point; I just mention the point to avoid possible misunderstandings.

But the differences between Scott and me about the EMH seem to be substantive. Scott quotes this passage from my previous post:

The efficient market hypothesis (EMH) is at best misleading in positing that market prices are determined by solid fundamentals. What does it mean for fundamentals to be solid? It means that the fundamentals remain what they are independent of what people think they are. But if fundamentals themselves depend on opinions, the idea that values are determined by fundamentals is a snare and a delusion.

Scott responded as follows:

I don’t think it’s correct to say the EMH is based on “solid fundamentals”.  Rather, AFAIK, the EMH says that asset prices are based on rational expectations of future fundamentals, what David calls “opinions”.  Thus when David tries to replace the EMH view of fundamentals with something more reasonable, he ends up with the actual EMH, as envisioned by people like Eugene Fama.  Or am I missing something?

In fairness, David also rejects rational expectations, so he would not accept even my version of the EMH, but I think he’s too quick to dismiss the EMH as being obviously wrong. Lots of people who are much smarter than me believe in the EMH, and if there was an obvious flaw I think it would have been discovered by now.

I accept Scott’s correction that EMH is based on the rational expectation of future fundamentals, but I don’t think that the distinction is as meaningful as Scott does. The problem is that in a typical rational-expectations model, the fundamentals are given and don’t change, so that fundamentals are actually static. The seemingly non-static property of a rational-expectations model is achieved by introducing stochastic parameters with known means and variances, so that the ultimate realizations of stochastic variables within the model are not known in advance. However, the rational expectations of all stochastic variables are unbiased, and they are – in some sense — the best expectations possible given the underlying stochastic nature of the variables. But given that stochastic structure, current asset prices reflect the actual – and unchanging — fundamentals, the stochastic elements in the model being fully reflected in asset prices today. Prices may change ex post, but, conditional on the realizations of the stochastic variables (whose probability distributions are assumed to have been known in advance), those changes are fully anticipated. Thus, in a rational-expectations equilibrium, causation still runs from fundamentals to expectations.

The problem with rational expectations is not a flaw in logic. In fact, the importance of rational expectations is that it is a very important logical test for the coherence of a model. If a model cannot be solved for a rational-expectations equilibrium, it suffers from a basic lack of coherence. Something is basically wrong with a model in which the expectation of the equilibrium values predicted by the model does not lead to their realization. But a logical property of the model is not the same as a positive theory of how expectations are formed and how they evolve. In the real world, knowledge is constantly growing, and new knowledge implies that the fundamentals underlying the economy must be changing as knowledge grows. The future fundamentals that will determine the future prices of a future economy cannot be rationally expected in the present, because we have no way of specifying probability distributions corresponding to dynamic evolving systems.

If future fundamentals are logically unknowable — even in a probabilistic sense — in the present, because we can’t predict what our future knowledge will be, because if we could, future knowledge would already be known, making it present knowledge, then expectations of the future can’t possibly be rational because we never have the knowledge that would be necessary to form rational expectations. And so I can’t accept Scott’s assertion that asset prices are based on rational expectations of future fundamentals. It seems to me that the causation goes in the other direction as well: future fundamentals will be based, at least in part, on current expectations.

Stock Prices, the Economy and Self-Fulfilling Prophecies

Paul Krugman has a nice column today warning us that the recent record highs in the stock market indices don’t mean that happy days are here again. While I agree with much of what he says, I don’t agree with all of it, so let me try to sort out what I think is right and what I think may not be right.

Like most economists, I don’t usually have much to say about stocks. Stocks are even more susceptible than other markets to popular delusions and the madness of crowds, and stock prices generally have a lot less to do with the state of the economy or its future prospects than many people believe.

I think that’s generally right. The efficient market hypothesis (EMH) is at best misleading in positing that market prices are determined by solid fundamentals. What does it mean for fundamentals to be solid? It means that the fundamentals remain what they are independent of what people think they are. But if fundamentals themselves depend on opinions, the idea that values are determined by fundamentals is a snare and a delusion. So the fundamental idea on which the EMH is premised that there are fundamentals is itself fundamentally wrong. Fundamentals are no more than conjectures and psychologically flimsy perceptions, and individual perceptions are themselves very much influenced by how other people perceive the world and their perceptions. That’s why fads are contagious and bubbles can arise. But because fundamentals are nothing but opinions, expectations can be self-fulfilling. So it is possible for some ex ante bubbles to wind up being justified ex post, but only because expectations can be self-fulfilling.

Still, we shouldn’t completely ignore stock prices. The fact that the major averages have lately been hitting new highs — the Dow has risen 177 percent from its low point in March 2009 — is newsworthy and noteworthy. What are those Wall Street indexes telling us?

Stock prices are in fact governed by expectations, but expectations may or may not be rational, where a rational expectation is an expectation that could actually be realized in some possible state of the world.

The answer, I’d suggest, isn’t entirely positive. In fact, in some ways the stock market’s gains reflect economic weaknesses, not strengths. And understanding how that works may help us make sense of the troubling state our economy is in. . . .

The truth . . . is that there are three big points of slippage between stock prices and the success of the economy in general. First, stock prices reflect profits, not overall incomes. Second, they also reflect the availability of other investment opportunities — or the lack thereof. Finally, the relationship between stock prices and real investment that expands the economy’s capacity has gotten very tenuous.

To put this into the slightly different language of basic financial theory, stock prices reflect the expected future cash flows from owning shares of publicly traded corporations. So stock prices reflect the net value of the tangible and intangible capital assets of these corporations. The public valuations of those assets reflected in stock prices reflect expectations about the future income streams associated with those assets, but those expected future income streams must be discounted so that they can be expressed as a present value. The rate at which future income streams are discounted into the present represents what Krugman calls “the availability of other investment opportunities.” If lots of good investment opportunities are available, then future income streams will be discounted at a higher rate than if there aren’t so many good investment opportunities. In theory the discount rate at which future income streams are discounted would reflect the rate of return corresponding to the marginal investment opportunities that are on the verge of being adopted or abandoned, because they just break even. What Krugman means by the tenuous relationship between stock prices and real investment that expands the economy’ capacity will have to be considered below.

Krugman maintains that, over the past two decades, even though the economy as a whole has not done all that well, stock prices have increased a lot, because the share of capital in total GDP has increased at the expense of labor. He also points out that the low — even negative — real interest rates on government bonds are indicative of the poor opportunities now available (at the margin) to investors.

And these days those options [“for converting money today into income tomorrow”] are pretty poor, with interest rates on long-term government bonds not only very low by historical standards but zero or negative once you adjust for inflation. So investors are willing to pay a lot for future income, hence high stock prices for any given level of profits.

Two points should be noted here. First, scare talk about low interest rates causing bubbles because investors search for yield is nonsense. Even in a fundamentalist EMH universe, a deterioration of marginal investment opportunities causing a drop in the real interest rate will, for given expectations of future income streams, imply that the present value of the assets generating those streams would rise. Rising asset prices in such circumstances are totally rational, which is exactly what bubbles are not. Second, the low interest rates on long-term government bonds are not the cause of poor investment opportunities but the result of poor investment opportunities. Krugman certainly understands that, but many of his readers might not.

But why are long-term interest rates so low? As I argued in my last column, the answer is basically weakness in investment spending, despite low short-term interest rates, which suggests that those rates will have to stay low for a long time.

Again, this seems inexactly worded. Weakness in investment spending is a symptom not a cause, so we are back to where we started from. At the margin, there are no attractive investment opportunities. The mystery deepens:

This may seem, however, to present a paradox. If the private sector doesn’t see itself as having a lot of good investment opportunities, how can profits be so high? The answer, I’d suggest, is that these days profits often seem to bear little relationship to investment in new capacity. Instead, profits come from some kind of market power — brand position, the advantages of an established network, or good old-fashioned monopoly. And companies making profits from such power can simultaneously have high stock prices and little reason to spend.

Why do profits bear only a weak relationship to investment in new capacity? Krugman suggests that the cause  is that rising profits are due to the exercise of market power, firms increasing profits not by increasing output, but by restricting output to raise prices (not necessarily in absolute terms but relative to costs). This is a kind of microeconomic explanation of a macroeconomic phenomenon, which does not necessarily make it wrong, but it is a somewhat anomalous argument for a Keynesian. Be that as it may, to be credible such an argument must explain how the share of corporate profits in total income has been able to grow steadily for nearly twenty years. What would account for a steady economy-wide increase in the market power of corporations lasting for two decades?

Consider the fact that the three most valuable companies in America are Apple, Google and Microsoft. None of the three spends large sums on bricks and mortar. In fact, all three are sitting on huge reserves of cash. When interest rates go down, they don’t have much incentive to spend more on expanding their businesses; they just keep raking in earnings, and the public becomes willing to pay more for a piece of those earnings.

Krugman’s example suggests that the continuing increase in market power, if that is what has been happening, has been structural. By structural I mean that much of the growth in the economy over the past two decades has been in sectors characterized by strong network effects or aggressive enforcement of intellectual property rights. Network effects and strong intellectual property rights tend to create, enhance, and entrench market power, supporting very large gaps between prices and variable costs, which is the standard metric for identifying exercises of market power. The nature of what these companies offer consumers is such that their marginal cost of production is very low, so that reducing price and expanding output would not require a substantial increase in their demand for inputs (at least compared to other industries with higher marginal costs), but would cause a big loss of profit.

But I would suggest looking at the problem from a different perspective, using the distinction between two kinds of capital investment proposed by Ralph Hawtrey. One kind of investment is capital deepening, which involves an increase in the capital intensity of production, the idea being to reduce the cost of production by installing new or better equipment to economize on other inputs (usually labor); the other kind of investment is capital widening, which involves an increase in the scale of output but not in capital intensity, for example building a new plant or expanding an existing one. Capital deepening tends to reduce the demand for labor while capital widening tends to increase it.

More of the investment now being undertaken may be of the capital-deepening sort than has been true historically. Aside from the structural shifts mentioned above, the reduction in capital-widening investment may be the result of declining optimism by businesses in their projections about future demand for their products, making capital-widening investments seem less profitable. For the economy as a whole, a decline in optimism about future demand may turn out to be self-fulfilling. Thus, an increasing share of total investment has become capital-deepening and a declining share capital-widening. But for the economy as a whole, this self-fulfilling pessimism implies that total investment declines. The question is whether monetary (or fiscal) policy could now do anything to increase expectations of future demand sufficiently to induce an self-fulfilling increase in optimism and in capital-widening investment.

 

Scott Sumner Defends EMH

Last week I wrote about the sudden increase in stock market volatility as an illustration of why the efficient market hypothesis (EMH) is not entirely accurate. I focused on the empirical argument made by Robert Shiller that the observed volatility of stock prices is greater than the volatility implied by the proposition that stock prices reflect rational expectations of future dividends paid out by the listed corporations. I made two further points about EMH: a) empirical evidence cited in favor of EMH like the absence of simple trading rules that would generate excess profits and the lack of serial correlation in the returns earned by asset managers is also consistent with theories of asset pricing other than EMH such as Keynes’s casino (beauty contest) model, and b) the distinction between fundamentals and expectations that underlies the EMH model is not valid because expectations are themselves fundamental owing to the potential for expectations to be self-fulfilling.

Scott responded to my criticism by referencing two of his earlier posts — one criticizing the Keynesian beauty contest model, and another criticizing the Keynesian argument that the market can stay irrational longer than any trader seeking to exploit such irrationality can stay solvent – and by writing a new post describing what he called the self-awareness of markets.

Let me begin with Scott’s criticism of the beauty-contest model. I do so by registering my agreement with Scott that the beauty contest model is not a good description of how stocks are typically priced. As I have said, I don’t view EMH as being radically wrong, and in much applied work (including some of my own) it is an extremely useful assumption to make. But EMH describes a kind of equilibrium condition, and not all economic processes can be characterized or approximated by equilibrium conditions.

Perhaps the chief contribution of recent Austrian economics has been to explain how all entrepreneurial activity aims at exploiting latent disequilibrium relationships in the price system. We have no theoretical or empirical basis for assuming that deviations of prices whether for assets for services and whether prices are determined in auction markets or in imperfectly competitive markets that prices cannot deviate substantially from their equilibrium values.  We have no theoretical or empirical basis for assuming that substantial deviations of prices — whether for assets or for services, and whether prices are determined in auction markets or in imperfectly competitive markets — from their equilibrium values are immediately or even quickly eliminated. (Let me note parenthetically that vulgar Austrians who deny that prices voluntarily agreed upon are ever different from equilibrium values thereby undermine the Austrian theory of entrepreneurship based on the equilibrating activity of entrepreneurs which is the source of the profits they earn. The profits earned are ipso facto evidence of disequilibrium pricing. Austrians can’t have it both ways.)

So my disagreement with Scott about the beauty-contest theory of stock prices as an alternative to EMH is relatively small. My main reason for mentioning the beauty-contest theory was not to advocate it but to point out that the sort of empirical evidence that Scott cites in support of EMH is also consistent with the beauty-contest theory. As Scott emphasizes himself, it’s not easy to predict who judges will choose as the winner of the beauty contest. And Keynes also used a casino metaphor to describe stock pricing in same chapter (12) of the General Theory in which he developed the beauty-contest analogy. However, there do seem to be times when prices are rising or falling for extended periods of time, and enough people, observing the trends and guessing that the trends will continue long enough so that they can rely on continuation of the trend in making investment decisions, keep the trend going despite underlying forces that eventually cause a price collapse.

Let’s turn to Scott’s post about the ability of the market to stay irrational longer than any individual trader can stay solvent.

The markets can stay irrational for longer than you can stay solvent.

Thus people who felt that tech stocks were overvalued in 1996, or American real estate was overvalued in 2003, and who shorted tech stocks or MBSs, might go bankrupt before their accurate predictions were finally vindicated.

There are lots of problems with this argument. First of all, it’s not clear that stocks were overvalued in 1996, or that real estate was overvalued in 2003. Lots of people who made those claims later claimed that subsequent events had proven them correct, but it’s not obvious why they were justified in making this claim. If you claim X is overvalued at time t, is it vindication if X later rises much higher, and then falls back to the levels of time t?

I agree with Scott that the argument is problematic; it is almost impossible to specify when a suspected bubble is really a bubble. However, I don’t think that Scott fully comes to terms with the argument. The argument doesn’t depend on the time lag between the beginning of the run-up and the peak; it depends on the unwillingness of most speculators to buck a trend when there is no clear terminal point to the run-up. Scott continues:

The first thing to note is that the term ‘bubble’ implies asset mis-pricing that is easily observable. A positive bubble is when asset prices are clearly irrationally high, and a negative bubble is when asset price are clearly irrationally low. If these bubbles existed, then investors could earn excess returns in a highly diversified contra-bubble fund. At any given time there are many assets that pundits think are overpriced, and many others that are seen as underpriced. These asset classes include stocks, bonds, foreign exchange, REITs, commodities, etc. And even within stocks there are many different sectors, biotech might be booming while oil is plunging. And then you have dozens of markets around the world that respond to local factors. So if you think QE has led Japanese equity prices to be overvalued, and tight money has led Swiss stocks to be undervalued, the fund could take appropriate short positions in Japanese stocks and long positions in Swiss stocks.

A highly diversified mutual fund that takes advantage of bubble mis-pricing should clearly outperform other investments, such as index funds. Or at least it should if the EMH is not true. I happen to think the EMH is true, or at least roughly true, and hence I don’t actually expect to see the average contra-bubble fund do well. (Of course individual funds may do better or worse than average.)

I think that Scott is conflating a couple of questions here: a) is EMH a valid theory of asset prices? b) are asset prices frequently characterized by bubble-like behavior? Even if the answer to b) is no, the answer to a) need not be yes. Investors may be able, by identifying mis-priced assets, to earn excess returns even if the mis-pricing doesn’t meet a threshold level required for identifying a bubble. But the main point that Scott is making is that if there are a lot of examples of mis-pricing out there, it should be possible for astute investors capable of identifying mis-priced assets to diversify their portfolios sufficiently to avoid the problem of staying solvent longer than the market is irrational.

That is a very good point, worth taking into account. But it’s not dispositive and certainly doesn’t dispose of the objection that investors are unlikely to try to bet against a bubble, at least not in sufficient numbers to keep it from expanding. The reason is that the absence of proof is not proof of absence. That of course is a legal, not a scientific, principle, but it expresses a valid common-sense notion, you can’t make an evidentiary inference that something is not the case simply because you have not found evidence that it is the case. So you can’t infer from the non-implementatio of the plausible investment strategies listed by Scott that such strategies would not have generated excess returns if they were implemented. We simply don’t know whether they would be profitable or not.

In his new post Scott makes the following observation about what I had written in my post on excess volatility.

David Glasner seems to feel that it’s not rational for consumers to change their views on the economy after a stock crash. I will argue the reverse, that rationality requires them to do so. First, here’s David:

This seems an odd interpretation of what I had written because in the passage quoted by Scott I wrote the following:

I may hold a very optimistic view about the state of the economy today. But suppose that I wake up tomorrow and hear that the Shanghai stock market crashes, going down by 30% in one day. Will my expectations be completely independent of my observation of falling asset prices in China? Maybe, but what if I hear that S&P futures are down by 10%? If other people start revising their expectations, will it not become rational for me to change my own expectations at some point? How can it not be rational for me to change my expectations if I see that everyone else is changing theirs?

So, like Scott, I am saying that it is rational for people to revise their expectations based on new information that there has been a stock crash. I guess what Scott meant to say is that my argument, while valid, is not an argument against EMH, because the scenario I am describing is consistent with EMH. But that is not the case. Scott goes on to provide his own example.

All citizens are told there’s a jar with lots of jellybeans locked away in a room. That’s all they know. The average citizen guesstimates there are 453 jellybeans in this mysterious jar. Now 10,000 citizens are allowed in to look at the jar. They each guess the contents, and their average guess is 761 jellybeans. This information is reported to the other citizens. They revise their estimate accordingly.

But there’s a difference between my example and Scott’s. In my example, the future course of the economy depends on whether people are optimistic or pessimistic. In Scott’s example, the number of jellybeans in the jar is what it is regardless of what people expect it to be. The problem with EMH is that it presumes that there is some criterion of efficiency that is independent of expectations, just as in Scott’s example there is objective knowledge out there of the number of jellybeans in the jar. I claim that there is no criterion of market efficiency that is independent of expectations, even though some expectations may produce better outcomes than those produced by other expectations.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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