Posts Tagged 'rational 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.


Hawtrey v. Keynes on the Rate of Interest that Matters

In my previous post, I quoted Keynes’s remark about the “stimulus and useful suggestion” he had received from Hawtrey and the “fundamental sympathy and agreement” that he felt with Hawtrey even though he nearly always disagreed with Hawtrey in detail. One important instance of such simultaneous agreement about principle and disagreement about detail involves their conflicting views about whether it is the short-run rate of interest (bank rate) or the long-run rate of interest (bond rate) that is mainly responsible for the fluctuations in investment that characterize business cycles, the fluctuations that monetary policy should therefore attempt to control.

Already in 1913 in his first work on monetary theory, Good and Bad Trade, Hawtrey had identified the short-term interest rate as the key causal variable in the business cycle, inasmuch as the holdings of inventories that traders want to hold are highly sensitive to the short-term interest rates at which traders borrow to finance those holdings. Increases in the desired inventories induce output increases by manufacturers, thereby generating increased incomes for workers and increased spending by consumers, further increasing the desired holding of stocks by traders. Reduced short-term interest rates, according to Hawtrey, initiated a cumulative process leading to a permanently higher level of nominal income and output. But Keynes disputed whether adjustments in the desired stocks held by traders were of sufficient size to account for the observed fluctuations in income and employment. Instead, Keynes argued, it was fluctuations in fixed-capital investment that accounted for the fluctuations in income and employment characteristic of business cycles. In his retrospective (1969) on the differences between Hawtrey and Keynes, J. R. Hicks observed that “there are large parts of the Treatise [on Money] which are a reply to Currency and Credit Hawtrey’s 1919 book on monetary theory and business cycles. But despite their differences, Hicks emphasized that Hawtrey and Keynes

started from common ground, not only on the need for policy, but in agreement that the instrument of policy was the rate of interest, or “terms of credit,” to be determined, directly or indirectly, by a Central Bank. But what rate of interest? It was Hawtrey’s doctrine that the terms of bank lending had a direct eSect on the activity of trade and industry; traders, having more to pay for credit, would seek to reduce their stocks, being therefore less willing to buy and more willing to sell. Keynes, from the start (or at least from the time of the Treatise 1930) rejected this in his opinion too simple view. He substituted for it (or began by substituting for it) an alternative mechanism through the long rate of interest. A change in the terms of bank lending affected the long rate of interest, the terms on which business could raise long-term capital; only in this roundabout way would a change in the terms of bank lending affect the activity of industry.

I think we can now see, after all that has happened, and has been said, since 1930, that the trouble with both of these views (as they were presented, or at least as they were got over) was that the forces they purported to identify were not strong enough to bear the weight that was put upon them. This is what Keynes said about Hawtrey (I quote from the Treatise):

The whole emphasis is placed on one particular kind of investment, namely, investment by dealers and middlemen in liquid goods-to which a degree of sensitivity to changes in Bank Rate is attributed which certainly does not exist in fact…. [Hawtrey] relies exclusively on the increased costs of business resulting from dearer money. [He] admits that these additional costs will be too small materially to affect the manufacturer, but assumes without investigation that they do materially affect the trader…. Yet probably the question whether he is paying S or 6 per cent for the accommodation he receives from his banker influences the mind of the dealer very little more than it influences the mind of the manufacturer as compared with the current and prospective rate of take-off for the goods he deals in and his expectations as to their prospective price-movements. [Treatise on Money, v. I, pp. 193-95.]

Although Hicks did not do so, it is worth quoting the rest of Keynes’s criticism of Hawtrey

The classical refutation of Hawtrey was given by Tooke in his examination of an argument very similar to Hawtrey’s, put forward nearly a hundred years ago by Joseph Hume. Before the crisis of 1836-37 the partisans of the “currency theory” . . . considered the influence of the Bank of England on the price level only operated through the amount of its circulation; but in 1839 the new-fangled notion was invented that Bank-rate also had an independent influence through its effect on “speculation.”

Keynes then quoted the following passage from Tooke:

There are, doubtless, persons, who, upon imperfect information, and upon insufficient grounds, or with too sanguine a view of contingencies in their favour, speculate improvidently; but their motive or inducement so to speculate is the opinion which, whether well or ill-founded, or whether upon their own view or upon the authority or example of other persons, they entertain the probability of an advance of price. It is not the mere facility of borrowing, or the difference between borrowing at 3 or at 6 percent that supplies the motive for purchasing, or even for selling. Few persons of the description here mentioned ever speculate but upon the confident expectation of an advance of price of at least 10 percent.

In his review of the Treatise, published in The Art of Central Banking, Hawtrey took note of this passage and Keynes’s invocation of Tooke’s comment on Joseph Hume.

This quotation from Tooke is entirely beside the point. My argument relates not to speculators . . . but to regular dealers or merchants. And as to these there is no evidence, in the following passage, that Tooke’s view of the effects of a rise in the rate of interest did not differ very widely from that which I have advocated. In volume v. of his History of Prices (p. 584) he wrote:

Inasmuch as a higher than ordinary rate of interest supposes a contraction of credit, such goods as are held by means of a large proportion of borrowed capital may be forced for sale by a difficulty in obtaining banking accommodation, the measure of which difficulty is in the rate of discount and perhaps in the insufficiency of security. In this view, and in this view only, a rate of interest higher than ordinary may be said to have an influence in depressing prices.

Tooke here concentrates on the effect of a high rate of interest in hastening sales. I should lay more emphasis on delaying purchases. But at any rate he clearly recognizes the susceptibility to credit conditions of the regular dealers in commodities.

And Hicks, after quoting Keynes’s criticism of Hawtrey’s focus on the short-term interest, followed up with following observation about Keynes:

Granted, but could not very much the same be said of Keynes’s own alternative mechanism? One has a feeling that in the years when he was designing the General Theory he was still clinging to it, for it is deeply embedded in the structure of his theory; yet one suspects that before the book left his hands it was already beginning to pass out. It has left a deep mark on the teaching of Keynesian economics, but a much less deep mark upon its practical influence. In the fight that ensued after the publication of the General Theory, it was quite clearly a casualty.

In other words, although Keynes in the Treatise believed that variation in the long-term interest rate could moderate business-cycle fluctuations by increasing or decreasing the amount of capital expenditure by business firms, Keynes in the General Theory was already advocating the direct control of spending through fiscal policy and minimizing the likely effectiveness of trying to control spending via the effect of monetary policy on the long-term interest rate. Hicks then goes on to observe that the most effective response to Keynes’s view that monetary policy operates by way of its effect on the long-term rate of interest came from none other than Hawtrey.

It had taken him some time to mount his attack on Keynes’s “modus operandi of Bank Rate” but when it came it was formidable. The empirical data which Keynes had used to support his thesis were derived from a short period only-the 1920’s; and Hawtrey was able to show that it was only in the first half of that decade (when, in the immediate aftermath of the War, the long rate in England was for that time unusually volatile) that an effect of monetary policy on the long rate, sufficient to give substantial support yo Keynes’s case, was at all readily detectable. Hawtrey took a much longer period. In A Century of Bank Rate which, in spite of the narrowness of its subject, seems to me to be one of his best books, he ploughed through the whole of the British experience from 1844 to the date of writing; and of any effect of Bank Rate (or of any short rate) upon the long rate of interest, sufficient to carry the weight of Keynes’s argument, he found little trace.

On the whole I think that we may infer that Bank Rate and measures of credit restriction taken together rarely, if ever, affected the price of Consols by more than two or three points; whereas a variation of }4 percent in the long-term rate of interest would correspond to about four points in the price of a 3 percent stock.

Now a variation of even less than 1/8 per cent in the long-term rate of interest ought, theoretically and in the long run, to have a definite effect for what it is worth on the volume of capital outlay…. But there is in reality no close adjustment of prospective yield to the rate of interest. Most of the industrial projects offered for exploitation at any time promise yields ever so far above the rate of interest…. [They will not be adopted until] promoters are satisfied that the projects they take up will yield a commensurate profit, and the rate of interest calculated on money raised will probably be no more than a very moderate deduction from this profit. [A Century of Bank Rate pp. 170-71]

Hicks concludes that, as regards the effect of the rate of interest on investment and aggregate spending, Keynes and Hawtrey cancelled each other out, thereby clearing the path for fiscal policy to take over as the key policy instrument for macroeconomic stabilization, a conclusion that Hawtrey never accepted. But Hicks adds an interesting and very modern-sounding (even 40 years on) twist to his argument.

When I reviewed the General Theory, the explicit introduction of expectations was one of the things which I praised; but I have since come to feel that what Keynes gave with one hand, he took away with the other. Expectations do appear in the General Theory, but (in the main) they appear as data; as autonomous influences that come in from outside, not as elements that are moulded in the course of the process that is being analysed. . . .

I would maintain that in this respect Hawtrey is distinctly superior. In his analysis of the “psychological effect” of Bank Rate — it is not just a vague indication, it is analysis — he identifies an element which ought to come into any monetary theory, whether the mechanism with which it is concerned is Hawtrey’s, or any other. . . .

What is essential, on Hawtrey’s analysis, is that it should be possible (and should look as if it were possible) for the Central Bank to take decisive action. There is a world of difference . . . between action which is determinedly directed to imposing restraint, so that it gives the impression that if not effective in itself, it will be followed by further doses of the same medicine; and identically the same action which does not engender the same expectations. Identically the same action may be indecisive, if it appears to be no more than an adjustment to existing market conditions; or if the impression is given that it is the most that is politically possible. If conditions are such that gentle pressure can be exerted in a decisive manner, no more than gentle pressure will, as a rule, be required. But as soon as there is doubt about decisiveness, gentle pressure is useless; even what would otherwise be regarded as violent action may then be ineffective.  [p. 313]

There is a term which was invented, and then spoiled, by Pigou . . . on which I am itching to get my hand; it is the term announcement effect. . . . I want to use the announcement effect of an act of policy to mean the change which takes place in people’s minds, the change in the prospect which they think to be before them, before there is any change which expresses itself in transactions of any kind. It is the same as what Hawtrey calls “psychological effect”; but that is a bad term, for it suggests something irrational, and this is entirely rational. Expectations of the future (entirely rational expectations) [note Hicks’s use of the term “rational expectations before Lucas or Sargent] are based upon the data that are available in the present. An act of policy (if it is what I have called a decisive action) is a significant addition to the data that are available; it should result, and should almost immediately result, in a shift in expectations. This is what I mean by an announcement effect.

What I learn from Hawtrey’s analysis is that the “classical” Bank Rate system was strong, or could be strong, in its announcement effects. Fiscal policy, at least as so far practised, gets from this point of view much worse marks. It is not simply that it is slow, being subject to all sorts of parliamentary and administrative delays; made indecisive, merely because the gap between announcement and effective operation is liable to be so long. This is by no means its only defect. Its announcement effect is poor, for the very reason which is often claimed to be one of its merits its selectivity; for selectivity implies complexity and an instrument which is to have a strong announcement effect should, above all, be simple. [p. 315]

Just to conclude this rather long and perhaps rambling selection of quotes with a tangentially related observation, I will note that Hawtrey’s criticism of Keynes’s identification of the long-term interest rate as the key causal and policy variable for the analysis of business cycles applies with equal force to Austrian business-cycle theory, which, as far as I can tell, rarely, if ever, distinguishes between the effects of changes in short-term and long-term rates caused by monetary policy.

HT: Alan Gaukroger

What Kind of Equilibrium Is This?

In my previous post, I suggested that Stephen Williamson’s views about the incapacity of monetary policy to reduce unemployment, and his fears that monetary expansion would simply lead to higher inflation and a repeat of the bad old days the 1970s when inflation and unemployment spun out of control, follow from a theoretical presumption that the US economy is now operating (as it almost always does) in the neighborhood of equilibrium. This does not seem right to me, but it is the sort of deep theoretical assumption (e.g., like the rationality of economic agents) that is not subject to direct empirical testing. It is part of what the philosopher Imre Lakatos called the hard core of a (in this case Williamson’s) scientific research program. Whatever happens, Williamson will process the observed facts in terms of a theoretical paradigm in which prices adjust and markets clear. No other way of viewing reality makes sense, because Williamson cannot make any sense of it in terms of the theoretical paradigm or world view to which he is committed. I actually have some sympathy with that way of looking at the world, but not because I think it’s really true; it’s just the best paradigm we have at the moment. But I don’t want to follow that line of thought too far now, but who knows, maybe another time.

A good illustration of how Williamson understands his paradigm was provided by blogger J. P. Koning in his comment on my previous post copying the following quotation from a post written by Williamson a couple of years on his blog.

In other cases, as in the link you mention, there are people concerned about disequilibrium phenomena. These approaches are or were popular in Europe – I looked up Benassy and he is still hard at work. However, most of the mainstream – and here I’m including New Keynesians – sticks to equilibrium economics. New Keynesian models may have some stuck prices and wages, but those models don’t have to depart much from standard competitive equilibrium (or, if you like, competitive equilibrium with monopolistic competition). In those models, you have to determine what a firm with a stuck price produces, and that is where the big leap is. However, in terms of determining everything mathematically, it’s not a big deal. Equilibrium economics is hard enough as it is, without having to deal with the lack of discipline associated with “disequilibrium.” In equilibrium economics, particularly monetary equilibrium economics, we have all the equilibria (and more) we can handle, thanks.

I actually agree that departing from the assumption of equilibrium can involve a lack of discipline. Market clearing is a very powerful analytical tool, and to give it up without replacing it with an equally powerful analytical tool leaves us theoretically impoverished. But Williamson seems to suggest (or at least leaves ambiguous) that there is only one kind of equilibrium that can be handled theoretically, namely a fully optimal general equilibrium with perfect foresight (i.e., rational expectations) or at least with a learning process leading toward rational expectations. But there are other equilibrium concepts that preserve market clearing, but without imposing, what seems to me, the unreasonable condition of rational expectations and (near) optimality.

In particular, there is the Hicksian concept of a temporary equilibrium (inspired by Hayek’s discussion of intertemporal equilibrium) which allows for inconsistent expectations by economic agents, but assumes market clearing based on supply and demand schedules reflecting those inconsistent expectations. Nearly 40 years ago, Earl Thompson was able to deploy that equilibrium concept to derive a sub-optimal temporary equilibrium with Keynesian unemployment and a role for countercyclical monetary policy in minimizing inefficient unemployment. I have summarized and discussed Thompson’s model previously in some previous posts (here, here, here, and here), and I hope to do a few more in the future. The model is hardly the last word, but it might at least serve as a starting point for thinking seriously about the possibility that not every state of the economy is an optimal equilibrium state, but without abandoning market clearing as an analytical tool.

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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