8 unanswerable questions

1   Is the EMH true?

2.  Free will or determinism?

3.  Poor countries; is it bad policies or bad culture?

4.  Do we know the Truth about reality, or do we merely regard things as true?

5.  Would economic problem X have been prevented by better regulation?

6.  Are murder, rape and slavery objectively evil, or do we regard them as evil?

7.  Can improved foreign aid significantly affect long run economic growth?

8.  The universe’s deepest structure:  pure mathematics, or  . . .  turtles all the way down?

Here’s my theory.  These questions are not about the nature of our universe, they are about the nature of our minds, our temperaments.  They reflect that fact that different people think about things in different ways.  On one side are the sort of world-weary fatalists.  On the other are the optimistic Americans with the can-do spirit.  The guys that want their hands on the steering wheel, and don’t want to be in the passenger seat.  I’m happier in the passenger seat (unless my wife is driving.)

I recall a quotation by William Easterly to the effect that the economic crisis was a point in favor of modern economics.  After all, the EMH says we can’t predict financial crises, and we didn’t.  It didn’t go over well.

I wasn’t surprised that Easterly and I would share this view, although logically there is no relationship between his views on the EMH, and on the efficacy of foreign aid.  But I would be very surprised if an American with that can-do spirit (say Jeffrey Sachs) had the same attitude.  My hunch is that people with a “can-do”  frame of mind are more likely to all line up on the optimistic side of these 4 economics and 4 philosophical questions (actually 3, the last was a joke.)

Given my views on the EMH, can you guess my views on free will and determinism?  Hint:  I’ll present both sides:

Determinism:  All scientific theory suggests that at the macro level, events are caused by the laws of science interacting with the pre-existing states of the universe.  This allows no role for free will.  At the micro level some events seem to be random, but those also don’t seem to involve free will.

Free Will:  Come on!  If there is a salt and pepper shaker in front of me, obviously I can choose to pick up the salt shaker, or I can choose to pick up the pepper shaker.

Compare that with two views of the EMH:

Pro-EMH:  Economic theory suggests that if asset prices had obviously moved away from their equilibrium position, investors would take advantage of the situation by going long in undervalued markets and short in overvalued markets.  This would eliminate any obvious mis-pricing.

Anti-EMH:  Come on:  If house prices are far too high relative to income, or stock P/E s are way too high, then you obviously have a bubble.

Robin Hanson wants some sort of test to see if there is a magic formula that can beat the market.  But in my “alchemist” post I argued that such a formula would be worth billions of dollars if held privately, but the value of the formula would fall to zero if published in a scientific journal, just as would the formulas for turning lead into gold—and yes, alchemists do know how, but they are not so stupid as to publicize the formula. :)   So we will never see Robin’s proposal enacted in a way that is acceptable to all sides.  If something seems to work initially, arbitragers will quickly eliminate any easy profits, and the EMH guys like me will say the initial success was just luck.  It’s not about tests, it’s about how you think about reality.  It is about whether you see yourself as a passive observer of reality, or an active agent of change that can “just do it.”

BTW, these views are not necessarily reflected in the way that people behave, but rather how they think about things.  Everyone behaves as if free will exists, regardless of their philosophical orientation.  And I like the term ‘orientation’ better than beliefs, as these varying outlooks are analogous to one’s sexual orientation.

Part 2:  Did government cause the crisis?

Vernon Smith says yes:

And we got into the business of, particularly at the federal level, the Community Reinvestment Act in the 1990s became a means by which the federal government enabled, wished to enable people of modest means to buy a home and so as a result that act created scoring system for private lenders whereby if they got good scores by aggressively, more aggressively making loans to people whose incomes were below 80% of the median those scores helped them, gave them, enabled them to more easily get approval for making expansions in regional banks and these scores were used in helping to decide whether to approve mergers, this sort of thing.  Various devices were used to encourage private lenders to more aggressively make loans on homes to be purchased by people of modest income and what we got from that was a particularly strong demand for homes at the low end of the pricing tier.

Whereas Tyler Cowen and Paul Krugman say no:

This is actually a very broad problem with all accounts of the crisis that try to exonerate the private sector and place the blame on the government and/or the Fed: none of the proposed evil deeds of policy makers were remotely large enough to cause problems of this magnitude unless markets vastly overreacted. That is, you have to start by assuming wildly dysfunctional financial markets before you can blame the government for the crisis; and if markets are that dysfunctional, who needs the government to create a mess?

BTW, this is a Krugman quotation, which Cowen calls “excellent.”

I am inclined to agree with both quotations, at least partially.  I should clarify that Vernon Smith did not explicitly blame the government, I just assumed most people would infer that from his remarks (very similar to my commenter Patrick.)

Here’s my take.  The government thought it a good idea to encourage banks and also F&F to make more loans to lower income people.  And the government thought this would not lead to a financial crisis that devastated banking. Private banks were partly encouraged by the government, but mostly simply decided that they could make money on lots of sub-prime lending.  And they also thought these actions would not devastate the financial system.  Indeed, you’d really have to have strong ideological blinders to argue against either of these assertions.

If I am right then society simply made a big mistake.  But most people aren’t satisfied with that answer.  We want villains, and we want policy implications.  I’m not much interested in looking for villains in either the public or private sector (excluding my Congressman of course) but I am interested in policy implications.  So if we roll back the clock, what do we do if both the government and the private sector are suffering from the sort of mass delusions that used to affect medieval villages that had a crop of bad mushrooms?  Obviously there is nothing we could do to directly address the bubble, unless you bring in a deus ex machina solution.  If Republicans and Democrats and bankers all missed it, and all wanted to shovel more money to borrowers with no income and no down-payment, then we are stuck.

But maybe there are alternative economic systems that could make those episodes of mass hysteria do less harm.  If you are a Democrat, perhaps the way to encourage more home ownership (a goal I don’t share, BTW) is to give tax credits to first time low income home buyers.  This doesn’t put our financial system at as much risk.  If you are a Republican you might want to abolish F&F, other countries get by fine without them.  If you are a libertarian you might want to abolish FDIC and TBTF.

Vernon Smith tends to favor free markets, but worries about the fragility of the banking system.  I think it is much less fragile than he thinks, because he wrongly attributes the problems of the 1930s to bad banking, whereas they were actually caused by the Fed letting NGDP fall in half.  Banks were actually far more conservatively run in the 1920s than the 2000s.  But he’s not a macro-historian, so his view is understandable.  Let’s say he is right that the system is inherently unstable, and also assume we are stuck with FDIC and TBTF. What then?  Smith gives what seems to me to be the only plausible answer:

And so what is important is really to avoid these kind of crisis situations in the first place and because they’re so difficult to deal with once we get into them because if nothing else the politics of these situations will drive policy and the politics is not necessarily good long term economic policy and of course the way to have avoided this kind of a problem in the first place was to have better collateralization of the kinds of loans that we’re being made in the housing market and generally in consumer credit markets.  It’s not only the housing market, but it’s also credit card debt, student loan debt, automobile loans, all of those credit markets, which ended up being the kinds of private credit instruments that the Federal Reserve found itself necessary to make loans on in 2008.

.   .   .

Born is seen now as something of a hero because she wanted to reexamine the question of the exempt status of those instruments and I think actually a fairly simple regulatory change for those derivatives is all that is called for and that is simply require them, derivatives to be listed on exchanges.  If you did that the exchanges then would require them to be collateralized and that is to me the main problem in the derivatives market, particularly that was true in the housing mortgage derivatives market because those are essentially markets where people are making bets on whether a certain class of mortgage backed securities are going to suffer default and the providers of that, the seller of those contracts. You see that’s a form of insurance in the sense the person who buys those contracts sees that as a way of hedging their risk of default, but it’s not insurance if the sellers of those contracts are not required to collateralize the contract and generally those contracts were not required to be collateralized.  This is basically how AIG go into trouble.

.   .   .

So to me it’s what is needed here is not some kind of heavy handed regulation, but simply an application of principles that we’ve already learned a lot about in other markets.

Collateral, collateral, and more collateral.  That’s the only practical answer.

Krugman seems to think it is realistic to expect regulators to spot bubbles in real time, and then do something about them.  Smith is more skeptical:

Question: What is the proper role of regulation in these markets?

Vernon Smith:  I don’t think there is anything you can do to prevent bubbles.  I think we’ve had frequent stock market bubbles that have self corrected and the burden of those bubbles and the pain is basically borne by the investors in those markets and you do not have collateral damage to the economy from bubbles in stock markets like you have in bubbles with housing and generally with consumer durables and I think the solution in the housing and the consumer durables markets is the same as the solution that we’ve worked out institutionally in stock markets and that is require these purchases to be reserved, collateralized.  

We can’t stop the winds from blowing.  Let’s build a financial system that can survive strong winds, not one that collapses in a light breeze.

Then let’s build a monetary policy that stabilizes NGDP growth.  Arnold Kling seems to think there is something inexplicable about the severity of this recession.  I don’t quite understand his puzzlement.  Standard macro theory (as illustrated in the AS/AD graph in the new Cowen/Tabarrok textbook) says that if NGDP suddenly grows 8% below trend then there will be a sharp drop in RGDP.  The severity of the drop is exactly what one would expect in a world of sticky wages (sticky relative to the fall in NGDP, not relative to the also sticky prices.)  The only interesting question is why did NGDP suddenly start growing 8% below trend.  That’s what this blog is mostly all about, but I’ve already gone on way too long.

PS.  Kling also makes this cryptic comment:

 The Keynesian story at least has some microfoundations. Scott Sumner’s Y = expected MV/P story is just hand-waving.

I recall discussing expected NGDP, but never expected MV/P.  [Edit, Bill Woolsey pointed out that I originally had a typo here, and Kling might have as well.]   And I use changes in expected future NGDP to explain changes in current NGDP, as do all the modern new Keynesians as far as I can tell.  So I am not quite sure how to respond to Kling.  I suppose my microfoundations are a bit more sticky-wage and a bit less sticky-price than those of the average Keynesian, but you can get a severe recession under either assumption if NGDP falls.

In fairness to Kling, while the severity of the recession is easily explicable, I expect the recovery to be slower than predicted by natural rate models due to a 40% jump in the minimum wage, 73 week extended unemployment benefits, and other supply-side problems created by Congress.

PPS.  Sorry Philo, I just can’t stay away from pop philosophy.

PPPS.  The Vernon Smith interview is very good.  Despite the occasional stumbles in macro, at least he intuits that we’d be better off if the price level were currently 6% higher.  (Actually we need NGDP to be 6% higher right now, but close enough.)


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56 Responses to “8 unanswerable questions”

  1. Gravatar of Greg Ransom Greg Ransom
    16. January 2010 at 12:05

    Scott, time to cancel the Netfix account and spend some serious time reading Wittgenstein.

  2. Gravatar of Jon Jon
    16. January 2010 at 12:30

    Scott:

    One of the more interesting courses I recall from my undergrad days was focused on the philosophies of causation. It is strike now, as then, how much ink was spilled to define what it means to say A caused B and how to substantiate such a claim.

    The brief take away though is there is a very narrow subset of causation that all theories share. This is the sort of causation you find in laboratory experiments or simulations where there has been a very deliberate effort to establish the conditions–lets not think about whether the scientist in this picture ’causes’ the result.

    … I think Tyler fell into a trap of sorts; he accepted a false premise–and this is Krugman’s brilliance. He makes true statements that political effect beyond their truth.

    This is actually a very broad problem with all accounts of the crisis that try to exonerate the private sector and place the blame on the government and/or the Fed: none of the proposed evil deeds of policy makers were remotely large enough to cause problems of this magnitude unless markets vastly overreacted.

    This argument presents a false dichotomy. i.e., we must either accept that the private sector was blameless or accept that markets are rational.

    I think you’ve had it right–even if I disagree with certain particulars: the broader market fall arose as a consequence of monetary policy actions in late 2008; an event that is superimposed upon a mild recession induced by the housing market.

    So yes, the policy effects of 2003-2007 were too small to be relevant on the scale of 10%+ unemployment, but you don’t need an irrational market to amplify those effects, you need a fumbled monetary policy in 2008.

  3. Gravatar of malavel malavel
    16. January 2010 at 12:49

    “After all, the EMH says we can’t predict financial crises, and we didn’t.”

    If we, the market, predicted that a financial crisis would occur next year it would occur right away or ‘never’ at all. Seems true almost by definition.

    Believing in some super smart regulator who can spot bubbles is like believing in Santa Claus.

  4. Gravatar of Marcus Nunes Marcus Nunes
    16. January 2010 at 12:51

    What does “the market overeacted” means? The “incentives” may be interpreted as “small”, but the “payoffs” could be expected to be “large”.
    BTW, you,ve mentioned more than once that, for example, that the jump in house prices in Nevada (Las Vegas) after 2003 was an “anomaly”. I found out some time ago that that happened AFTER restrictions were placed on land development at that time.

  5. Gravatar of Greg Ransom Greg Ransom
    16. January 2010 at 12:57

    Scott, if someone is pouring honey from a big pot onto the floor, there will be a “bubble” of honey at the point where the honey is poured onto the floor. The honey has to “enter the system” somewhere, and that somewhere is the point where it is being poured. It then distributes out. No one knows how long the guy with the pot — let’s call him F. R. or China Baby — will keep pouring out honey from the honey pot.

    And note well, “hard” scientists can’t predict when a sand pile will collapse, but they can provide the math explaining the causal mechanics and mathematical structure of the collapse after it happens. Similarly, Darwinian biologists can’t predict when speciation will occur or when particular adaptations will arise, but they can explain the causal mechanism at work after the facts, and then can even very roughly anticipate characteristics of these in advance “” but one Darwinian biologist can’t make the equivalent of a better “money making” prediction of the future course of speciation and adaptation against other rival Darwinian biologist.

    Robin Hanson is just trying to enforce bad philosophy (not good economics) with a really dump picture of science and knowledge — in physics the 3-body problem and the problem of initial conditions blocks simple numerical predictions of particular places in space and time.

    Scott writes:

    “Robin Hanson wants some sort of test to see if there is a magic formula that can beat the market.”

    But this is just dumb. In a complex system like the economy, there can be systematic distortions across the structure of production and relative prices that take time to expose their unsustainability — structural pathologies which are very hard to identify in all of their dimensions and interconnectins, distortions that can be roughly identified by folks like BIS chief economist William White and his research staff, but not easily profited from in a simply day traders timing sense — although a small group of people did make hundreds of million dollars betting against people who didn’t but A, and B, and C, and D together in a systematic model the way White and a few other did.

  6. Gravatar of Marcus Nunes Marcus Nunes
    16. January 2010 at 12:57

    I tend to agree with Vernon Smith. In november 2008 I wrote a piece for RGE Monitor which I called “The hand that rocks the craddle”. My conclusion was that the “hand” was the Government´s.

  7. Gravatar of 123 123
    16. January 2010 at 13:02

    “Is the EMH true?”
    This is a wrong way to formulate a question.
    It is much better to ask:
    “To what extent EMH is true?”
    “If I am an investor, how much should I spend to acquire information about stocks and mutual funds” (for most investors the answer is use index funds)
    “Do stockmarkets allocate resources more or less efficiently than public officials?”
    “What kind of market regulations lead to more efficent capital markets?”

  8. Gravatar of 123 123
    16. January 2010 at 13:38

    Here is what Gary Becker said about EMH:

    “Q. Two of the big theories associated with Chicago are the efficient-markets hypothesis and the rational-expectations hypothesis, both of which, some say, have been called into question. How do you react to that?

    A. Well, these are not areas that I have particularly specialized in, but let me give you my reaction. The people who argue that markets were always efficient and there was no problem, that was an extreme position””something a lot of people at Chicago had recognized before. The weaker notion that markets, particularly financial markets, usually work pretty well, and it’s very hard to beat them by investing against them, that I think is still very powerful.”

    Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-gary-becker.html#ixzz0coVVujeG

  9. Gravatar of 123 123
    16. January 2010 at 13:40

    Here is even more Becker”
    “Q. But what about speculative bubbles? I recall interviewing Milton Friedman, in 1998, I think, and he said he thought the stock market was in a bubble. The idea that Chicago economists don’t believe in bubbles””was that more Greenspan?

    A. Absolutely. I think bubbles have been recognized. Certainly, Friedman and others, including myself, said there are phenomena that are hard to explain without thinking it’s a bubble. The people working in macro theory have had difficulty deriving these bubbles from any reasonably rational set of actors that are somewhat forward looking, although there are models that can do it now. That’s an analytical challenge. But the fact that there have been episodes throughout history that were clearly bubbles, that foreign-exchange rates overshoot and undershoot their real values””yes, I don’t think there’s any question about that. I don’t think that most Chicago School economists thought that these things didn’t happen. I think most Chicago economists recognized that, and, certainly, Milton Friedman did. “

  10. Gravatar of 123 123
    16. January 2010 at 13:44

    I fully agree with Becker here:
    “There was some theology built into the efficient-markets literature””some of it in Chicago. It became more theological than based on empirical evidence.”

  11. Gravatar of woupiestek woupiestek
    16. January 2010 at 14:31

    The market should decide how much money to spend on collateralizing debts. It’s basically a question of comparing spending now, to losses in an unexpected crash. Apparently, the market underestimated the necessary amount of collateral on mortgages. But given EHM the market’s guess is the best there is. So saying that more collateral is needed is rational now. But it won’t be always. At some point the market will undervalue collateral again, and this will set up the next crash.

    I’m thinking that EHM implies a policy of more collateral cannot work for the economy as a whole. We may save ourselves by being cautious, but only if there are risk takers who have profited more. But I may be missing something.

  12. Gravatar of StatsGuy StatsGuy
    16. January 2010 at 15:32

    ssumner:

    “In fairness to Kling, while the severity of the recession is easily explicable, I expect the recovery to be slower than predicted by natural rate models due to a 40% jump in the minimum wage, 73 week extended unemployment benefits, and other supply-side problems created by Congress.”

    It’s interesting that you never mention debt and corporate/household insolvency, and nor does Kling. The Austrians, for all their warts, have a deep appreciation of debt. But in your models, does the current Debt-To-GDP ratio have any impact on potential future growth?

    (I suspect the answer is no, but if it is yes, then the follow up is: Does distribution of wealth, and therefore the % of households that are close to insolvency, matter at all? My guess is the answer has to be no, since otherwise there might be a risk to a global decrease in wages if a high percentage of households are burdened by high nominal debt.)

    So, the only way your views are consistent is if we say:

    1) Distribution of wealth doesn’t really matter
    2) Debt levels don’t really matter (since we can force the creation of new credit)
    3) We can speed up recovery/transition if we let lots of firms/folks go insolvent (and through bankruptcy) but compensate with monetary policy to keep NGDP at 6%.

    In other words, you are endorsing liquidationism, but with the singular modification that monetary policy should keep NGDP growth at 5%, even if it requires monumental monetary action.

    Perhaps I’m misinterpreting – If debt levels do matter to growth in your model, could you explain how? Or are you claiming debt is irrelevant if the Fed targets NGDP?

  13. Gravatar of David Pearson David Pearson
    16. January 2010 at 16:21

    Scott,

    Its a shame to contribute to the myth that the CRA was even partially involved in the subptime crisis. Was the government at fault? I think its fingerprints are all over it, but not with the CRA.

    Let me give you an “inside look” at some of the data. In 2006, the peak year of subprime, state-by-state deliquencies and loan amounts varied wildly. In places like Ohio and Michigan, loan amounts were small and >90 day deliquencies were in the low teens. In places like Florida, California and NY (together, about 65% of subprime loans), loan amounts were very high (a median of around $300k in CA), and delinquencies were almost non-existent (sub-2% in California!).

    So what explained the above divergences? Simple. In non-bubble states, maybe there was a vestige of CRA thinking: that is, loans were made in smaller amounts to low-income people that had trouble repaying them. However, this had not changed in years! The lenders had ample data to reserve against these loans. There is NO WAY these loans could have brought down subprime. There was not enough of a change between predicted and actual delinquency experience.

    In the bubble states, subprime loans were made to middle income people in large amounts (again, even in CA, a median low-income house was not $360k). The people originally required virtually no reserving as their delinquency levels were so low. When CA delinquencies rose from 2% to over 20%, the loan portfolios were devastated: the margins, reserves and overcollateralization on the loans could not support that kind of a change in delinquency experience.

    So, the moral is, if you want to make loans to poor people, go ahead, because its easy to know ahead of time how much to charge for and reserve against those loans. But if you want to make loans to middle income people in higher amounts than they can service, watch out, they will take you down.

  14. Gravatar of Tom Hickey Tom Hickey
    16. January 2010 at 16:43

    Greg Ransom: “Scott, time to cancel the Netfix account and spend some serious time reading Wittgenstein.”

    Agreed. (Disclaimer: I wrote my dissertation on Wittgenstein’s On Certainty.)

    I would also suggest spending some time curling up with cognitive science. 1993 economics Nobel laureate Douglass C. North has a must-read paper, “Cognitive Science and Economics.”

    Here’s a review of Out of Crisis: Rethinking Our Financial Markets by David A. WestbrookOut of Crisis: Rethinking Our Financial Markets by David A. Westbrook at Open Economics. A comment of mine is appended.

  15. Gravatar of Tom Hickey Tom Hickey
    16. January 2010 at 17:11

    “Then let’s build a monetary policy that stabilizes NGDP growth. ”

    This following is snipped from a comment I just posted on Paul Krugman’s blog post in answer to Charlie Cook:

    “President Obama’s statement that ‘the government is running out of money’ is troubling in this regard. His advisors apparently have not explained to him that a sovereign country that is the monopoly provider of a non-convertible floating fx currency of issue cannot reasonably become insolvent, go bankrupt, or default on it own debt. Such a government is not financially constrained. The only constraint is real. If nominal aggregate demand is overstimulated to the degree that it exceeds real output potential, then inflation will result. With an output gap of a~30% and U6 of 17.3% (BLS-Dec 09), there’s no danger of that anytime soon. The other real constraint is that if the government allows nominal aggregate demand to fall short of real output capacity, then recession and unemployment will rise, and eventually depression and deflation will set it.”

    Of course, there is also the possibility that the currency will be devalued in the fx market through the floating rate. That would improve the CAD and serve to close the output gap.

    See L. Randall Wray, Understanding Modern Money: The Key to Full Employment and Price Stability (1998) for an explanation that is non-technical. (It’s available to read at Google Books.) Wray updates and expands upon Abba Lerner’s principles of functional finance and Wynne Godley’s stock-flow consistency. For a technical approach, see Wynne Godley and Marc Lavoie, Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth (2007). BTW, Jamie Galbraith names Wynne Godley (and the Neo-Chartalists) as one of the few that predicted the crisis on a solid theoretical footing in Who Are These Economists, Anyway?. Galbraith also mentions the “descendents” of Hyman Minsky. Randy Wray, by the way, studied under Minksy, as well as being a Neo-Chartalist.

  16. Gravatar of StatsGuy StatsGuy
    16. January 2010 at 19:18

    @Tom

    Looked up neo-chartalism

    “For example, (Febrero 2009) argues that modern money draws its value from its ability to cancel (private) bank debt, rather than to pay government taxes.” (wikipedia)

    “Note that the key is the ability of the crown to impose a debt on its subjects. More generally,
    Minsky had later recognized that “bank money”, which today takes the form of demand
    deposits (although for most of bank history, bank money took the form of paper notes) has
    “exchange value because a multitude of debtors to banks have outstanding debts that call for the
    payment of demand deposits to banks.”

    http://www.cfeps.org/pubs/wp-pdf/WP10-Wray.pdf

    So, money is valuable because of nominal debt…

    I think I’m a neo-chartalist.

  17. Gravatar of Philo Philo
    16. January 2010 at 19:53

    Hi Scott–

    I’m sorry, too!

  18. Gravatar of Tom Hickey Tom Hickey
    16. January 2010 at 20:24

    @ Stats Guy
    “So, money is valuable because of nominal debt…
    I think I’m a neo-chartalist.”

    Most Neo-Chartalists conclude that in a modern monetary system in which the sovereign government is the monopoly provider of its currency of issue, which alone is acceptable at government payments offices, the necessity for obtaining the currency of issue arises from one’s obligations to government, which are chiefly tax obligations. The currency of issue is then adopted by non-government for its transactions. Bank money (generated by loans which create deposits) is ordinarily denominated in the currency of issue, because interbank settlements take place at the central bank based on reserves denominated in the currency of issue.

    But it remains true that a lender accepts its own IOU’s in payment of debts owed. For example, Bill Mitchell wrote to Arnie that he could resolve his financial crisis by issuing CA state IOU’s and accepting them in payment of state taxes. They would then have value as state money, as it were, even though technically they would not be “money,” which only the federal government can issue in the US. See “My letter to the Governor (arnie).”

    Wray examine the roots of this is some detail in Understanding Modern Money, cited above. Bill Mitchell provides a simple model illustrating it in a blog post, “A Simple Business Card Economy.” Bill fleshes this out with a model of a simple two person economy in another post, “What causes mass unemployment?” It’s right at the beginning of the post. Warren Mosler also presents it in 7 Deadly Innocent Frauds”.” It’s in #1. This preview of Warren’s forthcoming short book based on Neo-Chartalism is presented in a way that anyone can easily understand, and it’s a fun read.

  19. Gravatar of Angelo Angelo
    16. January 2010 at 21:02

    Scott said: “PPPS. The Vernon Smith interview is very good. Despite the occasional stumbles in macro, at least he intuits that we’d be better off if the price level were currently 6% higher. (Actually we need NGDP to be 6% higher right now, but close enough.)”

    One question that bothers me when I think about targets related to some price level (it can be “price level targeting”, “NGDP targeting” or, as it was very common in emerging economies in the 90’s, some peg to the exchange rate) is how to determine the “right” price level. I can see that, today, in a NGDP target system, a higher NGDP level would be desirable as a short run objective for policy. However, why “6% higher”? Why not 5, 7 or 8%? I can understand that you have a level of production that is “in the trend”, so deviations from that trend, in the NGDP target, must be corrected. But where is the “trend” for the price level? How do we determine the “neutral”, “normal”, or “whatever-you-prefer-to-call” price level to make it operational?

    Can you elaborate a little on some of this ideas, Scott? I’m very curious about how to make a NGDP target system operational.

    Thanks!

    Angelo

  20. Gravatar of woupiestek woupiestek
    17. January 2010 at 00:37

    @ Statsguy

    The debt levels where high in the summer of 2008, but the problems started in the fall. The idea that tightening caused the crisis seems more plausible than the idea that we past some mysterious invisible threshold. Therefore, I think the levels of debt where adjusted or adjusting to expected NGDP and only became to high when money tightened. How would an Austrian economist refute this analysis?

  21. Gravatar of Bill Woolsey Bill Woolsey
    17. January 2010 at 05:00

    Scott:

    Kling must have made a typo. And then you made another typo here!

    Kling said that Y = expected MV/P. I read Y to be nominal income, but that is wrong. It would be real income. y = expected MV/P. Real income (output) equals expected real expenditure. I think there is some truth to that, but not what you (or I) are trying to communicate.

    Your typo is Y = expected MV/Y. You put nominal income (or real income,) on both sides of the equation, where Kling had P on the right.

    I think what Kling should have written is Y = expected MV.

  22. Gravatar of Bill Woolsey Bill Woolsey
    17. January 2010 at 05:05

    Angelo,

    With nominal expenditure targetting, the price level varies with Y*/yp, where yp is the productive capacity of the economy and Y* is the target value of nominal expenditure.

    My view is that we need to move nominal expenditure close to its past growth path, and then have it stay on a 3% growth path in the future. I am not sure what that will do to the price level exactly, but wherever it settles down, it will be pretty stable as long as this regime is maintained.

    All monetary regimes have this issue. What price of gold? What growth path for the quantity of money?

    Oh, I suppose the status quo of 2% higher from its current level, whatever it might be, “solves” the problem by making the price level unspecified.

  23. Gravatar of Mike Sandifer Mike Sandifer
    17. January 2010 at 06:01

    Dr. Sumner,

    Given the central role you assign an NGDP decline in ’08 in the subsequent meltdown, why not short based on that construct? I would think this is a very tradable perspective, especially given the claim that this is a fairly unique one. Would EMH suggest that your construct will lack robustness, at least for trading purposes? If not, then do you recognize NGDP as a solid fundamental upon which to based future trades?

  24. Gravatar of DanC DanC
    17. January 2010 at 06:59

    From a Forbes argue with comments from coworkers of Friedman at Hoover

    For the bubble itself? Probably nobody. From the tulip mania in Holland more than three-and-a-half centuries ago to the dot-com bubble here in the U.S. less than a decade ago, wildly irrational behavior sometimes develops in markets. “Friedman never argued that markets are perfect,” says Jay, “only that over the long run they’re a lot more efficient than any other method of allocating resources.” Sometimes, Milton recognized, bubbles just happen.

    Whatever the origin of the bubble, however, Milton would have blamed Congress for making it much, much worse. Congress, after all, created Fannie Mae (nyse: FNM – news – people ) and Freddie Mac (nyse: FRE – news – people ), institutions that spent tens of billions of dollars on subprime instruments. “Congress told Fannie and Freddie to subsidize bad loans for the purposes of social engineering,” says Jay. “It was terrible, just terrible.”

  25. Gravatar of Doc Merlin Doc Merlin
    17. January 2010 at 07:14

    @ Tom Hickey
    “Most Neo-Chartalists conclude that in a modern monetary system in which the sovereign government is the monopoly provider of its currency of issue, which alone is acceptable at government payments offices, the necessity for obtaining the currency of issue arises from one’s obligations to government, which are chiefly tax obligations”

    Hrm, that makes Greenspan a Neo-Chartalist.

    Also, a state issuing IOUs which are then payable to the are “bills of credit,” which are explicitly unconstitutional for a state to issue. (Not that anyone pays attention to that document anymore.)

    @Scott
    “Krugman seems to think it is realistic to expect regulators to spot bubbles in real time, and then do something about them.”

    Krugman is pro anything that gives government regulators more power, but only if its arbitrary and easily abused, as far as I can tell.

    1 and 2 are not just unanswerable questions have the same structure. When we act as if EMH is true, it becomes false (markets become inefficient is we act as if they are). When we act as if determinism are true then it destroys society and social function.

    This is why philosophically I am, more or less, a pragmatist. I hold EMH and determinism to be false because its more useful and has better results to treat them as false.

  26. Gravatar of ssumner ssumner
    17. January 2010 at 08:53

    Greg, I don’t watch movies at home. What little I know of Wittgenstein, I like.

    Jon, That’s a good point. I should clarify that I think it is easy to explain the 10% unemployment, but I was referring to the subprime fiasco of late 2007, which I believe involves substantial errors of both the public and private sector.

    malavel, I agree. I think Krugman would argue that you can predict the bubble but not the crash. But I’m not even sure about that. It’s only a bubble if followed by a crash, isn’t it?

    Marcus, I heard about the land restrictions. And I suppose there must have been SOME REASON for what was going on. But in retrospect the reasons weren’t very good. Does anyone have data on (developable) raw land prices in Phoenix and Vegas duing the boom? That would help pin down what was going on. If the raw land also soared in price, it was the big land investors who screwed up. If it didn’t, then it was the average home buyers who made a big mistake. Now that I think about it, I’m surprised I haven’t seen any articles about that. It would tell us a lot about who was irrational, or if you prefer, who made rational decision that were very unwise in retrospect.

    Greg, It isn’t just you, but lots of commenters raise two issues that I just don’t think provide excuses for the anti-EMH position:

    1. It’s hard to sell short.
    2. The market can stay irrational longer than yoy can stay solvent.

    Your point about not knowing when the sandpile will collapse is a variant of the second point.

    These are both really bad arguments. I keep asking why a mutual fund run on anti-bubble principles wouldn’t outperfrom an index fund. Neither of those factors can explain why it is hard to beat index funds. So I remain unconvinced by the anti-bubble ideas. You don’t need to go short to take advantage of undervalued assets. And you don’t need a lot of leverage to beat index funds, just patience. The bottom line is that there is no answer to my question, which is why the EMH will never disappear–the logic in favor is simply too strong.

    Of course if the anti-EMH types say it’s impossible to identify undervalued assets, then they have lost the argument.

    Marcus, I also agree with Smith, except his views on the Great Depression.

    123, I completely agree with all of your points. I am a pragmatist like you seem to be. I like to say the EMH is useful for certain purposes, but not precisely true. Markets are human institutions, and thus flawed.

    123, I agree with the empirical perspective you mention in regard to Friedman. Here’s my point. When I examined the subprime fisaco I was really interested in the question of whether the pro-regulation people in DC missed the bubble, or whether they saw it, but were held back by Bush’s anti-regulation ideology. When I found out that Bush was about the only one in DC even trying to slow down the bubble, I took that empirical evidence as showing, “Yes, society does stupid things, but investors and regulators are part of that stupid society, so don’t expect bubble theories to produce any useful policy implications.” So my view is empirically formed, not theological.

    That may seem to conflict with my earlier view about mutual funds, so let me restate it. I think people are irrational enough that a Vulcan like Spock might be able to beat an index fund. But last time I looked there were no Vulcans on planet Earth. My hunch is that Friedman would not have been able to beat the market, because not only would he have not held stocks in 1998, but probably not in 1996 either.

    Woupiestek, You said;

    “The market should decide how much money to spend on collateralizing debts. It’s basically a question of comparing spending now, to losses in an unexpected crash. Apparently, the market underestimated the necessary amount of collateral on mortgages. But given EHM the market’s guess is the best there is.”

    This may be the implication of the EMH in a free market, but not in a market like ours where taxpayers pick up the tab if there isn’t enough collateral. AIG is a perfect illustration.

    More to come . . .

  27. Gravatar of Tom Hickey Tom Hickey
    17. January 2010 at 08:59

    @ Scott,

    The claim that the 8 unanswerable questions is paradoxical in that EMH and the related REH are called “hypotheses.” Economics holds itself out as a science, and for a scientific hypothesis to be significant it must be falsifiable ( if you think that Karl Popper was correct in this regard, as I do). The other 7 are not presented as scientific hypothesis, and when we examine them, we discover that they function quite differently. For example, specific answers to many of them function as norms in a universe of discourse that characterizes an ideology rather than as assertions of fact that can be checked. Therefore, #1 cannot be on the same level as the other 7, which are not scientific, and also be scientific.

    What would falsify EMH and REH? Or if REH and EMH aren’t scientific hypotheses, what are they? Norms of a particular universe of discourse that are essentially arbitrary and assumed?

    Do market failures disconfirm REH and EMH? Certainly, there have been market failures (if we can believe Sec. Paulson, for instance, when the interbank markets froze.)

    However, Popper also observed that lack of falsification in the case of a potentially falsifiable hypothesis does not confirm its truth. So in this sense, I would agree that EMH and REH aren’t true.

    But this doesn’t imply that REH and EMH aren’t true in the same sense that the other 7 aren’t true. For if REH and EMH are a scientific hypotheses, then they are not of the same logical order as the other 7, which aren’t scientific hypotheses. Lumping them together with respect to their truth involves a category mistake, just as confusing a tautology or contradiction with a scientific protocol statement.

  28. Gravatar of DanC DanC
    17. January 2010 at 09:03

    From an interview with Milton Friedman in March
    2000

    Peter Robinson: Well, we better go into that for a moment. So the Great Depression was the fault of the Fed?

    Milton Friedman: That’s right. Now the stock market–I’m not saying that the stock market collapse was the fault of the Fed.

    Peter Robinson: That was a genuine bubble.

    Milton Friedman: The Fed may have contributed to it, but it was primarily a genuine bubble. And it was a bubble that was stimulated, a boom, the boom market of the 20s was stimulated by exactly the same kind of forces that have been stimulating our present bull market, technological development–

    Peter Robinson: So there were real change–real changes in the economy, that were indeed impressive–

    Milton Friedman: That’s right.

    Peter Robinson: They were objectively taking place; that wasn’t nonsense. But the bubble–now you’d better actually define what you mean by a bubble?

    Milton Friedman: I don’t know that I want to talk about a bubble. I want to talk about a bull market that gets very high and then is reversed and comes down again.

    We’ve had three comparable bull markets since the ’20s. We’ve had the ’20s in the United States, we’ve had the ’80s in Japan, and the ’90s in the United States. And if you pluck them one on top of the other they almost coincide, they have exactly the same pattern.

    So if this is new, the ’80s was new, if that was new, the ’20s are new.

    Peter Robinson: So we’re inching our way toward the edge of the precipice?

    Milton Friedman: No, that’s a different question. What happens after–no doubt such a bull market tends to overshoot. By how much and when, those are much more difficult questions. And especially by how much, because that partly depends on what happens after the bull market breaks.

    In the United States, in the three years after the bull market broke–

    Peter Robinson: In ’29.

    Milton Friedman: ’29, from ’29 to ’32 or ’33, the Federal Reserve permitted or forced the stock of money to go down by a third. For every $100 in existence in money–I’m now talking about bank deposits and currency in your pocket–for every $100 in existence in 1929, there were only $67 in 1933.

    And as a result, when that collapsed, I think it was a decline of 80 percent.

    Peter Robinson: The Great Depression was a long time ago. Haven’t we learned a thing or two about managing the economy since?

    Shocking the System

    Between 1890 and 1945 the United States experienced seven contractions, three of five percent, two of ten percent and one of almost 15 percent. Yet since 1945 we have experienced just one contraction of a mere three percent, and today in the so-called new economy, we find ourselves in the midst of an 18-year expansion that has been marred by only one mild recession.

    So the business cycle is becoming less important?

    Milton Friedman: No. I’ve always questioned whether there is such a thing, really, as a business cycle. What you have is an economy which is subject to shocks from time to time. And a shock comes along which knocks the economy down, and then it recovers. But the idea that there are regular intervals, regular size, I think that is not supported by the–I have no doubt whatsoever that to a large extent past recessions were produced by mistaken monetary management; that they were not natural in the economy, that they did not have to occur; but you had a situation in which the monetary authorities–this is particularly after the Federal Reserve was established–followed a policy of tending sort of a stop-go policy. They were late in reacting to changes in the economy, and when they acted, they acted too strongly.

    And even the Fed has learned from experience. And I believe that the performance of the Fed under Mr. Greenspan has been better than any prior chairman. You may know personally I’m in favor of abolishing the Fed.

    http://www.hoover.org/multimedia/uk/3391336.html

  29. Gravatar of ssumner ssumner
    17. January 2010 at 09:33

    Statsguy, I don’t think income distribution or debt levels have much impact on AD, and it can be easily offset by monetary policy. Debt could lead to some reallocation of resources out of housing, but that mostly occurred before mid-2008. Since then the housing decline has been driven by falling AD.

    And of course my preferred monetary policy would greatly ease the burden on debtors, although that is not why I advocate easing.

    David Pearson, I am not sure why that is directed at me, I also said the CRA does not excuse all the bad decisions made by bankers. But even if the CRA played no role in the subprime fiasco, it was very bad public policy. And of course the role of the government went far beyond the CRA and into encouraging middle income home ownership.

    Tom Hickey, Thanks for the reading tips. Regarding fiscal policy, I agree with your observation, but would point out that it is far better to have monetary policy generate a bit more inflation, than to run up massive fiscal debts which later lead to high inflation.

    Statsguy#2, Money’s value has nothing to do with banking, money has value for the same reason wallets do, it makes shopping easier.

    Philo, As expected.

    Angelo, Nothing special about 6%. Stable NGDP growth is the goal. We were on about a 5% growth path for several decades, then recently dropped 8% below that path. So some catch up is needed, but it is hard to say exactly how much.

    Bill, Thanks, I made the change.

    DanC, Yes, and BTW, there is a book arguing tulipmania was not a bubble.

    Doc Merlin, I think we are much better off if policymakers assume the EMH is true, and don’t try to second guess markets.

  30. Gravatar of David Pearson David Pearson
    17. January 2010 at 09:49

    We agree on the government’s role in housing, especially with regards to the GSE’s. I also think, however, that conservatives’ attempts to scapegoat the CRA smacks of intellectual sloppiness and desperation. The financial crisis was not caused by a bunch of clueless socialists trying to help poor people (the preferred conservative narrative). It was caused by a bunch of clueless socialists who were trying to help the middle class. The reason conservatives pick on the CRA is because the vast majority of conservative Republicans opposed that policy. Unfortunately, the vast majority of Congressional Republicans did not oppose the GSE’s dominance over housing finance, for the simple reason that the GSE’s doled out lobbying money to the dem’s and GOP alike. This “inconvenient fact” is responsible for the CRA “smokescreen”.

  31. Gravatar of Greg Ransom Greg Ransom
    17. January 2010 at 09:52

    Scott, I misunderstood. I thought you were making a claim about macro, and the impossibility of systematic distortions across the structure of relative prices and production through time.

    And I’m also confused, because you’ve already conceded that people who put 2 & 2 together forming a perceptionof the macro distortion crushed the index funds, making hundreds of millions of dollars and even billions of dollars — untold millions saved themselves financial ruin by avoiding mistakes made by those incapable
    of putting two and two together. Others made billions exploiting those misled by a pathological and unsustainable Fed and U.S. Government price and reg environment.

    Actual implies possible.

    We have actual at both the investor and the macro level — people actually exploited the massive time structure distortion for massive financial gain, and top research economists like William White and his BIS team actually connected the dots and drew a picture of what was happening in advance of the inevitable collapse of the systematic distortions in the structure of the economy over time.

    Ignorance of the causal mechanisms at work here is no excuse for not acknowledging the ability of folks to document a perception of structual relations that were beyond the competence of MIT, Harvard and Chicago economists — a perception that extended into patterns of future events that became actual.

    If you aren’t trying to claim that the truth of EMF makes the truth of systematic and unsustainable distortions in production and price relations across time impossible, clear things up and just say so.

  32. Gravatar of Tom Hickey Tom Hickey
    17. January 2010 at 09:54

    @Doc Merlin

    “Hrm, that makes Greenspan a Neo-Chartalist.

    As Chairman of the Fed, Greenspan had better have understood Neo-Chartalism because Neo-Chartalism aka MMT (modern monetary theory) is based on accounting principles, especially reserve accounting, rather than theoretical assumptions. See Bill Mitchell, Stock-Flow Consistent Macro Models. I would assume that as Fed chairmen Greenspan and Bernanke were acquainted with the operation of the US and global interbank monetary systems.

    MMT is a description in terms of stock-flow consistency of how the post-August 15, 1971 monetary system actually operates after Nixon closed the gold window and the US went on a non-convertible floating fx currency and the world followed. See Godley and Lavoie, cited above, for a detailed account of stock-flow consistency. It’s purpose is to inform government how to take advantage of the opportunities that this system offers and avoid its disadvantages. In doing this, MMT couples this understanding of the operation of the modern monetary system with Abba Lerner’s principles of functional finance. See “Functional Finance and the Federal Debt” by Abba P. Lerner, and L Randall Wray, “Functional Finance And Us Government Budget Surpluses In The New Millennium.”

    “Also, a state issuing IOUs which are then payable to the are “bills of credit,” which are explicitly unconstitutional for a state to issue. (Not that anyone pays attention to that document anymore.)”

    True. If Arnie wanted to do it, he probably could have gotten away with it, at least temporarily, when the state was forced to issue IOU’s. But the principle stands anyway.

  33. Gravatar of Tom Hickey Tom Hickey
    17. January 2010 at 10:54

    @Scott

    “Tom Hickey, Thanks for the reading tips. Regarding fiscal policy, I agree with your observation, but would point out that it is far better to have monetary policy generate a bit more inflation, than to run up massive fiscal debts which later lead to high inflation.”

    Scott, thanks for your response. In clarification, MMT is agnostic about using spending or taxation to accomplish the same end, which is providing net financial assets when nominal AD lags real output capacity. Bill Mitchell emphasizes spending, and Warren Mosler, tax-reduction. But practically speaking its an argument over the relative mix. Here are Warren’s 11 prescriptions for fixing the economy. (Here’s Warren’s bio from Rolfe Winkler who blogs at Reuters: Warren Mosler, who moved to St. Croix in 2003 to run for Congress in’04, ran a fixed-income arbitrage fund for 15 years without, he claims, a single losing trade. He turned it over to his partners in 1998 with over $3 billion of capital. He’s the progenitor of some of the derivative products traded today and even has his own ultra-cool [racing] car company” [Mosler Automotive]. source

    Government spending increases non-government NFA and taxation reduces it. Therefore, increasing spending and reducing taxes accomplish the same thing in different ways. The arguments among liberal and conservative MMT’ers tend to be over the balance of spending and taxation. The advantage of both over monetary policy is that they can be tightly targeted and fixed as automatic stabilizers to a considerable degree. The upshot is that when the public wants to save, business under-invests, or there is a CAD an output gap will arise that only government can fill. Whether it does this by increasing spending or reducing taxation doesn’t really matter all that much.

    When output gap is close to closing, the government must then extract at least some of what it added by reducing spending or increasing taxation. This already takes place through automatic stabilizers like unemployment insurance and progressive taxation, but sometimes the government needs to act additionally when the automatic stabilizers are insufficient.

    Conversely, the Fed doesn’t have all that great a record of getting monetary policy right. The Great Moderation ended in the Great Bust that’s far from over. Moreover, Paul Volker’s draconian raising of rates was a big wrench, so monetary policy is not always that benign, and a lot of people are wondering how Bernanke is going to withdraw all the liquidity he has injected.

    The difficulty with using monetary means is that monetary policy is a rather blunt instrument since it injects liquidity into the banking system instead of affecting NFA. This means that it operates through bank money which creates debt and puts control in the hands of the financial sector, which is not accountable to the will of the people the way Congress is. I guess it depends in part whether one trusts financiers or politicians to look out for one’s interests. At least we can fire politicians very election cycle while old bankers never seem to die or face away either.

    The essence of the matter lies in the relative role of currency issuance and control of interest rates through the overnight interbank rate (FFR). Spending and taxation have to do with currency issuance, while borrowing is related to the FFR, in that to hit its target rate. The Fed needs to make sure that excess reserves do not drive down the rate below its target rate, and this means draining excess reserves somehow. OMO can do this, or course, but not in great quantity. Then the Fed has to rely on the Treasury issuing bonds that will soak up reserves corresponding to its increased spending. The Treasuries just convert reserves (the banks’ “demand deposits” at the reserve bank to “time deposits” “” simply a switch of one asset class to another, as the accounting shows.

    The Fed could do the same thing by paying interest on reserves sufficient to prevent rates from falling below its target instead of the Treasury issuing debt that transfers switches reserves to securities. Randy Wray and Marshall Auerback propose that the government do just this hereand here. Borrowing is a holdover from the day’s of a convertible fixed rate currency regime that’s no longer necessary and is now obsolete. It’s a naive mistake to think that the government needs to tax or borrow to “fund” itself under the present system, when it is the issuer of a non-convertible currency floating x currency, and as such, is not financially constrained.

    Here are a couple of Bill Mitchell’s posts critical of monetarism:

    Money multiplier and other myths

    The natural rate of interest is zero!

    Quantitative easing 101

  34. Gravatar of Doc Merlin Doc Merlin
    17. January 2010 at 11:14

    @Scott:

    “Doc Merlin, I think we are much better off if policymakers assume the EMH is true, and don’t try to second guess markets.”

    Hrm, Scott, that is a good point and an interesting split. It makes sense that society could probably do better better if governments believed in EMH whereas society would do worse if individuals believed in it. This is an awkward result. Maybe it has to do with government’s role as an initiator of force/violence in society. Anyway, the economics of force is still not well understood, and we won’t really grasp government very well until it is.

  35. Gravatar of Jon Jon
    17. January 2010 at 15:07

    Scott Remarks:
    “I was referring to the sub-prime fiasco of late 2007, which I believe involves substantial errors of both the public and private sector.”

    I’d be careful how you count your chickens and hens. Realized losses in the subprime market are much lower than one might suppose. Indymac and WaMu both succumbed to bank-runs not capital adequacy problems for instance.

    Now I grant you that plenty of small-banks have gone under, but many of those were crushed under the weight of bad mortgages arising from CRA obligations and losses stemming from their holdings of Freddie/Fannie securities.

    Last, it isn’t obvious that Merill et al misjudged the value of the securities. They–and others–made highly geared risky investments. They lost. Do we know whether given the chance to run this game repeatedly that they may have on net survived? This is what the EMH is all about. Yes, some big players rolled the dice and lost everything, but most of us rolled the dice (and lost a bit–its a recession!) and are still here. Lucky for us, the guys running Merill Lynch did not run the government and the government does not plan all our investments!

    In the meantime we should focus on the things which are clear:
    1) Freddie, Fannie
    2) CRA
    3) Maybe, maybe Naked Short Selling and other cases where regulatory arbitrage and clever rule manipulation unduly favor certain market participants.

    Instead we seem fixated on discussing a ‘Bank Tax’ and other punitive measures against institutions that necessarily are not the ones that screwed up significantly.

  36. Gravatar of Greg Ransom Greg Ransom
    17. January 2010 at 21:31

    Many giant Wall Street firms took “risk” betting the politicians tied to them at the Fed and bankrolled by them in Washington would bail them out if they lost their “bets”.

    And the corrupt Freddie and Fannie framework was right on the centermof the mix — playing a much larger role than most people know.

  37. Gravatar of StatsGuy StatsGuy
    18. January 2010 at 11:53

    ssumner:

    “And of course my preferred monetary policy would greatly ease the burden on debtors, although that is not why I advocate easing.”

    Yes, it would, which is one of the reasons I do advocate it. But decreasing wages (as an alternative to increasing price levels) would not ease the burden on debtors.

    To presume an equivalency between inflation (price increases) and wage decreases, in the presence of massive amounts of nominal debt, seems like it’s leaving a very big piece out of the puzzle.

    So my assertion is this: In the presence of massive nominal debt throughout the economy (and internationally), cutting wages and increasing prices do not achieve the same outcome.

  38. Gravatar of ssumner ssumner
    18. January 2010 at 13:14

    Tom Hickey, I don’t agree with Popper. I am a methodological pragmatist.

    DanC, Thanks for that interview.

    David Pearson, Those are good points.

    Greg, You said;

    “Actual implies possible.”

    Not in finance. The fact that you beat the market doesn’t prove you can expect to do so, ex ante. The cyclical mistakes by the Fed that work into production distortions are immediately reflected in asset prices. I’m not saying some people don’t occasionally have insights that others miss. But I am saying it is very hard to beat the market. Certainlty you can’t just invest based on some textbook of bubbles or misallocation or whatever, and expect to do better than index funds. It is much harder than that.

    Regarding price distortions, they may systematically relate to monetary policy, but not in a way that is exploitable by investors. Even in 2006 investors did not know that the stocks of housing developers would crash. If they had, no one would have held these stocks. I also don’t like theories where there is a subset of smart people, smarter than economists, smarter than Wall Street pros, who somehow see that all this is going to happen. Perhaps once in a great while, but not in any systematic way.

    Tom Hickey, You said;

    “The difficulty with using monetary means is that monetary policy is a rather blunt instrument since it injects liquidity into the banking system instead of affecting NFA.”

    I don’t understand this kind of statement. We are always doing monetary policy. The only issue is whether we do it well or poorly.

    I don’t understand what you mean by paying the government’s bills by printing money. Didn’t Weimar Germany do that?

    I have a recent post that addresses a Bill Mitchell post. I wasn’t impressed.

    Doc Merlin, The key is that, as you say, someone in the private sector needs to make the market, and hence do the research. We don’t need to government to be involved at all.

    Jon, It is hard to know what to make of thought experiments where you run the same event 10 times over. Something would presumably have to change for banks to come out better. But I generally agree with the thrust of your comment, and we certainly shouldn’t be going after banks in a punitive way, rather we need regulations that reflect the underlying problems—such as mortgages with no money down made by institutions that are backstopped by the Treasury.

    Greg, I agree

    Statsguy, I am not claiming an exact equivalence (for reasons you mention.) Nor are wage cuts my favored solution—higher NGDP is. I don’t even think wage cuts are politically feasible, at least in the short run.

  39. Gravatar of 123 123
    18. January 2010 at 13:45

    “It’s only a bubble if followed by a crash, isn’t it?”
    No, sometimes bubbles are followed by a decade of near zero returns.

    “I keep asking why a mutual fund run on anti-bubble principles wouldn’t outperfrom an index fund.”
    At least some of the best performing mutual funds are clearly built on anti-bubble principles.

    “When I examined the subprime fisaco I was really interested in the question of whether the pro-regulation people in DC missed the bubble, or whether they saw it, but were held back by Bush’s anti-regulation ideology. When I found out that Bush was about the only one in DC even trying to slow down the bubble, I took that empirical evidence as showing, “Yes, society does stupid things, but investors and regulators are part of that stupid society, so don’t expect bubble theories to produce any useful policy implications.”

    In other blogs your quote above would be an excellent short blog post.

    “My hunch is that Friedman would not have been able to beat the market, because not only would he have not held stocks in 1998, but probably not in 1996 either.”
    Ex ante in 1996 treasuries were a much better investment than stocks. Ex post it is also true if you have enough patience to wait 8 or 13 years.

  40. Gravatar of Simon K Simon K
    18. January 2010 at 16:28

    Jon – IndyMac failed for the most part because the secondary market for non-conforming mortgages (ie. those the GSEs do not normally buy) ceased to operate. Like most mortgage lenders, they held very few loans in their portfolio for long. When it became impossible to sell most of their loans, their cash flowed ceased up. At this time many people also withdrew deposits, but it was a secondary thing – there was no way IndyMac could have remained in business lending only their own reserves.

    Many of the failures around that time (Downey Savings, Northern Rock in the UK, etc) were similar in nature – those banks never had enough capital of their own for the level of lending they engaged it and while the secondary market was working they didn’t need it. I’m sure lots of small mortgage bankers and brokers, who operated with just a line of credit and had no reserves, suffered the same fate.

    Capital adequacy problems were more important at the other end of the food chain, but they were caused by essentially the same event. The investment banks with large mortgage-backed portfolios had a huge problem when the market for those products ceased to operate and they could no longer be valued sensibly. The realised losses are just the tip of the iceberg.

  41. Gravatar of Lord Lord
    18. January 2010 at 17:52

    The flaw of efficient markets is to equate price to value, making price the fundamental value, forestalling the real search for value, and defining markets as efficient rather than ask the tough questions of how efficient it is and whether that efficiency is increasing or decreasing. Until we go beyond it, we will get nowhere.

  42. Gravatar of Lord Lord
    18. January 2010 at 17:53

    In other words, the problem is it is meaningless.

  43. Gravatar of Doc Merlin Doc Merlin
    18. January 2010 at 21:03

    @Lord
    Price is a type of weighted “average” (using the term loosely) measure of value. It is a “market clearing” exchange value wrt money. The main problem is that prices are only reflective of past exchanges or future promises of exchanges. However as an average they are often used as indicative of the nature of future exchanges, because there is no better alternative.

    I do agree however that we need to get beyond the “perfectly efficient” meme and begin to find ways to measure efficiency in a macro context. My intuition tells me this will have something to do with opportunity costs.

  44. Gravatar of Doc Merlin Doc Merlin
    18. January 2010 at 21:04

    GAAAAA, did I say opportunity costs, I meant transaction costs.

  45. Gravatar of malavel malavel
    19. January 2010 at 04:45

    Scott, would Krugman claim that a few really smart guys could predict the crash (but not the exact timing), or the larger part of the market?

    I suppose you could argue that it might be profitable for the ones who predict the coming crash to still invest heavily in that market if they believe they can get out in time. I have a faint memory of someone claiming that the banks were reasoning like this. Some got out in time (JP Morgan?), while others (like Bear Stearns) didn’t.

    I wonder how much damage the FED might do in the future if they try to pop bubbles. I assume they wont try to pop art bubbles, but only highly leveraged markets that might cause big problems if the FED stays incompetent. =) But what about stock bubbles? Could be pretty bad if they feel like they have to keep S&P from increasing too fast.

  46. Gravatar of Mike Sandifer Mike Sandifer
    19. January 2010 at 09:05

    Dr. Sumner,

    On the chance my previous questions here were simply overlooked, I’m inquiring about your views concerning NGDP, monetary policy, and tradable advantage. I apologize if these questions were addressed elsewhere, as I have read many of the initial posts on this blog and have followed along since I started reading here, but haven’t seen these asked.

    If it is possible for central banks to proactively keep NGDP at a specific level, is it also useful for investors to track changes in NGDP? And if, as claimed, there is wide misunderstanding of monetary policy such that tight policy is sometimes seen as loose, does this present opportunities for investors who avoid this mistake?

    Additionally, if the rather rare investor can benefit from tracking NGDP, does this present a problem for EMH, especially given some evidence that relevant misunderstandings have been very robust?

    I know you say you don’t like discussing some of these issues, but with another thread here, I had to ask.

  47. Gravatar of Mike Sandifer Mike Sandifer
    19. January 2010 at 09:48

    I should mention that it’s obvious that if the market is indirectly aware that NGDP is trending downward, then looking at market signals has limited benefit. I just wonder if the market properly predicts the magnitude of NGDP changes.

  48. Gravatar of scott sumner scott sumner
    19. January 2010 at 19:17

    123, You said:

    “At least some of the best performing mutual funds are clearly built on anti-bubble principles.”

    Studies show there are no such things as “best performing funds,” it is all luck. Returns one year are uncorrelated with the next.

    You said;

    “Ex ante in 1996 treasuries were a much better investment than stocks.”

    I don’t agree, it all depends on your time horizon. If you held stocks for 4 years, you got great returns. Ditto for 11 years. If stocks beat bonds at all horizons, no one would ever hold bonds.

    Lord, It depends on whether you are thinking about the problem as an academic, a regulator, a small investor, or a Wall Street pro. The issue you raise is only of concern for the Wall Street pro

    malavel, I am pretty sure that people like Krugman would not claim to be able to predict when the crash would occur. So he would probably just say “avoid the bubble market entirely.”

    Mike, I think economists often misunderstand monetary policy, but markets understand it quite well. That’s why the TIPs markets don’t expect much inflation despite the big rise in the MB. So I don’t think studying NGDP gives you any significant advantage–it is already priced into markets.

  49. Gravatar of 123 123
    20. January 2010 at 07:12

    “Studies show there are no such things as “best performing funds,” it is all luck. Returns one year are uncorrelated with the next. ”
    It makes no sense to analyze correlation of annual returns. It is better to look at multiyear returns. Fama & French do a great job here:
    http://www.dimensional.com/famafrench/2009/11/luck-versus-skill-in-mutual-fund-performance-1.html
    They find that some of the 97th, 98th, and 99th percentile mutual funds have some skill, and some of them are bad funds that are just lucky.
    So it makes sense to analyze strategies of top performing funds.

    “I don’t agree, it all depends on your time horizon. If you held stocks for 4 years, you got great returns. Ditto for 11 years. If stocks beat bonds at all horizons, no one would ever hold bonds.”

    How could you know that you have to hold shares for 4 years starting from 1996?

  50. Gravatar of ssumner ssumner
    20. January 2010 at 19:35

    123, You said;

    “How could you know that you have to hold shares for 4 years starting from 1996?”

    That’s my point. You don’t know. So it makes no sense to talk about one investment being better than another ex ante. All you can say is that some turned out better than others. Whether stocks or bonds did better depends on your time horizen, which is exactly what the EMH predicts.

    I just had time to glance at the paper tonight, but aren’t they saying that even the top 3% of funds only do about as well as index funds, and all the rest do worse? That seems to me to conform to my view that the EMH is approximately true, but not exactly true.

    And of course all this depends on lots of econometric guesswork about distributions, etc.

  51. Gravatar of 123 123
    22. January 2010 at 08:18

    Shiller’s model lets you talk about one investment being better than another ex ante. Evidence since 1996 supports Shiller’s theory more than it supports EMH.

    Fama/French paper does not compare mutual funds to index funds. Here is the key paragraph:
    “The 97th, 98th, and 99th percentiles of the three-factor t(α) estimates for actual net fund returns are similar to the simulation averages. This suggests that buried in the results are fund managers with more than sufficient skill to cover costs (they have positive true α), and the lucky among them pull up the extreme right tail of the net return t(α) estimates. Unfortunately, these good funds are indistinguishable from the lucky bad funds that land in the top percentiles of the t(α) estimates but have negative true α. As a result, if we buy a portfolio of the top three percentiles of t(α) estimates, the expected three-factor net return α is zero; the positive true α of the lucky (but hidden) good funds is offset by the negative true α of the lucky bad funds”
    So Fama/French say that some mutual funds among top 3% have positive alpha, and other top mutual funds are bad but lucky mutual funds.

  52. Gravatar of ssumner ssumner
    23. January 2010 at 06:42

    123, Regarding F&F, your quote supports the point I have been trying to make all along. The EMH is not precisely right, but it is approximately right. I have always said that there are probably a few individuals out there who have insights that the market misses. But we don’t know who they are. So for a pragmatist like me the bottom line is that ordinary investors ought to act as if the EMH is approximately true, as should ordinary regulators. Even the elite you refer to cannot know that they are part of the elite, as we all tend to be overconfident, so those that ended up in the top 3% through sheer luck will think they were smarter than others.

    I am pretty sure that I have done far better than if I had followed Shiller’s advice, and I have been mostly 100% invested in stocks, although mostly overseas. Shiller was saying sell stocks in 1996, when did he say “buy?”

  53. Gravatar of 123 123
    23. January 2010 at 13:24

    F&F – yes, mutual fund selection is one of the areas where EMH is very useful, as opposed to areas where it is harmful. But even here we can get interesting results about bubbles. There are 3% top mutual funds, and if we look deeper, we will see that there are three somewhat overlapping categories of such funds:
    1. funds that avoid bubbles
    2. funds that ride bubbles up and try to get out before the the crash
    3. lucky funds

    Shiller’s P/E10 ratio was below average from November 2008 to May 2009. Previous periods with below average ratios were approx. in 1988-1991 and 1974-1986. Of course you need to consider other alternative investments when choosing what is the minimum P/E10 ratio that is good for stocks.
    Almost all foreign markets were more attractive according to Shiller’s model than S&P500. 1998 Asia was extremely attractive according to Shiller’s ratio.

  54. Gravatar of ssumner ssumner
    24. January 2010 at 09:22

    123, Are you saying that Shiller says (since 1991) we should only invest in stocks in periods like Nov 2008 to May 2009? What about 2002-03? We would have missed many great opportunities.

  55. Gravatar of 123 123
    25. January 2010 at 06:24

    No, Shiller did not say that. It is my interpretation that it makes sense for long term investors to be 100% in stocks when Shiller’s P/E10 is below average, and start proportionally reducing your allocation to stocks until P/E10 reaches say 22. Such strategy is likely to outperform S&P with less risk over 10-20 year horizons.

  56. Gravatar of ssumner ssumner
    25. January 2010 at 07:43

    OK, that makes more sense.

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