Is my faith in markets warranted? (Reply to Caplan)

In a recent post, Bryan Caplan questioned my faith in markets as the best indicator of the impact of government economic policies:

Forbes provokes Sumner to don the robes of hanging judge for the hypocritical right:

“If Forbes is right, and the markets are made up by a bunch of fools, then why not go with socialism?”

.   .   .

His verdict rings true, but it reminds me of an earlier question that’s still bugging me: Why did financial markets like Nixon’s price controls so much?  What gives, Scott?  Was it just a random error, or what?

When you don’t have strong arguments, it is best to substitute quantity for quality, use some misdirection, and end up with an appeal to religious authority.  I’ll do all three.

I was only 15 when Nixon made his famous August 15th price controls announcement, so I apologize if my memory fails me on a few points.  But here is what I recall:

a.  Nixon installed a ”temporary” wage/price freeze, which was to last for 90 days.  It was widely (and correctly) anticipated that this freeze would be followed by a period of looser controls.  It was also anticipated (correctly) that the weaker price controls would be easy for firms to evade.  Wage controls were the real issue, price controls provided political cover.

b.  Nixon pulled an FDR, and did an end run around the Fed by devaluing the dollar against gold by 10%.  This had the effect of devaluing the dollar against many other major currencies.  He also closed the gold window. 

c.  He cut taxes.  I don’t recall exactly which ones, but I believe there were income tax cuts and a cut in excise taxes on cars.

1.  My first argument is that it is not clear that the positive stock market response was in reaction to the wage/price controls announcement.  The stimulus to AD was very impressive, and could explain at least part of the response.  Nevertheless, for two reasons I do not want to rely on this excuse.  First, because my hunch is that the stock market did welcome the wage/price controls, or at worst was neutral on them.  Furthermore, the monetary stimulus was probably unwarranted, as NGDP growth was adequate.  So what are some other possible reasons for the market reaction?

2.  Wage/price controls combined with monetary and fiscal stimulus were a very potent mixture, almost sure to benefit the economy in the short run, and boost the odds of Nixon’s re-election.  However the response of the markets was stronger than what one would expected from a mere increase in the probability of Nixon being re-elected.  (The stock market rises about 2% on a 100% increase in the odds of a Republican winning.)  And of course this argument would cut against my view that markets can tell us something about the wisdom of policy initiatives.

3.  At the time, the controls were viewed as a sort of “incomes policy,” a way of shifting the Philips curve to the left and making it easier to reduce inflation.  Some European countries were believed to have had success with this sort of policy, although the record was definitely mixed.  If you believe that nominal wages were above the optimal level in 1971, perhaps due to the strength of unions, then wage controls can actually improve the performance of the economy.  I recall reading that Hitler used wages controls to spur a rapid recovery in Germany after 1933, although I suppose Hitler is not someone I want on my side.  So let’s move on.

4.  Perhaps the wage controls combined with stimulus to AD were seen as a way of shifting income from labor to capital.  I am pretty sure that corporate profits did well for the next two years, although someone should check-double that.  In that case the market response might have been “rational” but again it would not support my argument that markets can tell us something about the wisdom of policy initiatives.

5.  Ex post, the wage/price controls were a significant error, but recall that the markets had no idea what was coming next.  They did not know that after 1973 productivity growth would slow sharply, causing monetary policy (which was excessively focused on real output and unemployment) to go off course and allow inflation to drift much higher.  And of course they had no idea that OPEC would drive energy prices much higher in 1973.  As far as I know, nothing like OPEC had ever been seen, at least at that scale of operation.  I do think that even under the best of assumptions the markets misjudged the Phillips Curve relationship in 1971, as did the vast majority of economists.  Which brings me to one of my strongest arguments.

6.  As far as I can recall most economists supported the wage/price controls.  This is important because this whole debate was motivated not by the question of whether markets are perfect, but rather whether they are better guides to policy effectiveness than the experts.  And in this case the experts were wrong as well.  So even in this 38 year old case, which admittedly looks very bad for EMH people like me, the experts seem to have done no better.

7.  My claim is that one should look at the response of real stock prices.  Usually the price level doesn’t change much from day to day, so a large rise in nominal stock prices translates into a large rise in real stock prices.  And that was also true on August 16, 1971.  But also note that US stock prices in terms of gold and foreign exchange fell sharply, as the 10% dollar devaluation was much bigger than the rise in the Dow (which I seem to recall was around 3% or 4%.) I really don’t have a good answer as to what to do in this sort of situation.  Obviously if the Fed suddenly announced a policy of hyperinflation, the nominal value of stocks would soar.  But that does not mean a policy of hyperinflation would be wise.  Because many prices are sticky in the short run, you have to be careful in interpreting the response of markets to nominal shocks.  Nevertheless, I stand by my previous discussion of market responses to policy in the Great Depression, and also in 2007-09.  I think the markets did correctly point out which monetary policies would be helpful, and which were woefully inadequate.

I suppose I should be flattered that Bryan had to go back 38 years to find an example where the markets clearly seemed to have blown it.  Especially since even in this example the experts did no better.  And I can find many more examples where the “experts” failed us.  I would also note that Bruce Bartlett made a similar comment (in my old blog), so apparently this example has become part of the folk wisdom that economists use when anyone cites market responses to policy to show that the “emperor has no clothes.”  But since when is a single anecdote enough to discredit an economic argument that has the virtue of being consistent with economic theory, especially given that dozens of anecdotes can be found to discredit the counterargument that experts are smarter than markets?

In fairness to Bryan Caplan and Bruce Bartlett, there may be many other such counterexamples, perhaps they simply chose the most famous example.  I admit that I was surprised by the seemingly positive market response to the Obama stimulus package, for instance.   At this point I am tempted to trot out a religious argument.  Recall how when someone mentions a particularly gruesome example of genocide committed by the “good guys” in the Old Testament, Christian fundamentalists will say something like; “The Lord moves in mysterious ways, we are not in position to second guess him.”  Don’t the Catholics also see this sort of  presumption as a sin?  Perhaps the same is true of market responses to policy announcements.  Maybe the markets thought the Obama stimulus package showed that the government was determined to avoid a depression, and that they would do whatever was necessary to boost AD.  Or that it would indirectly make monetary policy more stimulative, by increasing the money multiplier.  The stock market moves in mysterious ways, it is not for us free market believers to question its infinite wisdom.

Returning to reality (now that I have offended Protestants, Catholics and Jews), I suppose in the end my best defense of 1971 would be the following.  The markets correctly saw that 1972 was going to be a very good year.  I first heard of Arthur Laffer when he used the stock market to forecast NGDP growth in 1972; most other economists used econometric models.  Laffer forecast higher nominal growth that the others, and was right.  My hunch is that the stock market correctly understood that the stimulus would lead to higher NGDP over the next few years, which would justify higher nominal stock prices.  In addition, the wage controls would weaken the power of unions and allow this higher nominal growth to show up in higher profits.  They correctly understood that firms could evade the price controls and in any case most firms were monopolistic competitors and would like like nothing better than to have a slightly smaller price increase, but a much bigger market.  Ex post the market was wrong.  Nixon’s policy failed for all sorts of reasons; a misunderstanding of the Phillips Curve, a mistaken belief that the sort of incomes policies that were workable in small consensual societies like Austria could work in the US, bad luck with OPEC and crop failures, etc.  But I don’t think the market reaction was quite as irrational as it might seem in retrospect.  And again, most economists made similar mistakes at that time.

So how about the following:  We will not use market responses to directly evaluate whether a particular policy is good or bad.  Rather we will use markets to answer technical questions, such as how much inflation or NGDP growth we are likely to get next year and the year after.  Right now the TIPS market says we can expect just over 1% inflation for the next few years.  The political and economic right says inflation is a much bigger problem than unemployment.  Let’s revisit this question in two years and see who was right.



22 Responses to “Is my faith in markets warranted? (Reply to Caplan)”

  1. Gravatar of D. Watson D. Watson
    31. December 2009 at 13:42

    I would be interested in your response to Tyler Cowen. This goes back also to my request for a story on how precisely increasing the money supply now is going to put people to work. (ie – Fed announces they will follow your blog for policy. Who moves first, how and why? Who acts in response, how and why? What are their assumptions….) Anyway, here’s MR:

    If someone wants to insist that “this is really an AD shock, not a sectoral shift,” I’m not so keen on fighting to keep one term over the other. I would insist, however, on an issue of substance, namely that not all AD shocks are alike. If we are going to switch terminology, it could be said that this is a real AD shock and not just a nominal AD shock. (Though there have been nominal AD shocks too.) A nominal AD shock can be offset more easily by goosing up some mix of M and V and restoring the previous level of nominal demand. If you want an example of a nominal AD shock, imagine a more neutral change in monetary variables and indeed those have happened in the postwar era. Or read David Hume’s parable of the money under the pillow. In those cases you don’t need to make people feel wealthier in real terms, you just need to get the flow of spending up again. Today, part of the problem is that people feel less wealthy in real terms and that influences the content of their spending and investment decisions.

    When a real AD shock comes, policy still should be expansionary in response, but there is an important difference. In absolute terms, nominal expansion won’t much help the labor market, which still has to reallocate workers from some sectors to others, given the collapse in asset prices and expectations.

    You’ll see indirect recognition of this from many current Keynesian writers, when they talk of the jobless recovery or fear that the economy will fall back next year after the stimulus money runs out. In general I agree with those points. Yet these writers are less willing to consider the implied conclusion that a bigger stimulus won’t much help — and may hurt — the longer-run adjustments which are required. Boosting MV will restore employment only to a very limited extent. It’s still the case that recovery will require a great deal of sectoral readjustment and that will take a good bit of time.

  2. Gravatar of ssumner ssumner
    31. December 2009 at 18:52

    D. Watson, Thanks, I’ll try to do a post on that. Unfortunately I am on the road, so I am not sure I can finish it far a few days.

  3. Gravatar of Doc Merlin Doc Merlin
    31. December 2009 at 21:29

    “Right now the TIPS market says we can expect just over 1% inflation for the next few years. ”

    I can’t believe this. Even the last 12 months have been a lot higher than this.

  4. Gravatar of Doc Merlin Doc Merlin
    31. December 2009 at 21:34

    I guess I should clarify, I don’t think the experts will do better. Nowdays, “the markets” mirror “the experts” pretty well, as everyone is using the same models. “The markets” are better, than the experts. Anyway, I think you are misreading the t-bill/tips spread.

  5. Gravatar of Ash Ash
    1. January 2010 at 05:19

    fyi, here’s a copy of Nixon’s speech with all the tax details . It’s quite a good laugh!

    Just one small point – it wasn’t a devaluation against gold, it was a suspension of convertibility into gold combined with a 10% import tax. It’s an important distinction because this was a smart way to achieve de facto unilateral devaluation without having to enter into negotiations with the trading partners who would now be forced by the import tax to revalue gold in their currencies to maintain the status quo.

    I think the market was reacting to this imminent collapse of the Bretton Woods system more than anything else. Given how many dollars were held in reserve abroad, it was atleast a short term positive for the country.

  6. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. January 2010 at 12:44

    Keep in mind that back in 1971 virtually all stock analysts were using flawed theory regarding inflation adjustments of earnings. It wasn’t until 1979 that Modigliani and Cohn published their paper showing that corporate debt also needed to be adjusted downward by the same factor.

    Back then markets were overly sensitive to inflation expectations, thus if Nixon’s controls were thought to work to control inflation it would be hugely favorable for stock prices. As Modigliani and Cohn put it: ‘…each percentage point of inflation typically reduces market value by a staggering 13% relative to what it would be if valued rationally…’.

    That’s from their article ‘Inflation, Rational Valuation and the Market’, in Financial Analysts Journal vol. 35, no. 2 (March-April 1979) pp. 24-44.

  7. Gravatar of TGGP TGGP
    1. January 2010 at 17:57

    Bryan Caplan compares the Austrian suggestion that “higher order goods” decline to the alternative focusing on durables in a number of posts on Austrian Business Cycle theory, more specifically that found in “America’s Great Depression”.

  8. Gravatar of ssumner ssumner
    1. January 2010 at 19:08

    Doc Merlin, You said;

    “I can’t believe this. Even the last 12 months have been a lot higher than this.”

    That’s the oil price bounce back. The best way of predicting future inflation is to look at wage trends and recent commodity prices. Assuming oil levels off around $80, then the wage slowdown will lead to low inflation over the next few years.

    Ash, The devaluation might not have been in the speech, but I am pretty sure the price of gold was raised to $38 at that time. I may be wrong, but I also think that the tariff might have simply been a club to force other countries to accept the devaluation. Perhaps someone else recalls exactly what happened.

    You are probably right about Bretton Woods, it would have been really interesting if we had TIPS markets back then.

    Patrick, Good point. But does the M-M model incorporate the fact that nominal earnings on capital are taxed, not real earnings. It does seem like high inflation hurts asset prices. (Just to avoid confusion, a higher price level clearly raises nominal asset prices—and that is what I am currently recommending. I do not favor a higher trend rate of inflation.)

    Thanks TGGP.

  9. Gravatar of Ash Ash
    2. January 2010 at 11:55

    Scott – the official devaluation was announced after negotiations with the Bretton Woods partners in Dec 1971 as part of the Smithsonian Agreement .

    But in August 1971, the govt stressed that this was not a devaluation. Of course, the import tax was tantamount to a devaluation and forced Europe to the negotiation table, the result of which was the Smithsonian Agreement where gold was revalued from 35 to 38 dollars.

    My reading of it all is that the wage controls were just one piece of a policy that was primarily triggered by the fact that the Bretton Woods system had reached breaking point. The Bundesbank had already let the mark float in May due to the pressures on them and the deficit showed no signs of falling. A negotiated devaluation was not possible in August because Japan and France wanted to keep the benefits of an undervalued currency despite the dollars flooding into their reserves. So this roundabout method via the import tax was the only way to get everybody to the table.

  10. Gravatar of Chris Chris
    2. January 2010 at 12:44

    I think that it is important to remember that the stock market is a proxy for the health of business – not of the economy at large. It is possible for specific policy to help business profits but not the economy. I think that the stimulus is a good example of this. Many companies were going to get a big hand-out which would make their short term profits better than they would otherwise be.

  11. Gravatar of Doc Merlin Doc Merlin
    2. January 2010 at 19:50

    Ash makes a good point, and…

    Chris wins the thread!

  12. Gravatar of scott sumner scott sumner
    3. January 2010 at 11:36

    Ash, Thanks for correcting me. How about closing the gold window? Was I correct that that occurred in August? The official price doesn’t matter after the window is closed, only the market price matters.

    I recall an economics professor at Wisconsin telling us in the mid-1970s that gold prices were a bubble, and would fall to $20. That was the beginning of me losing faith in expert opinion.

    Chris, True, but when stock market gains (or losses) are very broad-based, and not limited to certain firms, it is generally a decent indicator of the health of the macroeconomy.

    Doc, Don’t I get to decide? :)

  13. Gravatar of Ash Ash
    3. January 2010 at 15:51

    Scott – yes, the gold window was closed in August. Anyway, the point of my factual quibbling was just to substantiate that the wage controls were just a small part of a policy, the primary aim of which was to move to a post Bretton Woods system on America’s terms.

    And Chris is spot on – what’s good for stock market is not necessarily good for the economy.

    And even if the market was wrong, so what? Not even the strongest form of EMH says that markets are always right, just that they don’t make systematic errors and that most people can’t do any better than the market.

    So I’d say that your faith in markets should not be shaken in the least by Bryan Caplan’s argument!

  14. Gravatar of ssumner ssumner
    4. January 2010 at 07:20

    Ash, I entirely agree with your recent comment.

  15. Gravatar of Jon Jon
    4. January 2010 at 10:08

    Faith in markets means believing that markets efficiently consider everything known. In Nixons day there was NOT a consensus about wage/price controls.

    The market can be wrong in an absolute sense. They can react in ways that in hindsight look wrong. The core observation is that the market will always do better than the government excluding cases of luck.

    Pointing to an incedent where the government was wrong and the market was wrong is bad logic; it is nonresponsive to the claim.

  16. Gravatar of jj jj
    5. January 2010 at 13:45

    If the Dow rose 3% when the dollar was devalued by 10%, then the real value of stocks fell ~7%. This is so obvious on the surface that I have to ask, why did nobody else say this?

  17. Gravatar of scott sumner scott sumner
    6. January 2010 at 13:13

    Jon, Yes, nothing is perfect.

    jj, I may have been in error about the timing of the devaluation. Perhaps someone could find a long time series to see what happened to the dollar that day.

  18. Gravatar of jj jj
    7. January 2010 at 12:16

    I got the 1971 data. It’s ridiculous for Caplan to suggest with any confidence that the financial markets liked wage controls; there’s just too much going on at the time. If anything, you’d have to say that at least against gold prices, the market did NOT like wage controls — but I wouldn’t have much confidence in that, either.

    A couple examples of why this kind of market reading is impossible:
    1) On Aug 17 the Dow dropped 3% against gold. However on Aug 16 the Dow rose 4% (in pts) — was the news leaked ahead of time? I don’t know what gold did that day; I could only get monthly average prices.
    2) The Dow was also in a 1-month long trough prior to Aug 17, which it gradually rose out of from Aug 10 to Aug 17; what caused the trough, and again, did the news begin to filter out on the 10th, or is the rise unrelated?

  19. Gravatar of ssumner ssumner
    7. January 2010 at 20:04

    jj, I won’t say it is ridiculous, because it isn’t obvious that gold is the right deflator. But I agree with you that it is nowhere near as clearcut as Bryan may have assumed. The CPI is sticky, but the devaluation may have sharply raised the expected future CPI. In that case real stock prices may not have risen.

  20. Gravatar of jj jj
    8. January 2010 at 08:27

    scott, I agree that gold isn’t the ideal deflator, but the claim is still ridiculous if it’s based on the logic:
    a) Nixon announces wage controls on Aug 17
    b) Dow rises a small amount on Aug 17
    c) QED – markets like wage controls

    You can only get ther if you are ignorant of the many other factors that affect nominal stock prices, on varying time scales as information disseminates.

    Now I agree that the market incorporates policy changes into prices, but you have to extract the timing of the policy change, market expectations of policy change before it’s announced, expectations of policy stability, the expected future growth AND inflation paths and appropriate discounting, not to mention other economic and policy news all over the world. I don’t know how cut and dried your story of markets dropping every time Smoot-Hawley cleared a legislative hurdle is, but I think those multiple data points can reveal something useful. For a single data point you really need to consider at least both the size of the movement in real terms, and the unpredictability of the news.

  21. Gravatar of scott sumner scott sumner
    9. January 2010 at 09:56

    jj, I agree with your points, but remember that Caplan was responding to my claim. I think he was trying to get me to clarify my views, not make his own claim. He probably didn’t know that I believe that reading market signals can be quite tricky.

  22. Gravatar of jj jj
    11. January 2010 at 12:22

    that’s fair, then

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