Archive for February 2010


Low rates aren’t the answer, they are (a symptom of) the problem

This WaPo story is slightly worrisome:

The Federal Reserve would consider reopening its program to support the mortgage market if interest rates spiked or the economy showed new weakness, Federal Reserve Bank of New York President William C. Dudley said in two new interviews.

Low long term rates are usually the sign of a weak economy, and rates normally rise as the economy recovers.  We saw this during 2009, when rates moved up somewhat after the economy seemed to pick up a bit in the second half.  I would be happier if the Fed was saying that they stood ready to respond with more stimulus if long term rates declined.  

Why do I say that I am only slightly worried?  Because Dudley also mentions that signs of further economic weakness would trigger additional stimulus.  Of course that begs the question:  How weak does the economy have to get before the Fed decides the US would be better off if aggregate demand were a bit higher?

Part 2.  I found the WaPo excerpt in an Arnold Kling post.  Kling makes the following observation:

Rates on 30-year, fixed-rate mortgages are 5 percent. The market wants those rates to be higher. Down the road, the market probably will want those rates to be much, much higher. If so, the ultimate lenders are going to take huge losses, as the interest rates they pay to keep these mortgages in portfolio will exceed 5 percent.

Who will bear these losses? As taxpayers, we will.

I’m no expert on the default risk on these securities, but I’d like to make one observation about interest rate risk, which is the subject of Kling’s remarks.  He is of course correct in noting that if rates rise sharply, the value of the Fed’s MBS portfolio will drop sharply, and ultimately the taxpayers will bear the cost.  I would add, however, that by far the strongest determinant of long term interest rates is the level and growth rate of NGDP.  Rates tend to be low when NGDP is falling, or is rising from a very low level (like right now.)  In my view the sort of macroeconomic environment that would produce much higher interest rates would also produce a robust recovery in the economy.  If we abstract from default risk, and consider Treasury bonds for instance, the worst thing that could happen would be if the Fed made a large profit on the T-bonds it accumulated in the so-called QE program.  That would indicate that long term rates had fallen to Japanese levels, and that for every dollar the Fed gained in higher asset prices, the Treasury was losing $10 in lower tax revenue and higher unemployment and welfare payments.

This is not to excuse the Fed for its purchases of MBSs.  I’d rather they would buy enough ordinary Treasuries to boost NGDP very sharply.  That’s the best way to help housing.  Trying to micro-manage specific sectors almost never works.

Part 3.  Tim Duy; devil’s advocate

Tim Duy has also been a critic of the Fed’s passivity in the face of a severe recession.  In this post he tried to play the devil’s advocate and look at things from the Fed’s perspective.  I think he makes a lot of excellent points, but I want to comment on this assertion:

We need to see sustained growth at more than twice that rate to bring unemployment quickly down to acceptable levels.  But there is simply no faith that such a feat can be achieved.  Most doubt there is sufficient pent up demand in the consumer to do the job, while Calculated Risk has repeatedly stated the case against a quick rebound in housing.  With fiscal stimulus set to slow, that leaves investment and the external sector to big up the slack – neither of which packs the weight of the consumer.  Consequently, the Fed can hold policy steady on the back of the current forecast, which lacks the post-1982 surge.

This is a fairly standard Keynesian approach to evaluating the prospects for a rise in AD.  I read similar things every recession.  But do you recall the phrase “it’s darkest just before the dawn?”  In almost every single recession things look bleak right before a rapid recovery occurs.  If you are deep in recession, and consumers are suffering massive job losses, you’d naturally expect sluggish consumer spending going forward.  The same would be true of business investment, as factories have excess capacity.  I grant you that housing is one area where we are worse off than usual.  In past recessions low rates have sometimes led to an early recovery in that sector.  But I still maintain that this approach to AD is wrong.  It seems to look at AD as a real variable, a collection of sectoral demands that must be added together.

The fastest AD growth in US history probably occurred between March and July 1933, when by all accounts no sector of the economy should have been doing well. We had 25% unemployment.  Where was all that AD going to come from?  Now instead of thinking of AD as a real variable, think of it as a nominal variable; NGDP.  And think of monetary policy (broadly defined as MV, not just M) as the driving force behind AD.  Then the only question is whether or not when NGDP grows rapidly (as it did after March 1933), the growth is prices or output.  It was mostly output in the spring of 1933, and I expect it would be today as well.

In the end I agree with Tim Duy’s conclusion that the recovery will muddle along at a slow rate.  After today’s drop in unemployment I am a bit more optimistic than last night.  But I think the real AD approach (C+I+G+NX) obscures the transmission mechanism of monetary stimulus in a deep recession, leading the casual observer to think more G is the only answer.  If people did draw that conclusion, it would be unfortunate.  At the same time I do understand the appeal of this approach.  Remember I am also a teacher.  I know how easy it is to explain ideas like the expenditure multiplier to students, and how hard it is to get them to grasp the essence of monetary economics–that people’s attempts to get rid of excess cash balances drives AD higher, even if you cannot see the effect in your own behavior.

Part 4.  Brad DeLong solves the age-old problem of estimating crowding out.

Many researchers have tried to estimate the extent to which government expenditures crowd out private expenditures.  We basically know that the crowding out is roughly one for one if at full employment, and also if the central bank has some sort of nominal target, such as inflation.  In other cases it is hard to tell.  As you know I am skeptical of the estimates for all sorts of reasons.  But as David Henderson points out, DeLong basically ignores the ceteris paribus problem in his criticism of a recent post by Steven Horwitz.  Here is Henderson making the sort of comment I had planned to make:

If wages are not falling, then that well could be due to extension of unemployment benefits and some of the additional spending in the stimulus package. DeLong has arbitrarily chosen zero real-wage increase as his baseline. But in a readjustment, what Arnold Kling calls a recalculation, there’s a case to be made for some real wages to fall. At those lower real wages, some of the currently unemployed would be employed. Those jobs that aren’t created, therefore, are a cost of the stimulus package. No one, including Steve Horwitz, claimed that there was a one for one. So the jobs not created by the private sector are indeed a cost of the stimulus package.

I was going to make a similar point about both wages and interest rates.  If DeLong’s evidence was really as definitive as he claims, then the whole crowding out debate should have been resolved long ago.  Just look at wages and interest rates!  They tell us everything we need to know.  No need for messy multiple regressions. 

I’ve never met Mr. Horwitz.  But when I saw him insulted in DeLong’s headline, I knew he must be a fine economist.  One of my proudest days was when DeLong treated me in the same way he treats distinguished economists like Fama and Cochrane.  I still proudly display the post on my office door.  “Scott Sumner simply loses his mind.”

PS.  If you ever forget DeLong’s blog address, just Google ‘Scott Sumner loses his mind.’  It will take you right there.

The EMH; reply to my critics

Bryan Caplan asks the following question:

My main complaint: Scott’s still not buying my simple modification that makes the EMH far more plausible.  It’s pretty obvious that investors’ mood swings matter a lot.  Why not just say that their mood swings are yet another important hard-to-predict variable that the best minds in the world struggle to forecast?

I’m not convinced mood swings are as obvious as they might seem.  I’ve argued that the stock market crash of 1929 was a rational response to the sudden awareness that we were rushing headlong into Depression.  I wonder if that stock market crash was one of those examples where Bryan thinks it’s “obvious” there was a mood swing.  Even if Bryan doesn’t believe that, I’d estimate about 99.9% of historians do look at the crash that way.  But they are wrong, as they don’t understand the underlying fundamentals driving AD.

Just to show I’m not being dogmatic, I admit that the 1987 crash is much harder to explain, so perhaps a mood swing did occur.  Does this violate the EMH?  Not as long as the mood swings are unpredictable.  But it is hard to claim that mood is unpredictable.  That would mean that it followed a random walk.  But variables that follow a random walk tend to eventually drift off toward infinity or negative infinity.

I am pretty sure that most people who believe in mood swings (including Bryan) have in mind some sort of mean reversion.  Think of 100 as a normal mood, and let higher numbers represent optimism and/or less risk aversion, while lower numbers represent pessimism and/or high risk aversion.

Now suppose the mood index hit 120 right before the 1987 stock crash, and bottomed out at 85 after the crash.  If people could observe current mood levels, the fact that there was some mean reversion would make future movements somewhat predictable.  And that would violate the EMH.  You might ask “Then why do I believe in the EMH?”  The answer might surprise you.  If events like the 1987 crash happened frequently, I would not believe in the EMH.  I think 1987 is a real problem for the EMH.  Even the 2000 bubble had at least the excuse of the massive uncertainty about the future prospects of the internet companies as a plausible explanation for some of the excesses.

Update:  Oops.  The first commenter below (OneEyedMan) pointed out that this is not correct.  It would not violate the EMH, as the changing expected return in 1987 (as stocks fell) would properly reflect the changing level of risk aversion.  So it looks like Bryan was more correct than I thought.  I think at some point we may enter deep metaphysical discussions of what the term ‘efficient’ means, in a world of investors as moody as 14 year old girls.  But since I’ve already made one silly error, I won’t hazard a guess right now.  End of update.

My other problem with Bryan’s argument is that if mood were truly unpredictable, then the EMH would not have to be modified.  Rorty said “that which has no practical implications, has no philosophical implications.”  If mood was a random walk, it would serve precisely the same role as randomly time-varying risk aversion.   It would be observationally equivalent.  But the EMH already allows for time-varying risk aversion.  (Actually I’ve never taken a finance course, so I don’t know that.  Let me rephrase that; the version of the EMH that I believe in allows for random time-varying risk aversion.)

Part 2.  What about those who did see the crisis coming?

Good for them!  That’s been my answer in several comment sections.  This relates to a post by Adam Ozimek:

I think this is part of the reason Sumner is frustrated by the anti-EMH crowd:  he isn’t distinguishing between those that identify profitability as sufficient proof from those who don’t, so he is faced with some people arguing that “people reliably profit off of bubbles, therefore EMH is false!” and others arguing that “market irrationality prevents reliably profiting off of bubbles, and EMH is still false”. There may be people who hold both of these contradictory points at the same time, and they are wrong. But the existence of two separate arguments against EMH that happen to contradict each other is not evidence against either theory or for EMH.

That’s a good point, and my post was meant sort of half jokingly.  I understand that the two complaints are logically distinct, and somewhat in conflict.  My point was more to show the difficulty with debating the anti-EMH crowd.  No matter what happens in the natural experiment performed by LTCM, it will be viewed as a defeat for the EMH by a sizable contingent of the anti-EMH crowd.

But he also raised another issue that is more serious:

Take Calculated Risk, for instance. He clearly and specifically identified the housing bubble using his extensive knowledge of the entire housing industry- from realtors to securitizers. Are we really going to demand that he identify the next bubble in gold, oil, Beanie Babies, or some other market he knows nothing about until we accept that he identified the housing bubble? I see no reason to expect this to be true. Nor do I see any reason to expect that all bubbles be equally identifiable. Using Sumner’s criteria, I’m not sure how you tell the difference between a world in which 1/5 bubbles are identifiable and a world in which 0/5 bubbles are identifiable.

I have actually made two separate arguments regarding the people who have become famous forecasters (Roubini, Calculated Risk) or famous investors (Soros, Buffett.)  I believe that group includes people who are both lucky and also people who actually did in some sense beat the market, or forecast something that the market as a whole missed.  But this is important, it is almost impossible to distinguish between the lucky and the smart.  As a result, their forecasts don’t have practical implications for ordinary investors, for public policymakers, or for social scientists like me.  They are flukes.  If they did it reliably we could simply observe where they invested, and mimic their stock investments.  Soros has even written accounts of his strategy.  Does anyone think I would do as well as he did if I read his explanation?

I hope I don’t botch this, as I am relying on memory.  But a commenter named 123 recently sent me a recent article by French and Fama that I think perfectly encapsulates what I am trying say.  Years earlier, some studies showed that the excess returns of mutual funds are not serially correlated.   These studies seem to me to be almost the only reliable test of the EMH that I have seen.  Other studies done by people like Shiller just strike me as data mining.  In any case, if markets could be beaten by smart investors, then mutual funds run by above average managers should do better on average.  Not every year, but on average.  This means that excess returns should be serially correlated.  But they aren’t.  The successful investors during one year tend to just do average the next, suggesting it was all luck.

Recently Fama and French took a closer look at the data, and found evidence that if you just looked at the top few percentiles, above 97%, there did seem to be a bit of serial correlation.  But even in that group there are also some funds that were lucky.  Interestingly, I am pretty sure that they found that if you could identify which of the top 3% were smart, and not just lucky, you could slightly beat the market.  But if you invest in all funds in the top 3%, you will get a mixture of skilled managers and lucky managers, and you won’t be able to beat an index fund (which has lower expense ratios.)  Odds are I’ve at least slightly misinterpreted their findings.  If so, someone let me know and I will add an update as soon as possible.

So for me the bottom line is that the EMH is not literally true, indeed no model in the social sciences is precisely true.  There are probably occasional mood swings like the 1987 crash, which set up at least slightly forecastable mean reversion.  And there are probably a few people who do on occasion see things the market misses, but they are hard to identify.  In the end, the EMH is still useful for ordinary investors, regulators and social scientists.  But I hope pundits like Calculated Risk and Nouriel Roubini will keep looking for bubbles on the assumption the EMH is not true, and I hope investors like Buffett and Soros will continue assuming the EMH is not true, so that they can help make it more true (or more useful, if like me you deny objective reality.)

I don’t have the copy at home, but I just finished reading Tyler Cowen’s book on globalization and culture.  I seem to recall that he ended the book arguing that us cosmopolitans can only enjoy sampling from a rich and diverse global environment if many segments of the world’s population refrain from cosmopolitanism, but instead impose constraints on people that generate distinct local cultures, and their associated artistic achievements.  The EMH is like that, perhaps Cowen made the connection himself.

Update 2/7/10:  Commenter 123 just sent me the following:

Fama&French study Scott mentioned is really great, you can see it here:
But they did not study autocorrelation of excess returns there. Their approach was to have a Monte Carlo simulation of distribution of lifetime fund returns where no funds have alpha, and to compare that simulation with a distribution of actual lifetime mutual fund returns.

People might also want to check out his blog, as he knows far more about the market efficiency literature than I do.  And he often disagrees with me.  So you will get a different perspective.

It’s October 1931

We are now more than two years into the Great Recession, which began in December 2007.  In the Great Depression, this was the point where the Fed decided to raise interest rates to keep the dollar from depreciating (after Britain left the gold standard.) 

Mr.  Bullard of the St. Louis Fed wants to see “at least one month of positive jobs growth” before raising rates.  Maybe it will come out tomorrow, but stocks fell sharply today on worries that the recovery is sputtering out:

NEW YORK (AP) — Stocks buckled Thursday under the growing belief that the global economy is weaker than many investors expected and is likely to stop the U.S. labor market from rebounding in the coming months.

.   .   .

The drop was similar to stumbles the market began having in mid-January. Stocks fell then in response to China’s attempts to curb its overheated growth. Those moves raised fears that the other world economies could suffer as a result. The pullback in stocks worsened as leaders in Washington said they would impose tighter regulations on U.S. banks.

So stocks crashed because investors are worried about Chinese moves to curb demand, and tighter regulation of the banking system.  Interestingly, Krugman has recently been calling for a higher value of the yuan (which is a deflationary policy for China) as well as tighter regulation of the banking system.  He also favors tariffs on big carbon emitters (i.e. China.)

I still think we will avoid an outright double dip (or perhaps I should say that I infer that the markets think this will be avoided, as I don’t do witchcraft.)  But I am increasingly worried about the Japanese scenario (which to his credit, Krugman has repeatedly warned about.)  The CBO just put out an estimate of 2.8% NGDP growth in 2011.  There is no way to overstate how depressing that number is.  During the recovery from the 1981-82 recession we had roughly 10% nominal growth for much of 1983 and 1984.  The normal NGDP growth rate has been just over 5% in recent decades.  In this recession we fell about 8% below that trend, and could now use some rapid catch-up.  Instead, we may fall even farther behind trend. 

Why does any of this matter?  Consider the following from a study of the Great Depression:

We find that, once we have controlled for lagged output and banking panics, the effects on output of shocks to nominal wages and shocks to prices are roughly equal and opposite.  If price effects operating through nonwage channels were important, we would expect to find the effect on output of a change in prices (given wages) to be greater than the effect of a change in nominal wages (given prices).  As we find roughly equal effects, our evidence favors the view that sticky wages were the dominant source of nonneutrality.

Let me explain what Steve Silver and I did when we studied the Great Depression.  We regressed (differences of logs of) monthly industrial production on monthly wholesale prices and nominal hourly wages.  We found higher prices had a positive effective, and higher nominal wages had a negative effect of a similar magnitude.  So it looks like real wages were the problem.  You can get higher real wages through deflation (for a given nominal wage) or through higher nominal wages (for a given price level.)  Either way you get high unemployment.

Actually I tricked you.  The quotation above does not come from the time series paper with Steve Silver that I just described, but rather from a different paper that looked at cross-sectional data for many different countries during the Depression.  Isn’t it interesting that they got almost the same findings, using a completely different technique.  BTW, the authors of the paper I quoted were Kevin Carey, and . . . some fellow named Ben Bernanke.

Late last year I expressed a lot of concern about how difficult it was going to be to get all workers to accept pay cuts that put them 8% below their previous trend line, assuming that NGDP doesn’t fully recover but rather starts a new 5% growth rate from this point forward.  I pointed out that NYC teachers, for instance, were about to get a 4% raise negotiated way back in 2005.  Little did I imagine that even 8% adjustments wouldn’t be enough.  Faster than 5% NGDP growth would allow us to get back to a reasonable unemployment level without painful and prolonged wage cuts.  Instead they’re estimating only 2.8% NGDP growth in 2011.  So after a painful round of wage cuts workers can look forward to  . . .  even more painful wage cuts.

I’m not a leftist, but if I was a conspiratorial leftist I would attribute today’s stock crash to investors waking up to the fact that the pain was spreading beyond the labor markets.  Here’s what a left-wing Sumner would assume was going through the mind of investors :

“For a while we had the economy in a sweet spot.  It was depressed enough to keep labor and other inputs really cheap, but at least we could look forward to steady 5% NGDP growth going forward.  Yeah, workers were suffering, but corporate profits were doing alright.  But now the hawks at the Fed and ECB and BOJ have gone too far.  If NGDP growth slows further, it won’t just be workers suffering; there won’t even be enough revenue to underpin higher corporate profits.  And now the Chinese are even tightening.  China; the one bright spot in the world economy during 2009!  And I just read that the ‘Davos men’ are pressuring China to adopt the Hoover/Mellon strong currency policies.  If the China recovery sputters out, who’s going to be the engine of the world economy?  I’m all for conservative policies, but not so conservative we end up in a depression.”

I’m not saying that’s what happened on Wall Street recently; just saying a left-wing version of me would entertain that hypothesis.

Part 2. Krugman wants a stronger yuan

Paul Krugman is again attacking the weak yuan policy, using a zero sum exchange rate model that takes no account of how the policy impacts world aggregate demand.  But Krugman is not a vulgar protectionist.  In the past he carefully noted that the weak yuan would not hurt the US if interest rates weren’t stuck at zero.  Normally, the Fed could ease policy to offset any negative effects on AD.  Instead, he only seems like a vulgar populist because he has a special “depression economics” model that allows for all sorts of unsavory policy advice once rates hit the zero bound.  Unfortunately, he is still wrong for three different reasons. 

1.  Start with his assumption that currency adjustments are a zero-sum game.  If that were true, and it’s not, then the weak yuan should help China and hurt the US.  Yes, some other poor countries might also be hurt, but they could offset the effect via devaluation.  In contrast, the US and Europe cannot easily devalue without triggering all sorts of international tensions.  But even if this view is right, his advice to the Chinese is wrong.  China has 1.35 billion mostly poor people.  The US has 310 million mostly affluent people.  A good liberal like Krugman should argue for a weak yuan, as the Chinese need the money much more than we do.

2.  The second thing wrong with Krugman’s argument is that (unless he has become a vulgar protectionist in the last few weeks) he himself notes that it only applies to a situation where the Fed is powerless to boost AD.  But even Krugman admits that they aren’t powerless right now.  They could set a higher inflation target.  They simply don’t want to.  So now he wants to impose hardship on millions of poor Chinese workers in export industries because our own Fed (and ECB) are too lazy to lift a finger to boost NGDP growth in the US.  Indeed they are just itching to tighten policy further.  So even if Krugman isn’t a utilitarian liberal like me, even if (unlike me) he doesn’t care more about the poor in China than the middle class in America, it’s still a bad argument, as the solution isn’t a higher yuan, it’s unconventional monetary stimulus in the US.

3.  But it’s even worse than that.  Because even if Krugman doesn’t care about the Chinese, and even if you assume the Fed is powerless, a stronger yuan is still a bad policy.  Why?  Because money isn’t a zero-sum game.  Currency policies are also monetary policies.  A stronger yuan is a deflationary monetary policy.  A weaker yuan is expansionary.  Krugman has spoken highly of FDR’s bold expansionary policies undertaken when he took office, even citing a 2008 AER paper by Eggertsson.  But the FDR policy that was far and away the most influential at boosting inflation expectations was dollar devaluation.  That’s right; he praises his hero FDR for pursuing exactly the sort of “beggar thy neighbor” policy that he wants the Chinese to stop doing.  Just to be clear, I understand that China has begun growing briskly again and that at some point they will need to start appreciating the yuan again to prevent overheating.  But Krugman was certainly wrong about the yuan in 2009, when China experienced deflation.  And the recent stock plunges all over the world, which seemed to follow the Chinese decision to tighten policy in January, should be a shot across the bow of those who want to tighten prematurely.  Krugman quite rightly points to the errors of 1937, when the US tightened policy during a period of rapid growth, but also a period when neither the US nor world economy was yet out of depression.  Let’s not make the same mistake again.  There’s plenty of time to tighten policy when things get a bit better.  If the Chinese recovery is real then by late 2010 a higher yuan will probably be appropriate.  But it is too soon to tighten now.

If China slows, our recovery will also be threatened, regardless of the fact that US exports to China are relatively modest.  China affects the entire world economy.  It has a huge effect on East Asia, on Australia, even on capital goods producers in Germany.  If the entire world economy slows, it will affect the US. 

And the effects are not just from exports, that’s more zero-sum thinking.  It will lower the world Wicksellian real interest rate, and that will drag central banks deeper into a Japanese-style liquidity morass.

I hope I am just overreacting to the stock market tonight (it fell 3.1%), and that we get a “strong” jobs number tomorrow.  (These days ‘strong’ would mean 10% unemployment, and a few hundred jobs gained after 8 million lost.)  But please, let’s err on the side of recovery.  I haven’t even talked about all the other problems with slow NGDP growth—more banking problems, debt crises in Southern Europe, and lots more.  Those who have studied the Great Depression know about all the ugly side effects.  And how about this Gideon Rachman’s description of the “best and the brightest” who represent us at Davos:

With the Americans and the Europeans experiencing a crisis of confidence, Davos man was keen to learn from China this year. American businessmen could be heard ruefully contrasting their own “dysfunctional” political system and flaky politicians with China’s decisive and meritocratic leadership.

Oh yes, China has strong leaders who can make the high speed trains get built on time.  Wish we had a leader like that here.  Our businessmen made many similar comments during the 1930s, but not about China.

Heads I win, tails you lose

The commenter 123 sent me a link to an article by Andrei Shleifer, which argues that markets aren’t efficient.  Before quoting Shleifer, a bit of background on the EMH.

The efficient market hypothesis implies that it should be very difficult to beat the markets, as asset prices should already reflect all publicly available information.  Many people found this hard to accept; surely really smart people are better investors than the average schmuck!  Not surprisingly, the very smartest people of all, including not one but two Nobel Prize-winning finance professors, gave in to temptation and joined a hedge fund that was set up to find market anomalies and to make investments that took advantage of the market’s inefficiencies.  That hedge fund was called “Long Term Capital Management.”  Of course anyone who has read ancient Greek tragedies knows what happened next.  Things didn’t work out quite as well as planned.  LTCM went bankrupt, and had to be rescued by a cartel of banks assembled by the Fed.

You might think this would lead the anti-EMH forces to give up their fruitless quest for the finance equivalent of the Holy Grail, the fountain of youth, or Prester John’s Kingdom.  The search for the hidden “intrinsic value,” that diverges from the vulgar market value.  You would be wrong.  The anti-EMH forces are stronger than ever.  But here is something I never would have expected.  The failure of LTCM, a firm founded and run on the premise that the EMH was wrong, actually shows that .  .  . the EMH is wrong!

A shrewd investor who noticed, for example, that in the summer of 1997, Royal Dutch traded at an 8% to 10% premium relative to Shell, would have sold short the expensive Royal Dutch shares and hedged his position with the cheaper Shell shares. Sadly for this investor, the deviation from the 60-40 parity only widened in 1998, reaching nearly 20% in the autumn crisis.  This bet against market inefficiency lost money, and a lot of money if leveraged.

In this case, it is said that when Long Term Capital Management collapsed during the Russian crisis, it unwound a large position in the Royal Dutch and Shell trade. Smart investors can lose a lot of money at the times when an inefficient market becomes even less efficient. In fact, as the
LTCM experience illustrates, their businesses might not survive long enough to see markets return to efficiency.

The inefficiency in the pricing of Royal Dutch and Shell is a fantastic embarrassment for the efficient markets hypothesis because the setting is the best case for that theory. The same cash flows should sell for the same price in different markets. It shows that deviations from efficiency can be large and persistent, especially with no catalysts to bring markets back to efficiency. It also shows that market forces need not be strong enough to get prices in line even when many risks can be hedged, and that rational and sophisticated investors can lose money along the way, as mispricing deepens.

You have to be impressed by the resourcefulness of the anti-EMH, crowd.  If LTCM and its merry band of Nobel-Prize winning economists had actually beat the market, if they had used market anomalies to get rich, well then it would have been the death knell of the EMH.  Every time Fama said “if you’re so smart how come you’re not rich,” people would have responded that Scholes and Merton did get rich by spotting market inefficiencies.  Instead they failed miserably, and this shows . . . it show that markets are inefficient because the market can stay irrational longer than you can stay solvent.

The more I study the psychology of the anti-EMH crowd, the more surprised I am that anyone still believes in the EMH.  It seems like anything that happens undercuts the EMH.  It reminds me of people who see monopoly everywhere.  High prices?  Clearly monopolistic exploitation.  Low prices?  Ah, that’s predatory pricing.  The same price as your competitor?  Obviously price fixing.

OK everyone, tell me where I’m wrong.  What outcome of LTCM’s bet on Shell Oil would have supported the EMH?

PS.  I don’t know enough about Dutch corporate law to comment on the specifics.  Is there any possible state of the universe that might cause the agreement between Royal Dutch and Shell to break down at a future date?  If so, it would seem to me that Shleifer’s example is invalid.

PPS.  After I wrote this I came across this excellent book review by Eric Falkenstein.  I should just stop discussing the EMH and reference him from now on.

A solution without a problem

From the time of the big bang, up to the middle of 2008, there has never been an example of a central bank that tried to create inflationary expectations, but failed.  But what about last year?  When Brad DeLong asked Bernanke why the Fed did not try to create 3% inflation expectations, Bernanke answered that it was a bad idea.  So I don’t think it’s going out on a limb to assume that the Fed is not trying to create inflation expectations.  So the universe’s perfect record still seems intact, no central bank has ever tried but failed to create inflation expectations.  And Chris Sims seems to agree with me:

A bank that has never in the past announced target paths for the inflation rate or its policy interest rate will have much more difficulty if it tries to begin announcing target paths for inflation for the first time when it hits the ZLB. If (as in the case of the US Federal Reserve) it tries to announce paths of the interest rate without any accompanying target path for inflation, the situation is likely to be even worse. The point of the announcement of a commitment to sustained zero interest rates is to generate expectations of increased inflation. Particularly if there is no history of connecting interest rate paths to target inflation paths in inflation reports, the public is likely to be uncertain how to translate beliefs about future interest rates into beliefs about inflation. Indeed, if the bank (like the US Federal Reserve) is reluctant to accompany its stated commitment to sustained low interest rates with an open discussion of its desired path for inflation and of the risk that inflation will temporarily go above target, the public might rationally perceive that the historical commitment to a ceiling on inflation visible in past policy is likely to trump an announced commitment to sustained low interest rates. In this case, the announced interest rate commitment will of course be ineffective.

I mostly agree with Sims, particularly the last line of this quotation.  An interest rate target might make it harder to create inflation expectations.  Instead, you need an inflation target (or NGDP, as I prefer.)

Is it possible that a central bank’s commitment to inflate might not be believed?  Perhaps, if it used inflation targeting.  If it used a price level target I wouldn’t worry about credibility.   But either way aren’t we spending a lot of time and effort modeling a hypothetical problem that has never occurred and probably never will occur?  Especially given the very real problem that monetary policy is now so tight that we are wasting hundreds of billions in fiscal stimulus in a futile effort to accelerate NGDP growth.  That’s a real problem; in the US, in Japan, and in Europe.

HT:  OGT and Mark Thoma.

BTW, I argued in the previous post that the Fed neutralized the fiscal stimulus.  Matt Yglesias recently linked to that post and made this comment:

I think maybe you need an academic’s confidence in his own theories to accept this as a reason to have avoided stimulus back in early 2009. As either a blogger or a policymaker, I’m more comfortable with the idea of joint fiscal and monetary measures to fight a downturn.

I’ve addressed this issue several times, but newer readers may not have seen my response.  So here it is one more time.

1. The point is not to stabilize inflation (or NGDP, which is what I prefer) rather the point is to stabilize expectations of inflation or NGDP.  And that is much less chancy than it seems.  Take inflation as an example.  If the Fed wants 2.5% inflation expectations, it can keep pumping money into the economy until the 12 month TIPS spread is somewhere between 2% and 3%.  The circularity problem will keep this from working perfectly, but it will allow you to avoid large errors.

2.  Stability in inflation or NGDP growth expectations are actually what we care about.  As long as expectations are anchored, any transitory movements in actual inflation or actual NGDP will have little effect on employment.  That’s why Katrina was such a tiny blip on the macro radar screen, despite disrupting Gulf of Mexico oil production for months.  It had almost no impact on 12 month forward NGDP forecasts, and hence firms had little reason to lay off workers.  What you need to avoid at all costs is a situation like late 2008, when 12, 24, and 36 month forward price level and NGDP expectations plunged sharply.  This dramatically depressed the prices of assets (stocks, commodities, real estate.)  When you combine sharply falling asset prices with sticky wages, you are asking for high unemployment.  And conservatives are wrong if they think wage cuts can easily solve the problem.  Even in an economy like ours, where unions are weak, there is far too much wage stickiness to expect employment to hold up during a severe deflationary shock.  Better to keep expectations anchored.  That will keep you out of a macro environment where wage cuts are needed to restore employment.