Paul Krugman has an excellent post discussing why stock prices are relatively high.  Apart from the opening paragraph, where he (implicitly) dismisses the EMH and rational expectations, I almost entirely agree with his interpretation.  (OK, the last bit defending Obama is also a bit questionable.)  I have expressed similar views, although of course Krugman expresses his ideas in a much more elegant fashion.  David Glasner was critical of this observation by Krugman:

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

Here’s how David responded:

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

First let’s be clear about what Krugman means by “investment spending” in the quote above.  He clearly does not mean the dollar volume of investment spending, in equilibrium, because equilibrium quantities cannot “cause” anything, including low interest rates.  Instead he means the investment schedule has shifted to the left, and that this decline in the investment schedule (on a savings/investment diagram) has caused the lower interest rates.  And that seems correct.

Unfortunately, Krugman adds the phrase “despite low short-term interest rates”, which only serves to confuse things. Changes in interest rates have no impact on the investment schedule.  There is nothing at all surprising about low investment during a time of low interest rates, that’s normally the relationship we see.  (Recall 1932, 1938, and 2009).

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

I’d also like to respond to David’s criticism of the EMH:

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

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

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

David concludes his post as follows:

Thus, an increasing share of total investment has become capital-deepening and a declining share capital-widening. But for the economy as a whole, this self-fulfilling pessimism implies that total investment declines. The question is whether monetary (or fiscal) policy could now do anything to increase expectations of future demand sufficiently to induce an self-fulfilling increase in optimism and in capital-widening investment.

I would add that the answer to the question that David poses is clearly “yes”, as the Zimbabweans have so clearly demonstrated.  I would rather avoid terms like “self-fulfilling pessimism”, as AD depends on monetary policy, or combined monetary/fiscal policy is you are a Keynesian.  Either way it don’t think it’s useful to view AD as depending on the expectations of investors, pessimistic or not.  Those expectations merely respond to what the policymakers are doing, or not doing, with NGDP.

PS.  Yes, I do understand that under certain monetary policy stances, such as a money supply or interest rate peg, exogenous expectations impact AD.  I just don’t think it’s useful to view those pegs as a baseline policy.

PPS.  Let me repeat what I said earlier, we are going to have an interesting test of the impact of uncertainty on (British) GDP, over the next few months.  Not a definitive test (which would require observations with and without NGDP targeting, to tease out AD vs. AS channels), but certainly a suggestive test.  I have an open mind at this point, and am eager to learn.

In two recent Econlog posts (here and here), I pointed out that a wise man or women should always have two levels of belief.  One is their own view of things, independently derived from their own research.  This is the view from within your skin.  The second level of belief is the awareness of the wisdom of crowds.  The awareness that an index fund is likely to do better than a fund that you personally manage. An awareness that the consensus view of the true model of the macroeconomy is likely to be better than your own model of the economy.  This is the view from 20,000 miles out in space, where it’s clear that you are nothing special.

In the comment section, Philo suggested:

In most things, you’re admirably sensible (insightful, etc.). In philosophy . . . well, better stick to your day job!”

He likes my market monetarist view of things, but not my philosophical musings.  But you can’t have it both ways.  If my philosophy is wrong then my market monetarism is equally wrong.  Either the wisdom of the crowds is true, or it isn’t.

(As an aside I’m aware that the wisdom of the crowds might be slightly better if the views are weighted by expertise, but that has no bearing on my claim.  Even if you think I have a bit more expertise that the average economist, the entire weighted sum of non-Scott Sumner economists is, objectively speaking, far more qualified than I am.)

In this blog I am normally giving you my views on the optimal economic model from the “within the skin” perspective, because otherwise I am of no use to society.  I’d be just a textbook.  In contrast, I give you my views on where markets are heading from the 20,000 miles up perspective, because that’s the most useful view for me to communicate the intuition behind market monetarism.  You don’t care where I personally think the DOW is going, and you should not care.

It is the job of the economics profession to weigh my arguments, and the arguments of those who disagree with me, and reach a consensus.  That consensus is not always correct, but it’s the optimal forecast.  Unfortunately, at the moment the optimal forecast is that I’m wrong about monetary offset, but I’ll keep arguing for monetary offset because that’s the view I arrived at independently, and I’m of no use to society unless I report that view, and explain why.

When I talk to philosophers about epistemology, they often mention concepts like “justified true belief” which seems question begging to me.  I’m certainly no expert on the subject, but I can’t see how the EMH is not right at the center of the field of epistemology.  If back in 1990, we wanted to know whether there were Higgs bosons or gravity waves, the optimal guess would not have been derived by asking a single physicist, but rather setting up a prediction market.  Yes, traders know less about physics than the average MIT physicist, but traders know whom to ask.

Many worlds vs. Copenhagen interpretation? Perhaps it can’t be tested.  But if it could, then set up a prediction market.  Robin Hanson’s futarchy is a proposal to have public policy based on society’s best estimate of what is true—derived from prediction markets.  He wants us to vote on values and bet on beliefs.  Richard Rorty might go even further, and have us bet on values, where the outcome of the bet depends on a poll of values 50 years in the future.  Rorty would say values are no more subjective than science.

I think the EMH is basically what Rorty meant when he said truth is what my peers let me get away with.

PS.  My two types of beliefs do not have a rank order; they are incommensurable concepts.  Both are essential, and one is not more or less important than the other.  There’s no answer to “What do I really believe about monetary offset?”  I believe different things, at different levels of belief.

As I get older, I become increasingly interested in the mythological folktales that are believed by most economists.  For instance the idea that LBJ refused to pay for his guns and butter program, ran big deficits, and kicked off the Great Inflation.  All you need to do is spend 2 minutes checking deficit data on FRED to know that this is a complete myth, but apparently most economists just can’t be bothered.

During the 1960s, the budget deficit exceeded 1.2% of GDP only once, in fiscal 1968 (mid-1967 to mid-1968.  LBJ responded with sharp tax increases in 1968, and the deficit immediately went away.

The LBJ guns, butter and deficits story is too good to drop now, it’s in all the textbooks. It would be like admitting that the textbooks were wrong when they tell students that the classical economists believed that money was neutral and that wages and prices were flexible.  We can’t do that, it’s too confusing.

Another one I love is that monetary policy impacts the economy with “long and variable lags”.

I’ve talked about this before, but today I have a bit more evidence.  The idea that monetary policy affects RGDP with long and variable lags has three components, one or more of which must be true for the theory to hold:

1.  Monetary policy affects NGDP expectations with a long and variable lag.

2.  Changes in NGDP expectations affect actual NGDP with a long and variable lag.

3.  Changes in actual NGDP affect actual RGDP with a long and variable lag.

All three are false.  The third claim is obviously false; NGDP and RGDP tend to move together over the business cycle.  So the entire theory of long and variable lags boils down to the relationship between monetary policy and NGDP.

The first claim is also obviously false, as it would imply a gross failure of the EMH. Now the EMH is clearly not precisely true, but it’s also obvious that market expectations respond immediately to important news events.  Even EMH critics like Robert Shiller don’t claim that an earnings shock hits stocks two week later; it hits stock prices within milliseconds of the announcement. That part of the EMH is rock solid.  There is no lag between policy shocks and changes in expectations of future NGDP growth.

So the entire long and variable lags theory rests on the second claim, that NGDP responds with a lag to changes in future expected NGDP.  Unlike the first and third claim, that’s possible.  But it’s also highly, highly unlikely.  While we don’t have an NGDP futures market, the markets we do have strongly suggest that markets (and hence expectations) move with the business cycle, not ahead of the cycle.

Perhaps the best period to test this theory is the 1930s.  That decade saw massive RGDP and NGDP instability, which was clearly linked to asset price changes.  Put simply, the Great Depression devastated the stock market.  Here’s the correlation between stock prices and industrial production, from my new book:

The stock market is clearly not a leading or lagging indicator; it’s a coincident indicator.  And that’s not just true in the 1930s; it’s also true today:

The onset of the recession lines up, as does the steep part of the recession.  The stock recovery in 2009 did lead by a few months, but the recent slump in IP led stocks by a few months.  In any case, there are no long and variable lags; it’s basically a roughly coincident indicator when there are massive changes in NGDP.

If there actually were long and variable lags between changes in expected NGDP and changes in actual NGDP (and RGDP), then forecasters would be able to at least occasionally forecast the business cycle.  But they cannot.  A recent study showed that the IMF failed to predict 220 of the past 220 periods of negative growth in its members.  That sounds horrible, but in a strange way it’s sort of reassuring.

Suppose that the business cycle is random, unforecastable, as I claim.  And suppose that declines in GDP occurred one out of every five years, on average.  In that case, the rational forecast would always be growth.  As an analogy, if I were asked to forecast a “green outcome” in roulette, I never would.  Each spin of the wheel I’d forecast red or black.  I’d end up forecasting 220 consecutive “non-greens” outcomes.  And yet, there would probably end up being about 11 or 12 green outcomes during that period, and I’d miss them all.  A 100% failure to predict greens.  Because I’m smart.

Of course if there really were long and variable lags, say 6 to 18 months, then there would be occasions where the IMF would notice extremely contractionary monetary policy, and accurately predict recessions a year later.  I’m not saying they’d always be accurate. The lags are “variable” (a cop-out to cover up the dirty little secret that there are no lags, just as astrologers cover their failures with the excuse that their model is complicated, and doesn’t always work.)  No, they would not always be successful, but they’d nail at least some of those 220 recessions.  But they predicted none of them. And that’s because there are no lags.  Because recessions begin immediately after the thing that causes recessions happens.

That’s the message the markets are sending loud and clear.  But economists can’t be bothered; they have their comforting stories. Who can forget this line from The Man Who Shot Liberty Valance:

Ranson Stoddard: You’re not going to use the story, Mr. Scott?

Maxwell Scott: No, sir. This is the West, sir. When the legend becomes fact, print the legend.

In this year of Trump, it has become fashionable to sneer at things you don’t understand.  Like the EMH.  TravisV sent me an example from the normally sensible Joe Weisenthal and Matthew Klein.  It’s also a good example of why I don’t use Twitter.  Lots of snarky comments that make a person look smart, but on closer examination merely show that the writer is witty.

JP Koning pointed out that I viewed yesterday’s market reaction as supporting the claim that the ECB actions helped European banks.  Stocks rose on the announcement, and bank stocks rose especially sharply.  I stand by that claim. Then Joe Weisenthal responded:

Almost all of the gains to which Sumner is referring to in this post were erased by the end of trading.

That’s true, but completely irrelevant.  The problem here is that people don’t understand markets.  Equity prices are always moving around.  When you do an event study, what matters is the market response immediately after the announcement, not later in the day.  You may “feel bad” that the stock rally didn’t last, but markets aren’t about feelings, they are about cold hard facts.  In fact, if markets never reversed gains made early in the trading day, then the EMH would be entirely false.  A few weeks back I was sent an email by a guy showing that previous BOJ surprises were followed by additional gains in the days and weeks ahead.  Free money?  Nope, right after making that observation, the Japanese markets reversed, and lost more than the initial gain from the BOJ’s recent decision to go negative. It’s just one coin flip after another.

Matthew Klein responds:

LOL

Joe Weisenthal responds:

Sumner’s insistence on using snap market reactions to judge policy a success or failure is head-scratching.

I’m honored that Joe thinks I invented “event studies”—that this is all my peculiar idea, but there are actually thousands of academic event studies.  I’ve seen Paul Krugman favorably discuss the outcome of event studies.  Then this was added to the Twitter thread, by someone else:

Sumner’s view is unfalsifiable. He will now say that ECB did not do enough.

Actually, event studies are among the most “falsifiable” of all academic studies. But notice how misleading this is.  I actually did say the ECB needs to do more, but the commenter is giving readers the impression that I use that as an excuse for the decline in stocks later in the day.  That is completely false, as it would not be consistent with the EMH.  Yes, they need to do more, but my explanation for the decline in stocks later in the day was exactly the same explanation as the financial press provided. That’s right, publications like the Financial Times are apparently just as clueless as I am.  I wonder why Weisenthal doesn’t say, “The mainstream financial press’s claim that asset prices reversed later in the day on Draghi’s comment that no further rate cuts were likely was head-scratching”?  Perhaps he doesn’t know that this is what happened.

Asset markets are ruthlessly efficient.  If they were not it would be easy to get rich. Just sell European bank stocks short after the “irrational” stock price run-up following an ECB announcement. Indeed I’d guess that even EMH skeptics like Robert Shiller mostly buy into the idea that markets respond immediately to new information.  What reporters don’t understand is that the real world is messy. Asset prices change all the time.  The standard deviation of daily changes in stock price indices is about 0.8%, which it pretty big (or at least it was last time I looked–for the 20th century).  But the average change in any 10-minute interval is far smaller, so when you have a dramatic policy announcement, it’s often possible to see the market response–it really jumps out when you look at the data.  And when you have many such announcements and the markets almost always respond as monetary theory would predict, then you can be especially confident.

Here is what apparently happened over the last couple of days:

1.  Stocks rallied and the euro fell on the more stimulative than expected ECB announcement.  Totally consistent with what we know about monetary policy.

2.  Stocks fell sharply and the euro rallied on Draghi’s (perhaps misunderstood) statement at a press conference.  Again, totally consistent with what we know about monetary policy

3.  I don’t know why the markets reversed course again today, but James Alexander watches these things more closely than I do, and here’s what he reports:

There seems to have been a lot of public and private follow upon Friday from the ECB to reinforce their original, positively-taken, message.

“The European Central Bank embarked on a rearguard action to win over skeptical investors on Friday, a day after chief Mario Draghi unveiled a new stimulus package but blunted its impact by suggesting the ECB would not cut interest rates again.

A number of top ECB officials, both publicly and behind the scenes, spoke out in support of the measures Draghi announced on Thursday although some recognized the ECB had muddled its message to financial markets.”
http://reut.rs/1U6EeID

I have absolutely no idea whether that Reuters story is right or wrong, but it’s the sort of information that moves markets all the time.  And markets should react to that sort of information, if it sends signals about future policy intentions. I’m sorry it’s so complicated, but that’s the world we live in.

Unfortunately, not all policy experiments are perfectly clean.  In the old days you could look at fed funds futures prices, and then see if the Fed cut rates more or less than expected.  The event studies were highly reliable.  I admit that announcements are now somewhat more complex, but let’s not throw the baby out with the bathwater; they are still far better than any other method.  What’s the alternative, wait 6 months and see what happens to the macroeconomy?  Really? Like we know what the macroeconomy would have looked like if the decision had been a few basis points loser or tighter?  That’s ridiculous.

This skepticism about market efficiency was one cause of the Great Recession (Joe’s probably thinking “Good Lord, Sumner’s now blaming me for the Great Recession, he really needs to take his meds.”)  The Fed scoffed at market predictions of sharply lower inflation, right after Lehman failed.  The markets were right and the Fed blew it.

Markets may look crazy, but only in the sense that an extraterrestrial being that was 100 times as smart as you or I would seem crazy.  Asset prices move around all the time because the future is highly uncertain, and seemingly innocuous comments (like Draghi’s suggestion that no more rate cuts are expected) are actually very consequential.

If the ECB skeptics are correct, and market movements are just so much noise, then I must be hallucinating to claim I can connect any given market movement to a specific policy announcement.  OK, then take a look at the graph below, showing the value of the euro against the dollar, which is from Timothy Lee’s excellent Vox story on the day’s events.  Suppose you didn’t know what time of day the ECB made it’s initial announcement and also the time when Draghi said this was going to be the final rate cut.  Do you think you could guess, just from the graph?  Maybe I’m hallucinating, but I think I see a meaningful fall in the euro at about 12:45, and a big jump just before 2PM.  Gee, I wonder what those correspond to? It turns out the original ECB announcement was at 12:45.  And Draghi’s statement that it was the final rate cut was at 1:56:30—just before 2pm.   Huge market moves right after important new information.  What an astounding coincidence!!  After all, event studies are useless, right?  Asset prices are just random noise.

PS.  People are always telling me to get on Twitter.  This is a perfect example of why I prefer blogging.  You can have the sort of serious discussion in blogs that’s just not possible in 140 characters.

Today we saw not one, but two experiments on the impact of negative IOR on bank stocks.  In my previous post I pointed out that European bank stocks soared on a more expansionary than expected stimulus package from the ECB, including lower IOR and QE.

Shares in eurozone banks rallied sharply after the ECB announcement with Deutsche Bank up 6.5 per cent, Commerzbank up 4.9 per cent,Société Générale up 5.4 per cent and UniCredit up 8.2 per cent.

But how do we know that monetary stimulus helps the banks?  Maybe it was some other aspect of the package.  Fortunetely, we got another policy experiment soon after.  Again, here’s the FT:

The European Central Bank cut its benchmark interest rates to a new low and expanded its quantitative easing package, in a bolder-than-expected package aimed at boosting the eurozone’s flagging economy.

However, Mario Draghi, ECB president, played down the prospects of further rate cuts, swiftly reversing a sharp slide in the euro against the dollar.

They are talking about Draghi’s comments at the press conference afterwards, which suggested that further rate cuts were unlikely.  Big mistake.  And exactly as expected, European bank stocks fell on the contractionary announcement, wiping out the gains from earlier in the day.  You don’t get much better natural experiments than today.

I’ll say it again:  So do more!!