Krugman on high stock prices
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.
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18. July 2016 at 06:58
Consider also the role of investor expectation (or perhaps one should say unfulfilled desire) in the real economy, particularly that which lower income levels played until recently, in terms of real estate. These pictures tell the story:
http://marketurbanism.com/2016/07/14/your-town-is-a-financial-timebomb/
As the “middle” shifted towards higher and lower income levels, those higher income levels may have felt that owning “yesterday’s” real estate sends the wrong social signal – not the baby boomers who were willing to maintain these earlier structures, but a younger generations. As for the lower end of the income spectrum, how many wish they could still invest and maintain this older real estate, but no longer have the resources to do so.
As a result, the above pictures provide a visual of capital deepening as opposed to capital widening. About the only capital “widening” going on, is the required government setbacks in highway infrastructure.
18. July 2016 at 09:09
I see that there is more support that the decrease business investment is partially because tech companies don’t need to borrow for brick and mortar. This does make sense that this investment tends to shorter term (non-tech companies amortize say 3 – 5 years) and riskier which is limits many investment needs. This is reasonable for why interest rates remain low (along with low population growth) but it is probably to best to aware markets will change.
Although a Micro issue, The strangest aspect of tech business is how quickly new businesses become either failures or near Monopoly/Oliogopolies. With little of upfront capital (so automotive with factories) that the barriers to new entrants should not be a lot. (As a side point, the continued dominance of Silicon Valley fits this contradiction as well.) The only thing I can think most of tech is like the QWERTY keyboard that users really don’t like moving.
18. July 2016 at 09:50
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.
Can you describe which outcome(s) would most strongly suggest that your current beliefs are wrong? I’m not hoping that they are, I’m just wondering if we can somehow put a marker down now to compare with the future.
18. July 2016 at 09:52
There seem to be a number of major strains of EMH: (1) markets are correct, the price is right and (2) market prices are the best available estimates of underlying value and (3) it’s very difficult to beat the market.
“EMH says that asset prices are based on rational expectations of future fundamentals” seems to be closest to (2). Is that right?
18. July 2016 at 10:35
There are some strange opinions our there on the meaning of efficient.
“The efficient market hypothesis (EMH) is at best misleading in positing that market prices are determined by solid fundamentals.”
No.
“EMH says that asset prices are based on rational expectations of future fundamentals”
Better… but still No.
The EMH says that markets quickly adjust to new information.
18. July 2016 at 11:17
“The EMH says that markets quickly adjust to new information.”
How do they adjust? For example, does the adjustment bear any relation to the information and, if so, what is the relationship?
18. July 2016 at 13:08
Tom, I have a post on that, I’ll put up tomorrow or the next day at Econog.
Foosion, That’s right, as is the third option.
Doug, Both.
18. July 2016 at 15:34
EMH seems to work.
High asset prices suggest abundant capital.
Housing is a bit of an exception, as scarcity is artificial in many regions.
The solution is more demand and more housing.
Print more money build more houses.
18. July 2016 at 16:10
Sumner trots out the old “lack of AD” thesis, which is the most logical explanation, but another plausible scenario is that investment is down since in the future machines will do all the work. Google “post-scarcity economy”. Rates of return will go south if machines ‘do all the work’.
18. July 2016 at 16:42
Isn’t talk about “fundamentals” an attempt to smuggle in some notion of intrinsic worth? Surely, the point of EMH is that price is based on expectations given current acted-on information and that, given a certain market scale, information is acted on speedily.
That can reasonably give prices some momentum, as people economise on information-gathering by following what other folk do (which humans are primed to do, for good evolutionary/information-management reasons). The more so, the more supply-constrained a market is, because the less supply responses will be a factor for information change.
Talk of “fundamentals” seems to be an attempt to sort responses to information into “good responses” and “bad responses” based on some notion of a superior information standpoint that doesn’t actually exist.
BTW it is a pity, that EMH was not Information Efficient Markets (IEMH), because that would more accurately depict the kind of efficiency being postulated. Just as it is a pity Rational Expectations is not Consistent Expectations. Both are, after all, denials of the notion of some reliably information-superior point of view.
18. July 2016 at 16:44
Hey Scott, I am not even an economist and I said fear is not what is driving the bond market and I said without reading Krugman. But then Krugman contradicts himself by saying investors have thrown in the towel. Is that fear?
It is simple, Scott, bonds are in massive demand, and this is interfering with stimulus attempts and theories because the Fed no longer has the power to raise rates. This is why the Fed gave up on NGDP targeting. This is why the Fed will probably not allow helicopter money although it could be carefully controlled according to Eric Lonergan.
The Fed is dead, if bonds are in demand. Actually the Fed has completed its work, if bonds are in massive demand. It has nothing further to do in its own mind.
18. July 2016 at 17:04
Scott:
Regarding the statement that “equilibrium quantities cannot “cause” anything, including low interest rates”:
How do you categorize the Federal Reserve’s rollover of maturing treasuries? Does it constitute maintaining equilibrium quantities or increasing stimulus?
18. July 2016 at 19:23
I have a theory on why the modern economy needs less investment. With advances in technology, we actually need less resources per unit of GDP. However, there’s two areas we need a lot of physical capital, namely real estate and associated infrastructure in economically booming areas. And we cannot deploy capital because of red tape.
19. July 2016 at 04:03
Ray, if more machines will be used, then more machines will need to be produced, which requires investment. It is not obvious that this supply change will have any bearing on investment RATES.
If investment falls in nominal terms, then ceteris paribus, profits rise in nominal terms. The difference between investment and overall spending is profits. The difference here is between future and present goods. That means people’s time preference. What you are saying then is that with more robots in production, people will reduce their desires for goods as such. In other words, robots will represent an excuse or a means by which mankind will just sit back forever and be satisfied with a particular quantity of goods and less work.
In other words, it assumes there is a maximum desire in humanity for wealth as such, and robots will finally help us reach that maximum.
That assumes action effectively come to a standstill. What you are imagining is not an economics world, but a Marxist post-scarcity world where everyone is a debutante artist dabbling whimsically in whatever artistic pursuit is interesting for the day, while their material needs are more than covered.
It is your subconscious trying to find a final state of rest, of peace, and deriving pleasure from the idea of robots being our slaves.
19. July 2016 at 04:03
Expectations do not need to be rational for EMH to be valid. Whatever the expectations are the significance of EMH is no one has an advantage over the “market” in knowing what the price will be in the future. The practical application of EMH is that no one can reasonably act to take advantage of erroneous market pricing.
During the dot-com bubble it was rational to expect that the stock prices of many firms were going to end up much lower than what the market was currently bidding. However, it is was not a simple proposition to act on that belief. For while it was rational to label as overvalued a firm trading at 50 times current revenues, the market was pricing similar firms at 100 times current revenues! With bubble math any price was possible, no matter how irrational it seemed to be.
19. July 2016 at 04:08
Low investment in nominal terms of not a symptom of low AD.
This is because investment spending PRECEDES, both logically and temporally, output spending.
To claim that low AD causes low investment is to reverse time and the direction of causality.
Any time one is speaking of an environment of a particular AD, one has already presumed a particular investment that preceded it. To speak of low AD is to have already assumed a particular level of investment. We cannot infer what investment has been by what current AD is now. History is unique.
Sumner, you have been repeating the same falsehood for years, despite all available literature that explains exactly how and why it is false.
“I have an open mind at this point, and am eager to learn.”
No you don’t. You are not eager to learn that which refutes your intellectual investment.
19. July 2016 at 05:03
Offtopic:
I would love to know your opinion on this piece by Richard Koo at FT Alphaville on QE. I found it somewhat weird and don’t know what to make of it.
http://ftalphaville.ft.com/2016/07/19/2170198/koo-why-us-quantitative-easing-worked-better-than-other-qes/
From what I understand, Koo is saying that QE in the US worked better than Japan, UK and EU because US engaged in less austerity.
19. July 2016 at 06:03
America can never grow again robustly, because the Fed can no longer raise interest rates significantly to stop any inflation that gets out of hand. Heck, they can’t even raise rates insignificantly.
The banks and counterparties have invested, massively, in collateral bonds, and those cannot be allowed to lose value and those cannot be allowed to gain yield or the margin calls would ruin the financial system.
That is why Trump’s various plans for big growth are impossible. The financial system will not allow it. Surely Trump understands this one would think.
19. July 2016 at 07:44
So, price is lower than equilibrium, Scott. The clearinghouses are causing bond prices to rise, as demand exceeds supply. When will that end?
Equilibrium cannot be reached because bonds are in massive demand as collateral, Scott. Equilibrium doesn’t even matter anymore.
19. July 2016 at 08:35
Lorenzo, You said:
“BTW it is a pity, that EMH was not Information Efficient Markets (IEMH), because that would more accurately depict the kind of efficiency being postulated. Just as it is a pity Rational Expectations is not Consistent Expectations. Both are, after all, denials of the notion of some reliably information-superior point of view.”
Very good point.
I don’t know what “intrinsic worth” means, so I won’t comment on that. I see fundamentals as being the future cash flow.
Carl, It is more stimulative than not rolling them over.
BP, Yes, I’ve seen many people express that general view. I think it’s pretty accurate.
Anand, Not a fan of Koo. He’s wrong about austerity; we did more of it than the Eurozone during their double dip recession.
Gary and Dan, Do you guys even realize how far over your heads you are? You are nearly in Ray country.
19. July 2016 at 09:29
Scott, on the investment supply side, do you think demographics play a role in this? I’m thinking Chinese savings and 1st World Boomers being at peak lifetime capital.
On the demand side, I suspect an increasing amount of economic activity is rent, which while it inspires large capital transfers (when someone is purchasing the rental flow) doesn’t actually require capital on net, plus (as other commenters noted) the technological fact of nearly-costless scaling of digital business.
19. July 2016 at 09:30
Scott, you have yet to speak of massive bond demand. Until you do it doesn’t matter who is over or under their heads. You know that. You won’t address it. You are a cowardly monetarist. You can gain your courage back, but you will have to leave Oz to do so.
Face it Scott, massive demand for long bonds is pushing yield down the world over. The demand comes mostly from the need for ever better collateral. Sovereign bonds are the most highly rated of all collateral, higher than gold.
You forgot Scott, that the Fed is done, the Fed has its demand for bonds, so it is resting and ignoring NGDP and ignoring helicopter money and ignoring things that could improve interest rates, all because the bonds cannot be disturbed as to value. Too much is riding on their stability now.
The system is sick, but you won’t even address it. Don’t keep roaring if your courage is gone.
19. July 2016 at 12:01
@MF – “Ray, if more machines will be used, then more machines will need to be produced, which requires investment.” – no, no true. The Magic Kingdom is that you have low volume and low prices from a few machines (‘universal printers’).
” It is not obvious that this supply change will have any bearing on investment RATES.” – it’s not obvious, but it’s a fact. The obverse of inflation is deflation. If a universal printer can make tons of stuff (or just a few) for pennies, then ‘stuff’ in the future is dirt cheap, hence deflation.
20. July 2016 at 04:46
myb6, I agree with both of those points.
20. July 2016 at 05:09
Scott,
You are a funny guy. You claim it is a good point when Lorenzo explains that EMH is about the efficiency of information. Yet When I write “the significance of EMH is no one has an advantage over the market in knowing what the price will be in the future” you say I am in over my head. But what I wrote is the same as what Lorenzo wrote. The efficiency of information means that no one has an advantage at predicting future prices!
There is no law that says prices must be rational according to “fundamental” analysis. There is also no law that says that prices today are predictive of future prices – in fact the opposite is true: Past performance is no guarantee of future results. Herein resides one of the great paradoxes in your pursuit to tout markets as a monetary tool.
The financial press reports that airlines that hedged against oil prices are enduring significant losses on those hedges. The price airlines agreed to pay for oil in 2016 is much higher than the actual price. Question to you Mr. Sumner: If futures markets predict prices how can there be such a large disparity between the price airlines paid for future delivery of oil and the actual price of oil when that time period arrived?
What is true is that at the time the airlines purchased these contracts all available information indicated it was a fair price. No one had an information advantage in predicting what the future price of oil would be. And so it is with any futures market. Such markets provide a useful function to producers and consumers to hedge against an unknown future. Prices give a hint to what the future might be but they do not and cannot be prescient of what prices will be.
22. July 2016 at 23:44
I have no idea what intrinsic worth means either, which is why it strikes me as a bad thing if “fundamentals” is being used to smuggle it in.
Talking about future cash flow strikes me as very superior to “fundamentals” because it is far more precise and rather more obviously able to be affected by a very wide range of factors.
23. July 2016 at 05:18
Lorenzo, Fair enough.