Reply to Nick Rowe

In my previous post Nick raises an interesting question:

What you are proposing is, I think, methodologically equivalent to “event studies” in financial markets. We take a very narrow window of time, so narrow that we can reasonably hope that nothing else changes except the policy announcement.

But suppose you lived in a world where everybody had been taught Keynesian (or RBC) economics at school. I wonder how NGDP and RGDP futures markets would respond to monetary policy announcements then?

I believe they’d react in exactly the same way as if they’d been taught market monetarism.  Markets ignore conventional wisdom and react on the basis of how the world actually works.  Some examples:

1.  Conventional wisdom in 1933 said leaving the gold standard was a very bad idea.  That’s what people had been taught.  But the actual decision to leave the gold standard sharply reduced risk spreads in the corporate bond market, and sharply raised equity prices.  Both market reactions (correctly) pointed to much faster growth ahead.

2.  In March 2009 the conventional wisdom was that the Fed was out of ammo and was pushing on a string.  This meant that QE would not affect market prices.  But markets understand market monetarism, and the dollar fell 6 cents against the euro on the day QE1 was announced.

3.  People are taught that easy money lowers interest rates.  Markets know better.  In January 2001 and September 2007 announcements of a dramatic easing of policy raised longer term rates.  In December 2007 an unexpectedly contractionary announcement caused stocks to crash, and interest rates fell from 3 months to 30 years.  The markets know that Keynesian interest rate theory is wrong.  Like Nick Rowe, they know that the IS curve often slopes upward.

4.  The yen recently plummeted on rumors of Japanese monetary easing, despite most people being taught Japan was in a liquidity trap.

I’ m not saying markets are always right.  The world is highly complex and market participants don’t always know how policies will impact the economy.  Especially new and untried policies.  But for the most part they ignore what they were taught in school and react as if they are all market monetarists.



22 Responses to “Reply to Nick Rowe”

  1. Gravatar of Nick Rowe Nick Rowe
    4. January 2013 at 08:57

    Scott: Hmmm. Moderately convincing response. Puzzling though. Not just “people don’t believe what they are taught in school”. More like “people don’t believe what they say they believe”. For the gold standard example especially. This puzzles me. (I know there are many things we believe that we don’t say in polite company, but was the gold standard like that?)

  2. Gravatar of Bill Woolsey Bill Woolsey
    4. January 2013 at 08:58


    Since most economists don’t accept your assumption that markets are always right, they will believe that these prediction markets tell us only what market participants believe. Most economists would find it necessary to consider the possibility that market participants are wrong.

    I suppose that market participants being wrong in their beliefs is inconsistent with rational expectations, so it would disprove models that depend on rational expectations.

    Perhaps markets clear, but if people don’t know that they clear, RBC models cannot be correct because they assume rational expecations.

    But that doesn’t mean that markets don’t clear and change in real output are due to changes in productive capacity.

    Similarly, if everyone believes markets clear, that doesn’t mean they really do. It is just rational expectations models that assume that prices are sticky in some particular way and everyone knows it would be false.

  3. Gravatar of Tyler Joyner Tyler Joyner
    4. January 2013 at 09:06

    To point #1, one could argue that abandoning the gold standard reduced risk spreads because the markets considered the risk of inflation less significant than the risk of default (which more or less vanished without the gold standard). The reduced risk of default on government debt -and- increased expectations of inflation would both serve to elevate equity prices.

    Just playing devil’s advocate.

  4. Gravatar of Tyler Joyner Tyler Joyner
    4. January 2013 at 09:10

    I realize abandoning the gold standard was a form of default, but it’s reasonable to say that a less-valuable dollar is still worth more than a promise of gold payment which never comes at all.

  5. Gravatar of Gregor Bush Gregor Bush
    4. January 2013 at 10:33


    I think that people believe what say they say they believe but they’re unclear on what those beliefs imply from a macro perspective. Those traders in 1933 proabably really did think that leaving the gold standard was “bad” but upon hearing the annoucement, they sold t-bills and bought stocks, commodities and corporate bonds.

    In Argentina, it is the 2001 devlauation rather than the 1991-2001 dollar peg, that’s viewed as a disatser by the general population and business community alike, despite that fact that the latter was the cause of a horrible depression. I gaurentee that the majority of Argentine traders thought the devlaution was a horrible mistake as they were scrambling to buy equities.

    Hayek was right, the market knows much more than any individual market participant. Unless one of those participants is Scott Sumner of course.

  6. Gravatar of Bob Murphy Bob Murphy
    4. January 2013 at 10:59

    Scott you’re killing me man. You wrote:

    I’ m not saying markets are always right. The world is highly complex and market participants don’t always know how policies will impact the economy.

    I really don’t get this. I thought *by definition* you gauged whether a policy worked or not, by the immediate reaction in the market?

    For example, what would it even mean in your worldview to say, “QE2 worked, but the market didn’t realize it.” ? I thought such a statement would be literally meaningless in your worldview?

  7. Gravatar of ssumner ssumner
    4. January 2013 at 11:14

    Nick, Interesting question. I’ll bet there are investors who would grouse at cocktail parties that imports from low wage countries hurt American companies, and who would buy equities on news that NAFTA adding Mexico cleared a close vote in Congress. People compartmentalize.

    Roubini said he was almost fully invested in equities during 2007-08, when the market crashed. Did he believe his forecast? I doubt it.

    Bill, Keep in mind that these liquidity trap models claim that monetary policy doesn’t affect inflation expectations. So if it does, the model is wrong even if they think people are expecting inflation for some sort of stupid reason. In an NK model higher inflation expectations boosts nominal growth, regardless of why it occurs.

    Tyler, My point was that it led investors to expect fewer corporate bankruptcies. That’s usualy associated with a healthier economy, isn’t it?

    Bob, It’s simple, I assume the market forecast is the best out there. Not perfect, but the best we have. So you can say “the market expects X, but dumb little me expects Y” But why would anyone want to do that?

  8. Gravatar of Laurent Laurent
    4. January 2013 at 11:22

    The market is good at gauging expectations, e.g. the expected value of inflation. These expectations matter, since they drive investment decisions, and to a lesser extent, consumption decisions.

    The decision of lending funds to sovereign governments vs corporations vs holding equity vs holding options or futures vs domestic currency vs foreign currency has a lot of economic consequences. Policy makers must take these expectations very seriously.

    But an exchange created solely to bet on some macro-economic variable seems to me no more valuable than InTrade.

  9. Gravatar of ZHD ZHD
    4. January 2013 at 12:05

    This and your previous post read as if you have never participated in a market. Initial reactions are a classic exercise in the Keynesian Beauty Contest””and measurably have no long term effect on prices.

    The JPY currency pairs dropped because of Japan’s history of massive currency interventions. Those firms holding 9 figure books don’t want to deal with an instantaneous 500 pip drop that comes on the whims of some government.

  10. Gravatar of Tyler Joyner Tyler Joyner
    4. January 2013 at 12:18

    “Tyler, My point was that it led investors to expect fewer corporate bankruptcies. That’s usualy associated with a healthier economy, isn’t it?”

    Hmm. My point was that “abandoning the gold standard = bad idea” was conventional wisdom because people anticipated that doing so would lead to inflation, correct? I was suggesting that the conventional wisdom could have plausibly been correct and that the outcomes you listed signaled nothing more than inflation, whereas other events accounted for the real growth. In the presence of other plausible causes of real growth, it would seem to me that you need more than corporate bond spreads and equity prices to assert that abandoning the gold standard caused the growth.

    Again, just playing devil’s advocate here. I’m not an expert on the 1930s.

  11. Gravatar of Luis Pedro Coelho Luis Pedro Coelho
    4. January 2013 at 15:07

    Markets can predict better than all participants. In fact, all participants may be wrong and markets can still work.

    Let’s say that all participants believe that free-trade is bad for the economy overall. However, when a free-trade agreement is announced, they will look at the sectors they know the best and move money from losers from free-trade to winners. Overall, in spite of them, they may move the markets up if the winners outnumber the losers, even though each, individually, thinks that the opposite is true.


    The real devil advocate’s rejoinder to the Gold Standard example is that it’s better to leave the Gold Standard than to be uncertain about whether it will hold because of the reduction in uncertainty; but it would have been even better to confidently stay.

  12. Gravatar of Rajat Rajat
    4. January 2013 at 17:31

    A question for you Scott. Why did bond yields spike after the Fed minutes were released on Thursday afternoon, when the minutes revealed that the FOMC had considered winding back asset purchases?

  13. Gravatar of ssumner ssumner
    4. January 2013 at 17:32

    Tyler, I find it hard to believe that the level of corporate bankruptcies is not reflecting the level of economic depression. But I suppose anything is possible. Of course there’s lots of evidence that the devaluation did spark a recovery. Each country devalued at different times, and each country began recovering right after it devlaued.

    Luis, Very good point about the way that markets aggregate information.

  14. Gravatar of ssumner ssumner
    4. January 2013 at 17:35

    Rajat, I don’t know, but it not the first time something like that has happened.

  15. Gravatar of Bill Ellis Bill Ellis
    4. January 2013 at 18:20

    Test it.
    Try a virtual market.
    You have plenty of M&Ms who would love to see it in action. You know and could invite all kinds of people who understand the rationality of your market and how to play the “NGDP futures market game” like a rational actor. Have a contest. (of course when evaluating how the market worked you would have to remember that the players were M&Ms and M&M sympathizers )

  16. Gravatar of Philo Philo
    4. January 2013 at 20:27

    It doesn’t matter what is taught in schools, because The Market doesn’t go to school. The Market can’t be taught anything, nor can it be bamboozled; The Market *already knows*.

  17. Gravatar of Saturos Saturos
    5. January 2013 at 00:14

    So what we’ve established is, if the EMH is 100% true (or “pragmatically true”) then we can resolve all the short-run macro disputes. But isn’t that the very thing that’s in dispute by economists? Isn’t yours still a pretty Chicago-centric view?

  18. Gravatar of Saturos Saturos
    5. January 2013 at 00:14

    Bill Ellis, really? Is that what you’re going with? M&M’s?

    Can I be the red one?

  19. Gravatar of cucaracha cucaracha
    5. January 2013 at 06:07

    “Why did bond yields spike after the Fed minutes were released on Thursday afternoon, when the minutes revealed that the FOMC had considered winding back asset purchases”

    People got afraid the FED does not want to “twist” anymore (less money in the bond markets, higher discounts = higher yields)

    “and round and round and up and down we go again …”

  20. Gravatar of ssumner ssumner
    5. January 2013 at 07:01

    Bill, That’s what I’m saying, someone should do it.

    Saturos, No, because the RBC-types believe efficient markets, and they’ll be proved wrong.

    And no, because some NKs say monetary stimulus at the zero bound doesn’t boost inflation expectations. If it boosts TIPS spreads they’ll be proved wrong, even if the market is irrational.

    cucaracha, That’s possible, I don’t know enough to comment either way.

  21. Gravatar of Mike Sax Mike Sax
    5. January 2013 at 15:20

    Nick a lot of the time I think people don’t know what they believe. They can honestly think they “believe X” yet when they act they “act Y.”

    In philosophy there’s always been a separation between thinking and doing.

    In their active life on the market, participants don’t think in the same way they do in graduate school.

  22. Gravatar of Mike Sax Mike Sax
    5. January 2013 at 15:22

    Or as Scott put it they “comparmentazlize” so that they believe a different thing at a cocktail party than when they’re a market participant

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