A Short Note on Rationality, Information Constraints and Business Cycles

According to the efficient markets hypothesis, “security prices at any time ‘fully reflect’ all available information (Fama, 1970; 383).” This is a description of EMH in its strong form, which according to Fama, “is probably best viewed as a benchmark against which deviations from market efficiency (interpreted in its strictest sense) can be judged.” I find EMH troubling, not because it is wrong per se, at least not in an impure sense, but because finding and interpreting information is tricky business. EMH is a specific standard that the world fails to live up to because of constraints on the transmission and interpretation of information.

If the strong form of the EMH accurately describes reality, or at least approximates it, we would expect few, if any, financial bubbles. Yet bubbles are a recurring feature of reality. Jason Potts notes that “asset bubbles are an endemic feature of market capitalism and as old as open societies with property rights over financial assets (2004, 17).” Bubbles are common and are likely endogenous. Prices are not always moving toward their long run equilibrium. In other words, the strong form of EMH does not hold in the short run, and the long-run effects of information may never fully reveal itself. The reason for this is intimately tied to the nature of information transmission and interpretation. Not all investors receive information simultaneously, nor do they interpret information homogeneously.Information does not interpret itself.

Let me posit, for the sake of elaboration, that there is some deep fundamental truth that ultimately guides, or at least should guide for the sake of efficiency, investment decisions. Some investors might actually be privy to this truth, although even if they are, I am skeptical about whether or not they actually know that they are privy. If this sort of investor does exist, or perhaps many investors act in this manner but only on limited margins, their decisions may not guide the market immediately toward a posited equilibrium.

Why?

Most investors are probably not privy to the truth. For example, there is an investment industry built upon technical analysis. (Thanks to Gene Callahan for turning me on to this idea in a recent article.) There are individuals who make trades simply because their novice neighbor suggested an investment he or she has had success with in recent months. There are also investors who simply copy other investors who they believe, rightly or wrongly, are smarter than themselves. All of these groups use special rules to guide their investment decisions, and none of these rules directly approach the truth that, according to EMH, guides the market – at least in the long run. I posit further that the majority of traders fall within this category. What does this mean for EMH? In the long run, markets might approximate the truth, but in the short run, extreme deviations can occur even if all individuals are optimizing. Business cycles, then, can occur endogenously.

Why?

Individuals optimize according to the information they have. They optimize according to their interpretation of information. The information they receive might be direct, that is, it is as close an approximation of the truth as is possible to attain, or it might be an inference from second and third order effects of fundamental changes in the economy – i.e., this is how I would categorize technical traders. If I am correct, then modern macroeconomics has missed the mark in more fully clarifying our understanding of markets. Heterogeneity of actors, of rule sets, and of institutions must be considered in order to more fully understand the market process. Models that employ representative individuals and/or that posit that macroeconomic variables actually act upon one another miss this mark. They banish disorder and disequilibrium from analysis except in cases of exogenous shocks. Even then, disorder is soon subsumed by movement toward a new, predetermined equilibrium. Even if useful, a myth to be sure.

Roundaboutness of Production?: Explaining Austrian Business Cycle Theory with Present Value

What is “roundaboutness” of production? What is a production period? These words are thrown around in Austrian circles, but as Inigo Montoya would say, “I do not think it means what you think it means.” An illustration with present values will make this more clear.

First, a decription of the cycle from Ludwig von Mises in the Theory of Money and Credit

So long as the rate of interest on loans coincides with the natural rate, it will not pay him [the entrepreneur]; to enter upon a longer period of production would involve a loss. On the other hand, a reduction of the rate of interest on loans must necessarily lead to a lengthening of the average period of production. It is true that fresh capital can be employed in production only if new roundabout processes are started. But ever new roundabout process of production that is started must be more roundabout than those already started; new round about processes that are shorter than those already started are not available, for capital is of course always invested in the shortest available roundabout processes of production, because they yield the greatest returns. It is only all the short roundabout processes of production have been appropriated that capital is employed in the longer ones. (360-61)

A precise re-establishment of the old price-ratios between production goods and consumption goods is not possible, on the one hand because the intervention of the banks has brought about a redistribution of property, and on the other hand because the automatic recovery of the loan market involves certain of the phenomena of a crisis, which are signs of the loss of some of the capital invested in the excessively-lengthened roundabout processes of production. It is not practicable to transfer all the production goods from those uses that have proved unprofitable into other avenues of employment; a part of them cannot be withdrawn and must therefore either be left entirely unused or at least be used less economically. In either case there is a loss of value. Let us, for example, suppose that an artificial extension of bank credit is responsible for the establishment of an enterprise which only yields a net profit of 4 per cent. So long as the rate of interest on loans was 4 ½ per cent, the establishment of such a business could not be thought of; we may suppose that it has been made possible by a fall to a rate of 3 ½ per cent which has followed an extension of the issue of fiduciary media. Now let us assume the reaction to begin, in the way described above. The rate of interest on loans rises to 4 ½ per cent again. It will no longer be profitable to conduct this enterprise. Whatever may now occur, whether the business is stopped entirely or whether it is carried on after the entrepreneur has decided to make do with the smaller profits, in either case – not merely from the individual point of view, but also from that of the community - there has been a loss of value. (362)

This can be restated without the confusing language of the roundaboutness of production. It is a simple present value problem. There is a stream of payments that a firm must pay from the moment a certain process of production is begun to the time that the final product of sale is sold. (It will be simpler to imagine that only one firm is involved in this process) and revenue the the firm will receive in the final period. The “problem” can be formalized like this:

Where

π = Profit

C = Cost

R = Revenue
i = period
n = final period

r =  nominal interest rate              0 < r < 1

For those of you not comfortable with math, don’t sweat. This says that the present value – meaning, the value of something when accounting for the interest rate – of the goods of final sale, minus the present value of the costs incurred by the firm over the course of production is equal to the firm’s profit. An increase in the period of production moves n, the period of final sale, away from the present by an additional period. Thus, the addition of a period, ceteris paribus, reduces the present value of profit by a factor of 1/(1 + r). In order for the addition of a period to be profitable, production must increase by a factor of at least (1 + r). That is, gains made from increasing production must exceed the gains a firm can receive by simply investing in an asset whose rate of return is the market rate.

If the rate of interest is depressed, either by a lowering of the reserve ratio or an artificial increase in the stock of base money, longer processes of production can be employed profitably as long as the rate remains depressed. Notice that this is because the payments received in the last period will be discounted at a lower rate. (Remember if r decreases, the present value of the final sale increases!)

If the interest rate increases some time between the start of production, period t = 0, and the final sale,  period t = n, then the company will receive smaller returns than expected, and therefore, smaller or even negative profits. The longer the interest rate remains depressed, the greater the impact will be on the structure of production and the greater the losses will be when the interest rate returns to the natural rate. The bust sets when a large portion of firms’ costs exceed their revenue. This inevitably impacts credit markets as firms revenues cannot cover their debts – a part of their costs – and so demand for money grows alongside a shrinking supply of fiduciary currency. The latter results from an decreased willingness of banks to lend.

Delong on Conservative Economists Who Still Believe that Inflation is Driven by Increases in the Money Stock

Brad Delong on conservative economists and the Fed’s payment of interest on excess reserves:

And Larry White chimed in: “the Fed has sterilized those injections” that had taken “the monetary base and see[n] it double and triple…” by paying interest on reserves.
 On the videotape, Josh Bivens looks visibly flummoxed. I can see him thinking: “All of these guys are relatively orthodox quantity theory guys–they all expect a tripling of the monetary base to cause 200% inflation. And here they are, all saying that what you need to halt that 200% inflation is for the Fed to offer to pay 0.25%/year on reserves. Paying the banks $5 billion a year on their $2 trillion of reserves is enough to stop a 200% inflation in its tracks, and do so indefinitely. Do they really believe this?”
 Apparently they do…

If Brad Delong is correct in his cynicism, we should not see a noticeable change in inflation from an increase in the base of nearly 400% in the last 6 years if the rate paid was 0%. If he is right, the program is pointless and the Fed's payment of interest on excess reserves only complicates things.

[Late Add]

Note from my last post that Greenspan successfully handled crises by standard injections of liquidity and these proved successful. Bernanke steered away from this policy and suddenly long-run inflation is no longer a function of the money stock?

Where's the Inflation At?: A Review of and Thoughts on Hummel's "Ben Bernanke Versus Milton Friedman"

Leading into the recent crisis, and especially after the Federal Reserve responded with “quantitative easing” [QE], the press was a flurry in talks about inflation. Over 5 years after the first QE, commodity prices have not risen in proportion to the increase in the monetary base. The hyperinflation predicted by many has failed to materialize. Why is this so?

Anyone who has taken a course in macroeconomics is probably familiar with the quantity equation.

MV = Py

Note that P = MV/y. An increase in the money stock, all else equal, leads to an increase in prices in the long run. But all else is not equal. Or so says Jeffrey Rogers Hummel in “Ben Bernanke Versus Milton Friedman: The Federal Reserve’s Emergence as the U.S.Economy’s Central Planner” Hummel writes that Bernanke believes that

a disruption of what he calls ‘the credit channel’ in effect will induce households and firms to hold more money rather than spend it on consumption and investment. True to his New Keynesian inclinations, what Bernanke is thus saying is that the failure of banks brings about a prolonged, negative velocity shock, although he never expresses this idea in such straightforward terms.

The collapse of major financial institutions may result in fear-induced cash holding – “a negative velocity shock.” This negative velocity shock is special in that it acts as a black hole for increases in the money stock. Someone beckons Keynes’s ghost.

“What was the norm during the previous chairmanship at the Federal Reserve?”, you ask. It was essentially that sudden changes in V should be stabilized by M (this is only approximately true, but you will see what I am getting at soon). Under Alan Greenspan, the Federal Reserve met negative shocks to V with increases in M. Hummel notes three instances:

1.    .   Black Monday (1987)
2.        The Y2K Scare (1999/2000)
3.         9/11

During all of these crises, the Federal Reserve temporarily raised the rate of increase of the monetary base. (You won’t observe an increase in the chart in 1987 as the intervention employed purchases that were bought back within two weeks.) The sharp increases in liquidity stabilized the markets.

Ben Bernanke’s tenure reflected a different approach. From the start of his chairmanship, the rate of growth of the base money stock dropped steadily. Bernanke was aware that a potential crisis was on the horizon, though the size of its impact was unclear. Hummel quotes Bernanke,

As late as May 17, 2007, Bernanke was predicting that troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.’

The course he charted, however, did not involve an increase in the rate of growth of the base money stock. Instead, he redistributed credit and continued to let the rate of growth of the base money stock drop.

By summer of 2008, lending to banks through the Term Auction Facility ahd climbed to $150 billion, and discounts added another $18 billion. Other things being equal, this lending would have brought about a substantial bulge in the monetary base. But other things were not equal. For pari passu, Bernanke was pulling money out of the economy by selling Treasury securities. As a consequence, during the year ending in august 2008, the monetary base had increased less than $20 billion, a mere 2.24 percent, which was well below its average annual growth of 7.54 percent during Greenspan’s nineteen years in charge… Bernanke was not injecting liquidity, just redirecting it.

Even when Bernanke’s actually expanded the monetary base, the expansion was actually another rendition of credit reallocation. He accomplished this by initiating a policy of paying interest on reserves held at the Federal Reserve. The entirety of the QE1 expansion did nothing to increase market liquidity directly. Instead, the new credit remain latent, collecting interest at the Federal Reserve. Oddly enough, management of credit by Bernanke created a nearly perfectly elastic demand for money by banks, much like the problem that he believed caused the Great Depression. He created a liquidity trap!

Management was a hallmark not only of Bernanke’s chairmanship, but his philosophy. Hummel again quotes Bernanke,

‘What we do know is that the central bank of the world’s economically most important nation in 1929 was essentially leaderless and lacking expertise. This situation led to decisions, or nondecisions, which might well not have occurred under either better leadership or a more centralized institutional structure [emphasis Hummel’s].’

Hummel continues in his own words,

These are not the words of a sedate central banker reluctantly intervening in a crisis but rather of an activist regulator who views the economy as requiring expert, detailed management with constant, coordinated control. Still more recently at Princeton University, Bernanke explicitly called for improved ‘economic engineering’ and ‘economic management’ by the regulatory authorities.

One might find this indictment harsh, but it is difficult to deny that Bernanke’s policies have reflected such an attitude. What has resulted is an empowered Federal Reserve and several years of lackluster growth under Bernanke. The economy would likely have faired better if, upon the first signs of crisis, the Federal Reserve provided a one-time spike in the base money stock that did not become locked away behind its own doors. I expect that we would have seen some failures, but that the market would have steadied and recovered in a more a robust manner than we have experienced thus far.





Originally posted here.

Would a System of Free Banking Automatically Reflect the Natural Rate of Interest and the Market Reserve Ratio?

I notice a tendency for economists that are friendly to free markets to overstate the case for free markets. There is a difference between saying that markets work well and saying that markets work perfectly or even near perfectly. The first claim allows for system wide errors in coordination while the second bears a resemblance to the strong form of the efficient markets hypothesis and real business cycle theory.

Lawrence White and George Selgin promote free banking in this manner. Banks under this system are said to be constrained by competition and the threat of losses in reserves that result from an over-issue of currency. No systemic over-issue can occur as disequilibrium is not allowed by the model. In “How Would the Invisible Hand Handle Money?” they write,

The standard inventory-theoretic model of reserve demand indicates, however, that a bank’s prudential or precautionary demand for reserves depends on the anticipated variance and not just the mean or expected value of the bank’s reserve losses. Although perfect in-concert expansion does not affect any bank’s mean clearing losses, it does increase the variance of each bank’s clearing losses, and does therefore increase each bank’s precautionary demand for reserves. The reserve ratio remains well anchored. [emphasis mine] (1724)

The model presented by Selgin and White is a long run model that employs representative banks that optimizes reserve levels according to the cost of issuing currency and the revenue earned from the issue. This sort of analysis overlooks short-run deviations that occur in a world of heterogeneous, competing firms and imperfect information. In their model, competition leads banks to adjust their reserves according to the market chosen reserve level, but this process takes time. It is unclear whether or not information asymmetries will temporarily prevent anchoring of the reserve ratio.

White states his thesis explicitly in terms of the boom and bust in an article for Cato,

The boom-bust scenario could not have happened under a commodity standard with free banking. Under that regime any incipient housing boom would have been automatically and promptly dampened, before a severe bust became inevitable.

White notes on the previous page that the recent boom and bust was caused not only by monetary expansion by the Federal Reserve.

A disproportionate share of that credit flowed into housing, channeled there by federal subsidies and mandates for widening home ownership by relaxing mortgage creditworthiness standards. The dollar volume of real estate lending grew by 10–15 percent per year for several years—an unsustainable path.

Until the crisis, these mortgages were very liquid, thanks in large part to the willingness of the government sponsored enterprises known as Fanny Mae and Freddie Mac to purchase them. For a time, this, in combination with high ratings that the securities received from Moody’s and S&P, promoted and maintained elevated prices in the housing market. But scarcity of liquidity ended the bull market in securities. The drop in prices that followed would have brought down Fannie and Freddie for good if not for the U.S. Treasury placing the two GSE’s into conservatorship.

But could this have occurred under a free banking system? Again, White does not think so.

… a commodity standard with free banking minimizes monetary shocks. Its strong self-regulating properties stop the banking system from overfinancing an investment surge, the way the Fed did for the housing market, to the point where it becomes an unsustainable boom full of the malinvestments that make a severe bust unavoidable.

This assumes that the Federal Reserve was the prime driver of over investment. It is likely that overinvestment in the housing sector would have occurred even under a free banking system, though in this case it is still due to an intervention. The incentives provided by the GSEs were powerful enough on their own to funnel investment into the housing sector even under a system of free banking. The Federal Reserve probably augmented the bubble, but I am not convinced that the existence of the Federal Reserve was a necessary condition for a “severe bust” nor am I convinced that the market rate of interest does not overshoot the natural rate as banks expand credit during booms and contract credit during busts. Banks must take risks in order to compete. Those banks that invest in too many failing projects will themselves fail. Ex ante it is unclear which banks these will be just as it is unclear what is the market level of reserves or what is the natural rate of interest. Only ex post can we conjecture what value or range of values may have fulfilled these standards.

Expect development of these thoughts coming weeks and the some consideration of the possibility bubbles driven by credit expansion in a free market.