…and the Financial and Economic Crisis
I don’t read very many books. At least not during the academic year. But I have read two books recently that are quite germane to thinking about the buildup to the financial crisis, and thinking about how to respond to the current economic downturn. The first is Akerlof and Shiller’s Animal Spirits. The second one is actually not yet out — it’s Justin Fox’s The Myth of the Rational Market (I got a prepublication copy; here’s a hint of it). They are both important books, well worth reading.
As one can guess from the titles of these two books, neither text is a paean to the predictive power of the neoclassical view of the world. I’d expect that most readers trained in this tradition would then skip this blogpost. But before you do, and go back to reading your financial industry newsletter, you might consider where these seemingly neutral phrases such as “risk appetite” come from. Why did “risk” seemingly disappear in 2005-06, only to reappear in 2008? Why did asset prices (including house prices) climb so much? Think about the traditional asset pricing (Gordon Growth equation):
Pt = Dt/(ke – g)
Where P is the stock price, D is the dividend today, ke is the equity discount rate, and g is the deterministic growth rate of dividends; and ke equals the risk free rate plus the equity risk premium.
Where does this equity risk premium come from? Well, it could come from the covariation of real equity returns with the ratio of the marginal utility of consumption. Or it could come from waves of excess optimism and pessimism. Or it could come from both – although one would need to take a stand on the relative weights of the two effects.
I’m sure there are readers out there at this moment saying “But what about the finding that stock prices follow a random walk; this is consistent with the efficient markets hypothesis.” But as Fox writes:
Fama had proposed that the way to test the efficient markets hypothesis was to see if stock price movements obeyed the dictates of the capital asset pricing model, but this was only a relative test. It might reveal whether stock price movements made sense in relation to each other and the overall market, but it was no help in showing whether the overall market was correctly price or not. (p. 184)
Digression 1: To place this in technical terms, the maintained hypothesis is the statistical null hypothesis of no predictability. Failure to reject to no-predictability null is consistent with the random walk hypothesis, and hence the weak form efficient markets hypothesis (EMH). However, it is very difficult for most statistical test to differentiate between no predictability and little predictability. Jeffrey Frankel has called this econometric approach “the zen of perfect nothingness”.
Digression 2: Larry Summers (J. Finance, 1985) showed how a financial market pervaded by strong and persistent deviations from the fundamentals (“fads”) would take five thousand years to have 50% chance of distinguishing it from a truly efficient market, defined in the statistical sense Fama defined it.
To the extent that these waves of optimism and pessimism — heck why not call them animal spirits — are a real world force, then this argues that self-regulation of the financial industry is not likely to be sufficient. It’s not a prima facie case in support of government regulation (especially if regulation can be captured, a la Simon Johnson‘s regulatory capture view). But I think we should at least try to regulation and/or other means of slowing down the excess movements (financial taxes could in principle work this way, as in the Tobin tax).
Akerlof and Shiller conclude Chapter 11 thus:
…financial markets require regulation. And sometimes, when these regulations fail, because of all the feedbacks between financial markets and the real economy, there is also room for thoughtful, careful policies of financial insurance. Rededication to protecting the financial consumer must be one of our highest economic priorities.
In an emergency, as a backup, when we do get into a recession, there is a monetary and fiscal policy. But we know that there are limits to such policy and to its effectiveness. It is now time to redesign financial regulations to take account of the animal spirits that often drive the markets, to make the markets work more effectively, and to minimize the extent to which we will need after the fact bailouts to get us out of the hole.
See also the oped in yesterday’s WSJ.
By the way, the authors of both books agree that the point is not to dispense with price theory. That point is made on page 2 of Akerlof-Shiller, and in a quote of one of the fathers of behavioral economics, Richard Thaler, regarding the Shanghai apartment market: “Maybe it’s just supply and demand” (p. 286). Rather, the point is that we need to augment price theory with a more realistic depiction of human behavior if we are to avoid a repeat of the current situation.
I leave with two figures from Robert Shiller’s paper “Do stock prices move to much to be justified by subsequent changes in dividends,” American Economic Review 71(3) (June 1981).
(Hint on interpretation: The dashed line should be more variable than the solid line, under the EMH and assumptions regarding stationarity. See Engel (2004) for updated discussion.)