Author Archives: Niels Madsen

The Efficient Market Hypothesis

Tim Harford has a nice post at the FT and his own site about the Efficient Market Hypothesis:

Burton Malkiel, author of A Random Walk Down Wall Street, noted in 2003 that the January effect had become a Wall Street joke, “more likely to occur on the previous Thanksgiving”. Elroy Dimson, another EMH expert, documented the reversal of a major anomaly – a tendency for shares in small companies to outperform the market – after it became known.

This is a good opportunity to recommend Donald Mackenzie’s brilliant book “An Engine, Not a Camera” about the self-fulfilling (strongly performative) aspect of financial theory and writing. The best case study in the book is Mackenzie’s extensive study of the Black-Scholes-Merton model as ensuring its own conclusions, through markets complying with its predictions as soon as the model spread(but not before). FT Alphaville had a post in October arguing in the same philosophical lines based on Christopher Cole’s note on the “postmodern economy”. All terribly exciting stuff, especially given that I’m currently following social studies of finance courses with a heavy influence of Bruno Latour.

What We’re Reading

So there may be radio silence on this blog for now, but thankfully the world is still moving. And we are following:

Ideas & Central Banks

Via Brad DeLong a very important NBER working paper by Larry Ball (link). Essentially the paper discusses how Bernanke went from being one of the strongest proponents of inflation targeting, given his extensive knowledge of the Japanese liquidity trap, to a strong opponent of this policy when in power as the Fed chairman.

Bernanke once advocated a 3-4% inflation target for Japan;
as Fed chair, he says “that’s not a direction that we’re interested in pursuing.” Bernanke has also
abandoned his early proposals for currency depreciation and for money-financed tax cuts. More
generally, he no longer argues that a central bank can easily overcome the zero-bound problem “if
the will to do so exists.”

Given the growing movement towards a nominal GDP targeting and the heated discussions regarding policy options in a liquidity trap, this clear shift in the policy stance of a very central player is critical. Any central bank sets long-run interest rates by shaping expectations of future policy. This is fundamentally a choice of signalling and communication. It is a choice which depends crucially on the economic models employed by their economists, and on prevailing tendencies in economic debates. Inherent in an inflation or NGDP target is an apolitical rule which would yield a much more stable macroeconomy than the one we see today. How high should the inflation rate target be in this new rule?

Greg Mankiw(link) hints at a possible numerical explanation of the current real interest rate that would yield full employment. We have previously linked to Paul Krugman’s very succinct summaries of this problem, see here for instance. An optimal inflation target needs to take the current liquidity trap into consideration. Oliver Blanchard has argued strongly for higher inflation and other economists within the IMF have defended this view strongly, often coming from the same framework as Bernanke, as in this article. They arrive at the same inflation target – around 4%. Bernanke’s shift is therefore even more significant given the support from the usually conservative IMF for an explicit inflation targeting rule at a higher permitted inflation rate than the one currently pursued by Western central banks. Going further would be the NGDP target, which found strong support in an important paper by Goldman Sachs last year. One central conclusion of this paper follows:

Simulations using a highly simplified model suggest that a nominal GDP target could improve economic performance substantially compared with a standard Taylor rule. In the model, the economy receives a significant boost through lower real long-term interest rates, via a delay of the first funds rate hike and temporarily higher expected inflation.

Source: Goldman Sachs Global ECS US Research

One benefit of the NGDP target is the very clear and uncontroversial measure of the economy as opposed to choosing a proper deflator or attempting to define the output gap, which has led to some discussions in the blogosphere over the last week.

In a political climate where “uncertainty” is the enemy for many hard-money hawks in central banks and in the broader policy debate, this is even more unfortunate. The benefit of a new version of the Taylor rule is the substitution of an institutional rule for shifting Fed bargaining power and leadership. Not every chairman for every central bank can have the bargaining power or economic climate that allowed for the Volcker disinflation. Matt Yglesias puts this personal incentives argument very succintly:

A central banker who implements those ideas would run the risk of needing to take responsibility for failure in the event that something bad happens. Opting for the fudge that constituted conventional wisdom from the fall of 2008 through to the subsequent winter got Bernanke hailed as Person of the Year despite the economy collapsing all around him.

John Ruggie famously subscribed to the view of an international regime as one in which the expectations of actors converged upon a specific set of outcomes. The obvious political co-option of the Fed during the economic crisis has led to the QE programs, and the very aggressive monetary goals going forward. It also allowed for the low interest rates leading up to the crisis. Thereby the convergence of expectations becomes a political rather than an economic judgment, and creates clear time inconsistencies in Fed behavior. Rule-based NGDP targeting in particular would allow for an apolitical and legitimate conduction of monetary policy in the United States, clearly aligned towards the dual mandate.

Given the current discourse of politicians and the increased transparency of Fed decisions and communications, this would grant a much-needed frame of reference for central bank governors and chairmen, one that is more open towards a broader field of stakeholders and that is more properly connected to the views of other major institutions. This does not mean that asset price inflation should not be a focus going forward, but implementing a pragmatic target based on output/inflation gets us a long way. And of course, let’s not even get started on the help it could grant the ECB in its organizational environment, since it is extremely unlikely that we will ever see the ECB making the strong commitments necessary to positively shape expectations given its narrow mandate.

Digital Love

In a National Bureau of Economic Research working paper, “Propose With a Rose? Signaling in Internet Dating Markets,” economists Soohyung Leeand Muriel Niederle ran an online event through a Korean dating site in which participants were given a couple of “virtual roses” to signal their interest in someone special. It turns out nothing says I’m interested like a rose: A digital flower increased the chances that an offer of a date was accepted by about 20 percent. The roses were even more effective when delivered by the most desirable suitors, whose entreaties to less attractive dating prospects weren’t taken seriously without them.

Brilliant article at Slate, h/t Marginal Revolution. In a related late-night story, check also his link on the decline in condom innovation.

Two Countries

Germany of course had many specific grievances against the existing order in Europe, from colonial and naval policy to the threat of Russian economic expansion. But in reading German justifications for the war, one is struck by a consistent emphasis on the need for a kind of objectless struggle, a struggle that would have purifying moral effects quite independently of whether Germany gained colonies or won freedom of the seas. The comments of a young German law student on his way to the front in September 1914 were typical: while denouncing war as “dreadful, unworthy of human beings, stupid, outmoded, and in every sense destructive,” he nonetheless came to the Nietzschean conclusion that “the decisive issue is surely always one’s readiness to sacrifice and not the object of sacrifice”

That is Fukuyama in The End of History, now for Italy (h/t Tyler Cowen):

We can list some of the qualities that made and still make Italy seem “special”: a tradition of regional rather than national loyalties (exacerbated by the fact that government is actually strongly centralized); a high level of organized (but not ordinary) crime; the power of the family in every sphere of life, but notably the economy; the melodramatically assertive tone of the labor force in all professional, commercial, and unionized sectors, whether they be taxi drivers, pharmacists, or steelworkers; a flare for making life complicated through bureaucracy and then for overcoming complication through evasion and petty corruption; a multitude of political parties with strong ideological or regional leanings; a Church with a propensity to undermine rather than reinforce people’s loyalty to the state; a tendency in general to foment and then thrive on a gap between the official version of events and their actual course, between rules and practice, appearance and reality: a foreigner seeking to participate in Italian life—buying a house, starting a career at the university, bringing up children in the state school system—soon appreciates that this is a country for initiates. It is never enough to read the instructions on a form to understand how it should be filled in. You need someone with inside knowledge beside you.

From by Tim Parks.

Democratic Governance

As previously mentioned, the real story about the European crisis is one of lacking governance structures, and the struggle to create a new durable fiscal compact in the midst of the crisis. Politics as a whole becomes infinitely more difficult when confronted with the resource shortages that can prevent both coalition building in parliaments and patronage-based election strategies. Francis Fukuyama has a brilliant piece in his newly revived blog at the American Interest that touches on the problem of “good governance”:

Conversely, I would argue that the quality of governance in the US tends to be low precisely because of a continuing tradition of Jacksonian populism. Americans with their democratic roots generally do not trust elite bureaucrats to the extent that the French, Germans, British, or Japanese have in years past. This distrust leads to micromanagement by Congress through proliferating rules and complex, self-contradictory legislative mandates which make poor quality governance a self-fulfilling prophecy. The US is thus caught in a low-level equilibrium trap, in which a hobbled bureaucracy validates everyone’s view that the government can’t do anything competently. The origins of this, as Martin Shefter pointed out many years ago, is due to the fact that democracy preceded bureaucratic consolidation in contrast to European democracies that arose out of aristocratic regimes.

This quote is absolutely crucial, and serves to underline the incredible complexity that lies in connecting nations with different national governance systems, different varieties of capitalism and different expectations for the transnational project. Putnams theory of two-level games illustrates the added complexity that comes with achieving domestic policy goals while attempting to build diplomatic ties with international partners. Add a supernational court and a “technocratic” commission and this job does not become easier.

The Danish discourse is often vaguely neoconservative in its imagery, with the European community now “helping” Greece not just in an economic sense but in a cultural and democratic one. Clearly this is a rather vague version of Huntington’s old theory of authoritarian transitions (Fukuyama describes this here). How much of Greece’s supposed acceptance of governmental change (but not reforms) is due to framing effects, and how much stems from true alignment with the policy goals of incumbent technocrats? The drama continues, and surely one of the key issues will be whether Greece chooses to impose its rather draconian bond laws on private investors. If this is the case, this is one blow against liberalism and free markets that will be very hard to condone as the swan song of the “old Southern Europe”.

Regardless, Greece is absolutely insolvent and there is no reason to beat around this conclusion. Felix Salmon has this succint summary of the situation, with Germany essentially setting the stage for an imminent Greek default. This will not be a smooth ride, but it is better to get it done as quickly as possible, for the populations in all countries. And with the ECB having prepared the Eurozone for this event, i see no reason that Greece will not have defaulted within a very short (a month or so) timespan, regardless of what politicians and the media will choose to call the event. And as Simon has pointed out, the handling of credit events in terms of CDS exposures will be as important as the Greek bond laws in establishing the proper financial regulatory framework that will prevail after the default.

What We’re Reading

How the US utilized fiscal/monetary policy

In this fantastic paper written by Alan Blinder and Moody’s Mark Zandi, effects of the US fiscal and monetary responses to the 2008/9 crisis are estimated. This is very important to keep in mind since the payroll tax cut and the extended unemployment benefits are expected to expire by the end of the year. Today’s GDP growth figures are not supportive of that proposition:

Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 2.0 percent in the third quarter of 2011 (that is, from the second quarter to the third quarter) according to the “second” estimate released by the Bureau of Economic Analysis.  In the second quarter, real GDP increased 1.3 percent.

Goldman Sachs (via Zero Hedge) estimates the drags on GDP from fiscal policy, both expansionary and contractionary:

gs%201 1 How the US utilized fiscal/monetary policy

According to the paper, fiscal stimulus achieved substantial easing compared to the events that would otherwise have unfolded:

Nonetheless, the effects of the fiscal stimulus alone appear very substantial, raising 2010 real GDP by about 3.4%, holding the unemployment rate about 1½ percentage points lower, and adding almost 2.7 million jobs to U.S. payrolls.

Real World Macro Teaching

Not much to add to this one. Thoughts from Robin Wells on the student walkout from Greg Mankiw’s Harvard economics intro course.

Right now the general public views the economics profession with a large measure of distrust and in some cases outright contempt. Students are entering the worst job market in well over a generation, without much prospect of improvement.  Many of them have seen their parents’ lives turned upside down by financial troubles.  They face being members of the first generation in American history with a lower standard of living than their parents.  Income inequality has reached levels not seen since the Gilded Age.  There are over 4 million long-term unemployed.


Eurobonds lurk in the shadows as one of the mechanisms to solve the current crisis and ensure solidarity between member states. My own position is that they are a necessary step. I would support the model described in this Wall Street Journal article where debt is issued up to a certain limit with full guarantees from Euro member states. This limit could be the 60% debt/GDP target of the S&G pact, adjusted for cyclical factors, lower during peaks in the business cycle and higher to allow for expansionary fiscal policy.

When this limit is reached, states should by default issue their own national bonds, maybe backed by limited guarantees from other member states. Alternatively the state should be allowed to issue further Eurobonds conditional on implementing reforms that bolster public finances. In this case the politicians of the individual states would face a clear choice between going at it alone, or adhering to the S&G pact and pursuing the policies favored by the commission, the ECB or a third entity that would be responsible for allowing emergency issuance of Euro bonds.

Interestingly the commission concludes:

The commission discussion paper suggests three options for issuing euro bonds. It concludes that they could be issued carrying limited guarantees from governments without changes to the European Union treaty that would require ratification from all 27 EU states. But it says that the benefits would be greater if all governments agreed to jointly guarantee bonds issued by the euro zone—but this would require changes to the treaty.

This may serve as an interim fix, but clearly the markets are increasingly penalizing half-measures. So a treaty change would be a requirement, leaving this as a solution for the future design of the currency, rather than as a quick fix to the current crises. For this, we still have to expect political leadership in the debtor countries coupled with a much stronger role played by the ECB.