Perry Mehrling, Fischer Black, and Finance
By Arnold Kling
I crossed the river yesterday to listen to Perry Merhling give a talk based on his book on Fischer Black and on this paper. Warning: what follows is pretty geeky.Mehrling’s paper says,
In fact, as I shall argue, neoKeynesian macroeconomics circa 1965 was destabilized not by the various internal theoretical problems that standard pedagogy emphasizes, but rather by fundamental changes in the institutional structure of the world that neoKeynesian macroeconomics had been developed to explain. We see this fundamental institutional change most clearly when we focus our attention on the financial sector, where the shift toward more flexible markets began, and we see its intellectual consequences most clearly when we focus our attention on the financial theory that arose to explain how these new more flexible markets work.
In the world of macroeconomics, what the Federal Reserve does affects ex ante rates of return. In the world of finance, particularly Fischer Black’s world where the risk-free interest rate is determined endogenously, ex ante rates of return come from expectations about the future. There is no channel by which the Fed can affect anything–not even the price level(!), unless somehow it affects expectations of the future. Not surprisingly, macroeconomists have yet to absorb this.
1. I think that the essence of the CAPM, particularly for Fischer, is that it splits risks into two kinds: idiosyncratic risk, which no one has to take; and market risk, which everyone has to take. So if he dislikes traded options markets, it is because he thinks people will use them to load up on idiosyncratic risk which is wasteful. And if he likes derivative markets, it is because he thinks that people will use them to spread idiosyncratic risk (perhaps–there are lots of ways that they can be misused. For example, for a firm to lay off idiosyncratic risk is not necessary–the owners of the firm can lay off the risk by diversifying their portfolios)
2. I think that his macro theory is that market risk is embedded in human capital as well as physical capital investments. If we think that the dotcom era is for real, then we invest in lots of fiber-optic cable and we teach ourselves to be web designers and business-development hotshots and entrepreneurs in online pet supplies. When things aren’t quite so good, we take losses on our human capital as well as our stock portfolios. Some of the losses in human capital show up as lower wages, but some of them show up as unemployment. Even that story is a bit misleading. It’s not so much that we invested in the wrong skills. It’s that we invested in a set of high-beta skills. Because we invested in high-beta skills and we got a bad draw, we take a hit.
If it were just a matter of investing in the right skills, we could have diversified away our risk. I think that if I hold the right portfolio, then it does not matter to me whether red shoes or black shoes are in next year. The color/fashion risk should be diversifiable. What matters is the draw we get from the urn labeled “market risk–not diversifiable.”
3. Some problems with the CAPM story. First, there may be large market factors, such as the price of oil, that are idiosyncratic but too important to be diversified away. Hence, arbitrage pricing theory (perhaps). Second, there may be incentive-compatibility problems with allowing people to diversify away idiosyncratic risk. The venture capitalist wants the entrepreneur to keep his “skin in the game.” The incentive compatibility problem may be really, really important. In a sense, a fully complete CAPM economy has the same incentive problems as socialism–having property rights only in the market portfolio is a bit like having no property rights at all.