Modern Finance vs. Portfolio Balance Theory
By Arnold Kling
The first chapter of the Macro Doubtbook definitely needs a section on the relationship between finance theory and macroeconomics. I think that relationship is an uneasy one.
Macroeconomists use what is called “portfolio balance theory” to argue that changes of the relative supplies of securities matter. Modern finance, instead, uses variations on the Modigliani-Miller theorem to argue that changes in the relative supplies of securities do not matter.
In portfolio balance theory, if a firm issues equity to extinguish debt, this disturbs the balance in investors’ portfolios. At the previous prices, they now have too much equity and too little debt, so they bid up the price of bonds and bid down the value of stocks in the capital markets as a whole..
In Modigliani-Miller, investors do not care about the firm’s financial structure. They know the risk of the projects that the firm is financing. The financial structure redistributes the risk, but it does not change it. The overall market for stocks and bonds is unaffected by the firm’s change in financial structure.
Christopher J. Neely has a paper that argues, using event studies, that when the Fed announced plans to purchase long-term assets, such as mortgage bonds, this raised the price of long-term bonds, both here and overseas. I trust that empirical work. However, he argues that the change in asset prices comes from a portfolio balance effect. There, I have a problem.
First, the Fed clearly indicated that these purchases were temporary. From the beginning, there has been much discussion of an “exit strategy.” So, the private sector knows that these securities are coming back into the market at some point. Moreover, even if the Fed is picking up some of the risk, that risk does not dissolve into thin air. It gets spread among taxpayers. One could make a Ricardian equivalence argument that people realize that their risk has not gone away.
To me, it seems that finance theory wants to pull in the direction of Fed impotence. But macroeconomists do not want to confront that. As far as I know, Fischer Black is the only economist who has attempted to reconcile macro with finance, and the result was a very unusual take on macro.