The Macro Doubtbook, Installment 7
By Arnold Kling
Previous installment is here. The new installment below discusses finance theory. I happen to think that the relationship between macroeconomics and finance is more problematic than the relationship between macro and any other branch of economics. John Hicks writing in 1937 simply did not have the perspective on capital markets that Markowitz, Sharpe, Lintner, Fama, Modigliani, Miller, Black, and Merton brought to bear. Even if you do not like modern finance, I think you owe it to the finance theorists to be very explicit about how your model differs, particularly since the empirical support for key ideas in modern finance, like passive indexing, is much stronger than the empirical support elsewhere in economics, especially in macro.Finance Theory
If I were advising a young economist who wants to achieve an important breakthrough, I would suggest looking at the intersection between finance and macroeconomics. (Actually, my advice to a young economist would be to drop the ambition of achieving an important breakthrough until you get tenure. Meanwhile, write papers that are less ambitious and more likely to get published.) This intersection clearly is relevant, given the way that the financial crisis was soon followed by an economic downturn. More importantly, there are some pretty obvious major problems with both finance theory and macroeconomics right now. Neither one gives a good account of financial intermediation.
In macroeconomics, one standard treatment of the bond market is called the IS-LM model. In this model, there are two relationships between the interest rate and income. One relationship, the IS curve, is that when interest rates are high, investment is low, because firms decide not to pursue projects when the cost of capital is high. In the real world, the most interest-sensitive component of spending may actually be household investment in new homes and consumer durables. In any event, this inverse relationship between investment and interest rates implies an inverse relationship between output and interest rates.
The other relationship, the LM curve, is one in which higher income raises the demand for money to be used as a medium of exchange. To meet this demand, people divert some of their assets from bonds to money, which causes the interest rate to rise. Combining the upward-sloping LM curve and the downward-sloping IS curve provides the sort of graphical equilibrium that economists love to play with.
It is widely known, however, that the IS-LM framework, which has a proud history dating back to John Hicks, is an intellectual swindle, because the interest rate for the IS curve is not the same as the interest rate for the LM curve. The interest rate for the LM curve is the short-term nominal interest rate, which should influence the choice between money and alternative short-term assets. The interest rate for the IS curve is the long-term real interest rate, which should influence the decision to undertake or postpone investment.
The IS-LM framework provides the causal chain between money and income in the textbook Keynesian model. When the central bank buys bonds with money, it lowers the short-term nominal interest rate. The lower long-term real interest rate raises investment and increases income and employment.
The missing link in IS-LM is the connection between short-term nominal interest rates and long-term real interest rates. That link is sometimes supplied by using something known as the “portfolio balance” model. I think of this as being due to James Tobin. The idea is that investors hold a portfolio of assets, including money, bonds, and other securities. When this portfolio is “disturbed” by the central bank purchasing bonds with money, private investors try to restore portfolio balance by buying bonds. This bids up the price of bonds and lowers their yield. With the lower yield, private investors are willing to accept holding fewer bonds in their portfolio.
This story of portfolio balance adjustment is inconsistent with modern finance theory in two ways. The first inconsistency is perhaps not major but nonetheless is quite interesting. That is the inconsistency with the efficient markets hypothesis (EMH). Under the EMH, all information available as of a given moment is reflect in asset prices. This leads to the view that stock prices and long-term bond prices should obey something that looks approximately like a random walk. That is, one should not be able to predict the path of stock and bond prices.
It is somewhat difficult to reconcile a random-walk explanation for long-term bond prices with a story that says that the Federal Reserve can control long-term bond yields. To the extent that Fed actions matter for long-term bonds, those actions should be anticipated by the market. Thus, if the Fed is expected to reduce the Federal Funds rate in 30 days, then the long-term bond market should not wait 30 days to incorporate this expectation into bond yields. Instead, bond yields should change today.
The implication is that only the unanticipated changes in Fed policy should cause clear changes in bond yields. As long as the Fed is keeping the short-term interest rate along the path expected by the market, long-term bond yields should evolve independently of Fed actions.
This is not quite as nihilistic as it might sound. As long as the market believes that Fed policy matters a great deal for long-term interest rates, the Fed makes a difference. For example, suppose that the market believes that the Fed can control long-term interest rates. Moreover, suppose that the Fed is known to follow a rule that leads it to try to reduce the long-term interest rate by 1 percentage point whenever the unemployment rate rises by 1 percentage point. In that case, if Friday morning’s data show an unemployment rate that is higher by 1 percentage point, the market may proceed to reduce long-term interest rates by 1 percentage point.
Perhaps I can make this point more plausibly in terms of the exchange rate. Suppose that the Fed had a target for the exchange rate between the dollar and the euro. If the market believes that the Fed can hit its target, then if the dollar appreciates, speculators will see an opportunity to profit by short-selling the dollar before the Fed intervenes. Thus, the market will help the Fed keep the exchange rate on target–provided that the market believes that the target is feasible.
My personal view of the Fed is that unless it goes beserk, by printing or extinguishing money at prodigious rates, then it actually has very little effect on long-term interest rates or anything else. That is why the Fed never announces a hard target for any macroeconomic variable. If the Fed were to state a target, then sooner or later it would become evident that it lacks the power to enforce that target without going beserk. It is best to instead issue vague pronouncements in order to try to maintain the aura that the Fed is in the financial market driver’s seat.
The second challenge that modern finance theory provides to the macroeconomic model of central banks is perhaps even more important. That is, modern finance theory does not have room for the portfolio balance model, in which investors are focused on their holdings of bonds relative to other securities. Instead, modern finance theory has investors looking underneath stocks and bonds to the ultimate risks embodied in the projects undertaken by firms.
I am speaking, of course, of the Modigliani-Miller theorem. This theorem states that the capital structure of a firm will be irrelevant, under certain assumptions. One way to explain the Modigliani-Miller theorem is to say that personal leverage can offset corporate leverage. Suppose that I am a shareholder in a firm, and the firm decides to issue debt to buy back some of its shares, creating a more leveraged financial structure. If I do not like the risk that this creates, then I can sell some of my shares in the firm and reduce my personal debt, or increase my holding of bonds. By doing so, I return my original risk position relative to my holdings of the firm to what it was.
A Digression: The Portfolio Separation Theorem
Modern finance theory has investors with different personal trade-offs between return and risk. It has an array of investment projects, with expected returns, variances, and covariances among them. Among the risky assets, there is a single optimal portfolio for trading off risk and return. Each individual then can set a dial for either more or less risk, which determines how they divide their investments between the market portfolio and the riskless asset. Investors with high tolerance for risk will put more into the market portfolio. Investors with low tolerance for risk will put less into the market portfolio and more into the riskless asset.
This portfolio separation theorem can be motivated as follows. Here is an argument that if investors care about two (or n) characteristics about their portfolios, then there will be two (or n) portfolios that together dominate all other portfolios.
In particular, suppose that investors care about the mean expected return and the variance of their overall portfolios. To simplify, we will posit a number called “safety” that corresponds to (the inverse of) variance. Suppose that we start with two portfolios. Portfolio 1 has an expected return of 5 units and a safety of 5 units. Portfolio 2 has an expected return of 7 units and a safety of 2 units. Next, suppose that we introduce a new portfolio, 3. There are three possibilities:
a) portfolio 3 is dominated by each of the other portfolios, or by some combination of those portfolios. For example, if portfolio 3 has a return of 6 units and safety of 3 units, it can be dominated by a portfolio that is 50 percent of portfolio 1 and 50 percent of portfolio 2. That 50-50 combinatino would have a return of 7 units and safety of 3.5 units. So we throw out portfolio 3.
b) portfolio 3, either by itself or in combination with portfolio 2, dominates portfolio 1. For example, if portfolio 3 has a return of 4 units and safety of 8 units, then a 50%-50% portfolio of 3 and 2 would have a return of 5.5 units and safety of 5 units, which dominates portfolio 1. In that case, throw out portfolio 1 and replace it with portfolio 3.
c) portfolio 3, either by itself or in combination with portfolio 1, dominates portfolio 2. For example, if portfolio 3 has 8 units of return and 1 unit of risk, then an 20% -80% combination of portfolio 1 and portfolio 3 would have 7.4 units of return (20 percent of 5 plus 80 percent of 8) and 1.8 units of risk (20 percent of 5 plus 80 percent of 1). In this case, throw out portfolio 2 and replace it with portfolio 3.
When we are finished with portfolio 3, we can move on to another portfolio. We can keep trying this until you have tried all possible portfolios. The point is that there will always be just two portfolios that survive in the dominant combination. The fact that we always end up with two portfolios when investors care about two characteristics is the portfolio separation theorem. Every investor, regardless of how he or she weighs those two characteristics, should choose some combination of the two dominant portfolios.
Next, assume that there is a risk-free asset. That is, there is an asset such that it has the maximum safety possible, a safety of infinity as it were. In that case, one of the two dominant portfolios has to be a portfolio consisting of nothing but the risk-free asset. The other portfolio will consist of risky stocks, and we can call it the market portfolio. Every investor will choose a combination of the market portfolio and the riskless asset, with relatively risk-averse investors putting more of their wealth into the riskless asset and withlatively risk-tolerant investors putting more of their wealth into the market portfolio.
An implication that Fischer Black emphasized is that no one is rewarded for taking unsystematic risk. If you choose a portfolio other than the market portfolio, then there exists some combination of the riskless asset and the market portfolio that could earn a higher return at the same risk as the portfolio you chose.
In a sense, what the portfolio separation theorem shows is that the capital structure for the entire market does not matter. It does not matter whether a particular firm issues more stock or fewer bonds. Nor does it matter if many firms issue more stock or fewer bonds. Investors will hold a market portfolio that depends on the risks of the projects that the firms undertake. Ultimately, how those projects are financed is irrelevant.
Seeing Through the Veil
Modern finance, such as the Modigliani-Miller theorem, is based on the idea that investors “see through the veil” of corporate financial structure and realize that what they ultimately own are securities based on the risky projects that firms undertake. Whatever projects get undertaken, somebody has to own them, whether they know it or not. Modern finance theory takes as its starting point the assumption that people know what they own. That is, they know ultimately what a particular bond or share of stock represents in terms of a claim on real assets.
One can carry this one step further and say that people know what they own with respect to the Treasury and the Fed. With respect to the Treasury, when a surge of government spending is financed by bonds, people know that they will owe more in future taxes to pay off those bonds. That is Ricardian equivalence.
Similarly, one might argue that when the Federal Reserve buys bonds, people know that those bonds have not disappeared. The bonds sit on the balance sheet of the Fed, which is a government agency that returns much of its revenue to the Treasury.
Suppose, for example, that the Fed (as it began to do in 2008) buys risky assets. Under the older portfolio balance theory, people will act if those risky assets have disappeared and say, “We now have a greater appetite for risk, so let us bid up the price of risky assets.” Under a “see through the veil” theory, people will say, “As taxpayers, we are subject to the risk of the assets that the Fed bought. Our collective appetite for risky assets should not increase.”
In fact, I do not believe that people “see through the veil” with the Fed, with Treasury, or with banks and other firms. I think that this assumption that underlies modern finance theory is not true, and it is not even true as a reasonable approximation.
It is my theory that people view government and financial institutions through a lens of habitual beliefs. That is, they become habituated to certain patterns. Banks earn regular profits. Firms pay regular dividends. The government always repays bondholders. The rate of inflation stays within a particular range. The foreign exchange rate stays constant or moves gradually.
Sometimes, however, particular patterns are not sustainable. The central bank does not have the reserves to defend the exchange rate. Or financial innovations raise the rate of inflation relative to the indicators that the central bank was using to set monetary policy. Or enough bondholders lose confidence in the government’s fiscal discipline for that loss of confidence to be self-fulfilling–the interest rate on bonds rises to the point where the government can no longer refinance its debt. Or bank profits turn out to have depended too much on unsustainable increases in house prices.
What I am suggesting is that because banks, firms, and government are far from perfectly transparent, there can be periods in which beliefs persist even though reality has changed. When beliefs start to catch up to reality, this can require a sharp jump to a new equilibrium. For example, when the market loses confidence that an exchange rate can be defended, the resulting depreciation will be quite large.
Certainly, this is not a completely worked out theory of macroeconomics and finance. Certainly, there are other plausible theories. However, I think that this approach is worth pursuing. However, if the goal is develop a finance-theoretic foundation for the IS-LM model, then I do not see how this approach necessarily does that. The implications of this approach for macroeconomics, and especially for the theory of monetary and fiscal policy, have yet to be worked out, in my opinion.