Mean Reversion and the Permanent Income Hypothesis: Suggested Answer
By Bryan Caplan
Suppose you – and
you alone – discover that the stock market is mean-reverting.
True, False, and Explain: If you are rational, you will NOT obey the
permanent income hypothesis.
If the stock market is mean-reverting, low returns now predict high returns in the future, and high returns now predict low returns in the future.
If you obey the permanent income hypothesis, your current consumption depends solely on your total wealth (including future labor income, of course), not current income.
My answer: TRUE. As long as there are no binding credit constraints, mean reversion implies that after periods of exceptionally low or high
returns, the market valuation of your wealth is temporarily misleading.
When returns have been low, you can expect your wealth to grow
unusually quickly in the future; when returns have been high, you can
expect your wealth to grow unusually slowly in the future. The researcher who
correlates the market valuation of your total wealth with your current
consumption will therefore find that you are less responsive to stock
market changes than the PIH implies.
Intuitively, imagine that the
stock market fell 50% today, but you (and you alone) knew for sure it
would return to its initial price tomorrow morning. You’d have
near-zero reason to revise your consumption this evening, because you’re
only poorer “on paper” – and you can readily borrow to resolve today’s cash
What if there are binding credit constraints? Then there’s another effect in the opposite direction. Key idea: Mean reversion implies unusually good investment opportunities after stock market falls. If you can’t borrow unlimited amounts at the market rate, you will have to partially “self-finance” to take advantage of these temporarily good opportunities. As a result, your current consumption tends to be more responsive to stock market crashes than the PIH implies. During bad times, you’ll want to really “tighten your belt” to take advantage of the situation.
In the real world, the relative size of these two effects is unclear – at least to me. But it would be a miracle if they exactly cancelled, leaving the PIH unscathed.