[Trigger warning for acrophobics like me.]
I have fond memories of growing up in the Midwest, and seeing big white mushroom-shaped water towers on the outskirts of small towns:
Back in 1970, a friend of mine told me about some guys he knew that played a game of dare. They’d go to the top of one of these, and then gradually crawl down as far as they dare, before climbing back up. But if you make a mistake and go to far, over the horizon, then it’s all over. I’m a bit acrophobic, so it makes me queasy every time I think about this story, which is several times a year.
The reason I frequently think about this story is because it reminds me of the “circularity problem” in economics. Consider the following parable:
A great power elects a leader who is not well informed on economic theory. He is inclined to adopt reckless economic policies, especially trade policies. But this leader is also a former businessman, and pays a lot of attention to the performance of the stock market. Indeed he views it as a sort of indicator of his effectiveness.
Stock investors see a healthy economy, with the main risk being reckless trade policies imposed by the leader. Whenever investors see the risk of these policies increasing, stock prices fall. But they don’t fall very much, as investors know that the leader pays attention to the stock market, and in the end will likely pull back from reckless policies. The leader knows that the stock market doesn’t like some of his polices, and uses it as a sort of gauge to determine if he’s gone too far.
The problem here is that the stock market will only give “warnings” to the extent that they think things have already gone to the point where they won’t be corrected, and there’s increased risk that the economy will slide into recession. Not a 100% risk of recession, but slightly higher than before. Meanwhile the leader knows that stocks bounce around for lots of reasons, and that only a big drop is a clear sign that he’s gone too far and needs to pull back. But investors know that the leader knows that investors are evaluating the risk of a policy accident. Think of an infinity of mirrors in a barbershop, another memory from my childhood.
In 1997, Ben Bernanke and Michael Woodford wrote a paper on the “circularity problem”, where Fed policymakers look for market guidance that they are off course, and then correct policy on that basis. Do you see the problem here? If the markets know the Fed will correct, they’ll never give a warning in the first place. As a result, I’ve always designed my NGDP futures targeting proposals with their paper in mind. The key is not to have markets predict the outcome, but rather predict the instrument setting that leads to an on target outcome (which is also their view, BTW.)
In the parable with the economically ill-informed leader who watches the stock market for guidance, no such mechanism is in place. It’s still true that watching the market is probably better than ignoring the market, but it’s not true that the market will definitely give the leader sufficient guidance to avoid a big mistake, for the simple reason that if that were true then there would be no guidance in the first place—stocks would rise along a path reflecting the healthy state of the economy, complacently assuming the leader would in the end avoid major mistakes due to market guidance.
In the water tower case, no one actually died (as far as I know). But there might have been a point where it was too late to turn back, and the reckless young man (why is it always men?) slid at increasing speed to his death. In macroeconomics, there may come a point where it’s too late for policymakers to get back on course in time to prevent a recession. In that case, stocks may plunge as fast as that unfortunate daredevil on the water tower. October 1929 and October 2008 were two such examples.
PS. I’d love to see a film like Free Solo, as I love mountains. But when that camera looks straight down . . .
READER COMMENTS
Lorenzo from Oz
Dec 6 2018 at 4:54pm
A fellow member of the somewhat acrophobic club! (Flying used to be hell, now it’s just intermittently unpleasant.)
It is always men because a basic pattern of human history is that risks are transferred from the care of children to men. And the sex that gets pregnant and looks after small children because they have the mammary glands better be more risk averse than the sex that doesn’t, otherwise a species with big brains that need to do much of their cognitive development and brain growth after birth is going to have a problem …
Lorenzo from Oz
Dec 6 2018 at 4:56pm
BTW, the risk transfer pattern is still the go in contemporary societies. It is why men are around 11 times more likely to be killed at work; they overwhelmingly dominate the dirty and dangerous jobs. (Strangely, feminists don’t generally protest as this grotesque gender imbalance.) The pattern is just somewhat obscured because of the massive increase in physically low risk jobs.
Lorenzo from Oz
Dec 6 2018 at 5:01pm
I was reminded of Goodhart’s Law, but you are making a different point, given that you are speaking of an inherent feature of stock markets and responses, rather than a change in the patterns of behaviour due to use as a policy indicator.
David Henderson
Dec 6 2018 at 6:28pm
I strongly recommend Free Solo. I went in the morning when there were 3 people (including me). At certain points, I worked off my tension by rocking back and forth in the chair and sometimes oohing and aahing out loud. When it ended, I walked over to the guy sitting closest to me to apologize if my behavior had bothered him. He said no problem because he was too busy trying not to have a heart attack.
Scott Sumner
Dec 6 2018 at 7:05pm
Lorenzo, Good points.
David, I’d love to see it, but I just can’t take those shots straight down.
Benjamin Cole
Dec 6 2018 at 8:08pm
Side point: I think someone really recently pointed out the FTSE 100 no longer reflects the British economy, as it is a multinational indicator.
I wonder to what extent the US stock market indices reflect a multinational community, and not the US economy.
Matthias Goergens
Dec 6 2018 at 8:54pm
Benjamin, it’s worse than that. The stock markets reflect big established companies. Eg introducing lots of new regulation is good for them, because it hurts their yet-to-be-founded want-to-be upstart disruptors more than them, even though it’s bad for the economy. (Financial regulation is especially strong and wrong.)
Scott, as long as the Fed prints the right amount of money, the reckless policies would at most give the country some supply side problems? Those are bad, especially in the long term, but they don’t seem to cause recessions. See eg the collapse of the American house building sector before the Great Recession or the fall of the GBP (and not a fall in British employment!) on news of the Brexit referendum.
TravisV
Dec 7 2018 at 12:29pm
I just read this. My reaction:
If a recession happens, then the “ill-informed economic leader” (POTUS) deserves like 5% of the blame. Maybe even less.
Who deserves 95% of the blame? The Federal Reserve board and the consensus of the economics profession itself.
TravisV
Dec 7 2018 at 12:35pm
The current market reaction to the China tariff news illustrates that the economics profession itself is ill-informed.
A similar example: the economics profession’s reaction when we temporarily suffered a negative supply shock (surprise oil shortage) in…….2008.
Scott Sumner
Dec 7 2018 at 12:53pm
Matthias, There are many examples of supply-side problems triggering bad monetary policy. It gives them less room to maneuver.
Travis, It’s difficult to allocate percentages when each of the three represent “necessary conditions”.
Everyone, Why focus on the blame issue? The President always gets blamed, regardless of who’s at fault. The “Fed” consists of leadership appointed by Trump, for instance.
Alan Goldhammer
Dec 7 2018 at 1:14pm
My biggest worry is that Larry Kudlow is seeking to reassure all of us that there will not be a recession. Given his track record, taking the opposing view (yes, a recession) may be the more intuitive choice.
TravisV
Dec 7 2018 at 1:16pm
Prof. Sumner,
It may be a bit challenging to “allocate percentages” but I think my estimate is within the right neighborhood.
What percentage of the economics profession has a good understanding of negative supply shocks causing negative demand shocks?
Enlightenment is urgently needed
Bat signal to the market monetarists—Sumner, Glasner, Beckworth, Christensen, Nunes—please take your bullhorns out of the closet and explain this point.
Brian Donohue
Dec 8 2018 at 4:39pm
Hmmm, what would be worse: a recession or modestly above-trend inflation?
Inflationphobes aren’t even fighting the last war- they’re fighting like four wars back, poor dears.
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