EMH and Macroeconomics

A reader asks,

if an economist comes up with a novel and correct theory that makes predictions about macroeconomic variables, shouldn’t this theory enable him to beat the markets using these predictions?…

Therefore, it seems that if we accept both the EMH and the basic validity of macroeconomics, the latter must be about predictions that are somehow novel, correct, and non-trivial, but at the same time provide no new information about future market prices, even in terms of crude probabilities. But what would be some examples of these predictions, and what principle ensures their separation from market-relevant information?

Consider financial variables, such as the long-term interest rate or the price-earnings ratio of the overall stock market. According to the efficient markets hypothesis, these are not predictable on the basis of known information. To put this another way, you cannot beat the market forecast for these variables.

On the other hand, in conventional macroeconomics these variables can be predicted using models and controlled using policy levers. Reconciling this with the EMH has challenged economists for decades. Here are various alternative ways of doing so:

1. Policy has no effect. Markets do what they will do, regardless. The market uses the best prediction model, so economists’ macro models can, at best, replicate the market’s implicit model.

2. Policy has an effect, but markets try to anticipate policy. The expected component of policy has no effect. Only policy surprises have an effect.

It seems to me that the market monetarists (e.g., Scott Sumner) believe something closer to (2) than to (1). But (2) can get you into some strange conundrums. Does the Fed have free will? That is, does it have the ability to surprise markets, other than by acting randomly? If its actions are not random, they should be anticipated by markets. If they are anticipated by markets, then they should have no effect. etc.

I prefer a third way of looking at things, which might be expressed in the work by Frydman and Goldberg. That is, there is no reason for all participants in markets to be using the same model. They have different information sets. The EMH is a useful guide to everyone, because it serves as a reminder that it is unwise to assume that your information set is somehow superior. However, it is not correct to impose “rational expectations,” in which everyone uses the same model.

A challenge with this “multiple information sets” view of the world is that we all trade in the same market. I think that people who own long-term Treasuries and people who own gold have different expectations for inflation. Why does someone not combine short positions in bonds and gold in order to arbitrage against these different expectations? I am afraid that one has to make risk aversion and leverage constraints do a lot of work.

From this perspective, the response to policy changes is hard to predict. For both economic modelers and policy makers, a difficulty is that you do not know which models the market participants are using. Thus, you cannot know how markets will react to policy moves.

I think that such humility is appropriate. Arguments of the form “on x date the Fed did y and subsequently z happened, just as my theory would have predicted” are not persuasive to me. One can usually find other instances of the Fed doing something like y with different results.

Incidentally, I recently re-read Perry Mehrling’s biography of Fischer Black. Black was perhaps the first economist to think about the contrast between modern finance theory and conventional macro, and Black was the first and perhaps the only one to attempt to recast macro entirely in terms of modern finance.

Also incidentally, here is a Brad DeLong post that, as I see it, chooses to reject the EMH, or at least to claim that his assessment of risk is superior to that of the market.

The aftermath of the financial crisis has left us without sufficient trusted financial intermediaries to properly evaluate and grade the degree of risk–hence no private-sector agent can create the safe securities that patient and prudent investors wish to hold. The overleverage left in the aftermath of the financial crisis has left a good many investors and financial intermediaries petrified of losing all their money and being forced to exit the game–hence the risk tolerance of the private sector is depressed far below levels that are appropriate given the fundamentals of risk in the real economy and given the degree of diminishing marginal utility of wealth in the economy. Until this overleverage is worked off, the private marketplace left to its own will deliver (a) a price of safe assets far above fundamentals because of the artificially high demand for them by investors, financial intermediaries, and firms, (b) a price of risky assets far below fundamentals because of both diminished appetite for them and because many assets that would in normal times be regarded as safe are today regarded as risky, and (c) a level of investment and thus of employment far below the economy’s sustainable and optimal equilibrium.

In such a situation, by issuing safe assets–and thus raising their supply–the government pushes the price of safe assets down and thus closer to its proper fundamental equilibrium value.

Pointer from Mark Thoma.

On the other hand, here is Leszek Balcerowicz:

“So they know better,” says Mr. Balcerowicz, about the latest fads in central banking. “Risk premiums are too high—according to them! They are above the judgments of the markets. I remember this from socialism: ‘We know better!’”

3 thoughts on “EMH and Macroeconomics

  1. You seem answer you own question:

    “It seems to me that the market monetarists (e.g., Scott Sumner) believe something closer to (2) than to (1). But (2) can get you into some strange conundrums. Does the Fed have free will? That is, does it have the ability to surprise markets, other than by acting randomly? If its actions are not random, they should be anticipated by markets. If they are anticipated by markets, then they should have no effect. etc.”

    You say this like it’s a paradox, but it’s not. Fed policy can easily affect equilibrium market prices without “changing them”. Imagine the Fed tries to make Nominal GDP level (or price level) travel along a growth path of 5%. Everyone know’s what they’re trying to do. They’re pretty successful at this. This affects financial market prices since obviously if the Fed did not exist the NGDP (or price) level would be different and that has effects on market prices. But at no time are market prices “changed” since there’s no news. No one has to react to changes in Fed policy since they don’t change it. Nothing paradoxical about it.

  2. Could I suggest my own answer to the reader’s first question? No.

    Ok, that’a a bit terse. Most modern macro models are general equilibrium, they contain consistent predictions for quantities and asset prices. Putting them together in a realistic way is a challenge, to be sure, but there’s no inherent inconsistency. I’d say the opposite: they give us two perspectives on the same underlying structure, which can be really useful.

    On your discussion: I didn’t find it all that helpful. For example, the suggestion that only policy surprises matter is a minor offshoot of the 1970s debate about the Phillips curve. There’s no question in most people’s minds that policies affect decisions and asset prices. As an example, think about tax rates. I don’t think anyone would regard that as counter to the spirit of the EMH.