Finance theory and the Fed

Eugene Fama says,

Actually, the central banks don’t do anything real. They are issuing one form of debt to buy another form of debt. If you are an old Modigliani–Miller person the way I am, you think that’s a neutral activity: You’re issuing short-term debt to buy long-term debt or vice-versa. That’s not something that should have any real effects.

Pointer from Alex Tabarrok.

Two papers that influenced my view of banking in general and central banking in particular were Bank Funds Management in an Efficient Market, by Fischer Black, and Banking in the Theory of Finance, by Fama. Both take seriously the modern theory of financial markets that begins with Modigliani-Miller. One could see smoke coming out of Scott Sumner’s ears even before he responded.*

In a Modigliani-Miller world, the financial structure of one firm does not matter. Investors use the financial markets to adjust their portfolios to undo the effects of one firm’s changes to its financial structure. The public ultimately holds what it wants to hold. If it doesn’t like the mix of securities that one firm creates (by substituting bonds for equity, for example), it has ways of dealing with that. The metaphor that I would propose is that a single firm’s changes to its financial structure is like me sticking my hand in the ocean, scooping up water, and throwing it in the air: I don’t make a hole in the ocean.

Modigliani-Miller is not strictly true. But it is the best first approximation to use in looking at financial markets. That is, you should start with Modigliani-Miller and think carefully about what might cause deviations from it, rather than casually theorize under the implicit assumption that it has no validity whatsoever.

Taking this approach, I view the Fed as just another bank. Its portfolio decisions do not make a hole in the ocean. That heretical view is the basis for the analysis of inflation in my book Specialization and Trade.

*Sumner’s response is actually beside the point, in my view. The Modigliani-Miller theorem does not in any way rely on different asset classes being close substitutes. It relies on financial markets offering opportunities for people to align their portfolios to meet their needs in response to a corporate restructuring.

11 thoughts on “Finance theory and the Fed

  1. This post conveniently ignores the obvious elephant in the room. How do these fed policies impact traditionally under represented groups? Even if the fed is just swapping pieces of paper for other pieces of paper, we have no way of knowing what those impacts might be. And, if the fed is “just another bank,” then I’m thinking that there is definitely a disparate impact that needs to be explored. I mean seriously, have you looked at the composition of the fed board lately?

    It’s time for some changes, and once again, California provides the prudent path forward:

    https://www.mofo.com/resources/insights/200831-new-california-law.html

  2. “Just another bank”? But the Fed controls the money supply–the quantity of dollars. How can that not make it “special”?

  3. So is Fama, the efficient markets guy, calling the markets wrong when they react to the Fed’s activities or pronouncements?

    • I don’t know how you got that. He’s saying the stock market, on average, *does not* respond significantly to the Fed’s activities or announcements, and that apparent relationships between particular announcements and stock prices are anecdotal just-so stories we tell after the fact.

      A direct quote: “But when we look at it systematically, we don’t see a big effect of Fed actions on real activity or on stock prices or on anything else.”

      • Consider this scenario:

        Fama is given advance notice that the Fed will announce a plan to sell $2 trillion worth of securities over the next six months. It will also immediately raise the rate of interest on excess reserves to 3%.

        Fama is told that he will not be prosecuted if he trades on this information.

        Anyone believe that Fama wouldn’t aggressively short the market?

  4. Something about macro is not making sense.

    With the advent of QE, we are seeing helicopter drops (when QE is combined with large federal deficits). Well, that is what Michael Woodford says.

    Seems to me helicopter drops, aka money-financed fiscal programs, would be stimulative within the nation they are taking place.

    I suspect QE with a balanced budget does little. Globalized capital markets are huge, about $400 trillion (bonds, equities, property). Money is fungible. If a lone central bank buys a few trillion in bonds…so what?

    QE does seem to deleverage a nation, in practice if not in theory. Investors accept newly minted cash for their bonds. They can exercise an immediate claim on output, but they may reinvest.

    The Temple of Conventional Macroeconomic Theology needs some new totems.

  5. Central banks may be just another bank for purposes of open market purchase transactions, but they are also responsible for regulating financial institutions and for assuring the overall financial health of the banking industry.

    Biden plans to do many that will disrupt banking and financial services generally. He says that he would:

    – Put an “end to the era of shareholder capitalism.”
    – Strengthen the Federal Reserve’s Focus on Racial Economic Gaps
    – Get the postal service into the banking business;
    – Make bankruptcy easier and less costly to borrowers;
    – Impose a 15% minimum tax on book income;
    – Eliminate deferral of taxes on earnings in 401(k) accounts and replacing with a tax credit; and
    – “expand the Community Reinvestment Act to apply to mortgage and insurance companies, add a requirement for financial services institutions to provide a statement outlining their commitment to the public interest, and, importantly, reverse new rules that allow these institutions to avoid lending and investing in all of the communities they serve.”

    One wonders how the Fed will manage to weather the resulting chaos.

  6. The Fed is not the ocean, but it’s perhaps like the ice glaciers covering Greenland. Which could melt, slip into the ocean, and cause a few feet of ocean rising and huge amounts of flooding & destruction of those places closest to the seas of money.
    More, far more, than any other bank on Earth.
    It would be a bubble.
    Popping.

    There was an internet dot.com bubble.
    There was a housing bubble, arguably two: a) in construction, ending 2006, and b) in financing, including MBS, liar loans and the bailout for big banks who “believed” liars in order to book profitable fees. Sort of knowing they’d get bailed out if the bubble popped.
    There was a stock market bubble in 1929 that popped.

    When will a bubble pop, and how much is lost after the bubble pop are always unknown.

    Fama’s denial of the existence of bubbles has long been disappointing, and Sumner. Yeah, there’s the tough issue of defining one before the pop, but that’s part of the characteristic of a bubble: faster than normal increases, then an even faster decline.
    Which might be followed by another increase.
    Here’s a good picture.
    https://www.fitsnews.com/wp-content/uploads/2013/10/real-estate-bubble.png

    There is no way to know a bubble, which will pop (fast decline), from merely a fast increase which is not followed by a pop, and thus not a bubble. It’s very difficult, impossible?, to distinguish them, before they pop, from other fast rising assets whose value doesn’t pop. The bubbles were the ones that popped.

    The failure of economics to identify bubbles discredits it as a science and all economists. As does the denial of their existence thru defining them away. They are way under-studied, and genius economists like Fama are part of the reason.

    Fama also says that more debt today from lower taxes today is just more taxes later. As do essentially all deficit-hawks. If this was a “scientific” statement, there would be some way to falsify it, wouldn’t there?

    He claims that the increased debt will certainly be a big problem, in some uncertain future time. I’m not so sure.

    But I am sure that the USA with 150% or less of their annual GDP as national debt will not suffer the “big problem” before Japan does, with over 200% of their GDP. (This year USA goes over 100%)

    Tho it’s also possible that Japan’s debt has stabilized, while the US debt continues to grow, rapidly. It might well be the USA exceeds the 200% level before Japan has a problem, and then the USA is first with the big problem/ debt bubble pop.

    (No discussion of my pet theory that debt “monetization” is happening thru rising asset prices, especially houses in good areas and stock markets. No pet rocks either)

  7. The M&M world has no “money” in it. Classical Arrow-Debreu world (which Black and Fama like) has nothing that is money or liquidity. Black rejects the entire concept of money.

    Fama has done good work on portfolio pricing models. Black, I think, has put the profession back. The finance world and the macro world are sailing on separate ships when they ought to be working together. Larry Summers did an address on the issue once. Finance is not even doing micro anymore, much less macro.

    Summers used the example of the price of ketchup bottles at the grocery store. If a microeconomist was asked to analyze it, he might spend time looking the prices of tomatoes, salt, vingear, and sugar, estimate a cost function, and consider the cost of bottles and distribution. Maybe market power would be considered.

    A finance sort would observe that there are no arbitrage profits to be made by shipping ketchup bottles from one neighborhood to another, or from breaking up large bottles into small bottles. He would conclude the market for ketchup is efficient and have nothing to say about the price of ketchup, about why it may go up or down over time.

    On price inflation, where macro would look at aggregate demand or money supply, the finance guys shrug their shoulders and say it is all just about expectations, making the CPI the same as a bubble. Although Black doesn’t believe in bubbles. Nihilism isn’t a theory, and if finance guys can’t model inflation, they should stand out of the way of those trying to understand and model inflation.

    M&M thinking doesn’t survive in a world of “frictions,” high transactions costs, and institutional rigidity.

    Finance guys might accept that the proof of the pudding is in the eating. To be sure. Here are two examples of finance cluelessness.

    One is from the mid-1980s, when finance guys thought using put options in portfolios was too expensive but claimed it could be replicated with dynamic insurance in which equities are sold as the market drops. Selling into a declining market, and the more it declines, the more you sell. What could go wrong? How about October 1987 as an example of how it could wrong. Alan Greenspan had to flood the market with liquidity and cut rates to prevent a recession. Macro bailed out the finance guys.

    Then there was LTCM. Founded and run by Nobel Prize winning options economists. They took highly leveraged bets with short term debt on macro trades in Europe. Hey, they were really smart people. In August 1998, they crashed and burned. The Fed called the banks for a restructuring. Alan Greenspan once again got scared about a financial market freeze up, and had to lend and cut rates to prevent a US recession. Once again, macro bailed out finance.

    Let’s just skip I-banks doing securitized subprime mortgages in the mid-2000s. That is too long a story, but finance guys in the mortgage business did not distinguish themselves. Robert Shiller called it right, not trading whizzes at Goldman.

    So, now, I am not impressed on how macro is handling the world. They make messes, and macro comes to the rescue. M&M theory, like the labor theory of value, is an intellectual curiosity, not scriptural truth.

    • Pretty sure you meant “finance” when the next sentence has macro coming to the rescue:
      So, now, I am not impressed on how macro is handling the world. They make messes, and macro comes to the rescue.

      OTOH Finance is handing the world very well – for finance folk.

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