SELECTED BLOGS: PHYSICS OF FINANCE, MARCK BUCHANAN// Blind on purpose: equilibrium as a conceptual filter in economics

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Blind on purpose: equilibrium as a conceptual filter in economics

A couple of years ago, I came across this article written in The Huffington Post by economist and game theorist David Levine. It carried the provocative title "Why Economists Are Right," and argued back against all those who were then criticizing economics -- especially the rational expectations assumption -- in the aftermath of the financial crisis. Levine's article is delicately crafted and sounds superficially convincing. Indeed, it seems to make the rational expectations idea almost obvious. His argument is a masterpiece of showmanship in the manner of Milton Friedman -- its conclusion seems unavoidable, yet the logic seems somehow fishy, though in a way that is hard to pin down.

The most notable passage in this sense is the following:

In simple language what rational expectations means is "if people believe this forecast it will be true." By contrast if a theory is not one of rational expectations it means "if people believe this forecast it will not be true." Obviously such a theory has limited usefulness. Or put differently: if there is a correct theory, eventually most people will believe it, so it must necessarily be rational expectations. Any other theory has the property that people must forever disbelieve the theory regardless of overwhelming evidence -- for as soon as the theory is believed it is wrong.

Seems convincing, doesn't it? Or at least almost convincing. Is this the only claim made by the rational expectations assumption? If so, maybe it is reasonable. But there's a lot lurking in this paragraph.

When I first read this I thought -- well, he's just assuming that people will learn over time to hold rational beliefs. In other words, he simply asserts (maybe because he believes this) that the only possible outcome in our world has to be an equilibrium. If people have certain beliefs, and their actions based on these lead to a collective outcome that does not confirm those beliefs, then they'll have to adjust those beliefs. There's no equilibrium but ongoing change. From this, Levine assumes that if this goes on for a while that peoples' beliefs will adjust until they lead to actions and collective outcomes that confirm these beliefs and bring about an equilibrium. But this is simply his personal assumption, presumably because he likes game theory and has expertise in game theory and so likes to think about equilibria.

The world is much more flexible. The more general possibility is that people adjust their beliefs, act differently, and their collective behaviour leads to another outcome that against does not confirm their beliefs (at least not perfectly), so they adjust again. And there's an ongoing dance and co-evolution between beliefs and outcomes that never settles into any equilibrium.

But I've kept this essay in the back of my mind, never quite sure if my interpretation made sense, or if the hole in Levine's logic could really be this blazingly obvious. I'm now more strongly convinced that it is, in part because of a beautiful paper I came across yesterday by economist Brian Arthur. Arthur's paper is a wonderful review of the motivation behind complexity science and its application to economics. Two passages resonate in particular with Levine's argument about rational expectations:

One of the earliest insights of economics—it certainly goes back to Smith—is that aggregate patterns [in the economy] form from individual behavior, and individual behavior in turn responds to these aggregate patterns: there is a recursive loop. It is this recursive loop that connects with complexity. Complexity is not a theory but a movement in the sciences that studies how the interacting elements in a system create overall patterns, and how these overall patterns in turn cause the interacting elements to change or adapt. It might study how individual cars together act to form patterns in traffic, and how these patterns in turn cause the cars to alter their position. Complexity is about formation—the formation of structures—and how this formation affects the objects causing it.

To look at the economy, or areas within the economy, from a complexity viewpoint then would mean asking how it evolves, and this means examining in detail how individual agents’ behaviors together form some outcome and how this might in turn alter their behavior as a result. Complexity in other words asks how individual behaviors might react to the pattern they together create, and how that pattern would alter itself as a result. This is often a difficult question; we are asking how a process is created from the purposed actions of multiple agents. And so economics early in its history took a simpler approach, one more amenable to mathematical analysis. It asked not how agents’ behaviors would react to the aggregate patterns these created, but what behaviors (actions, strategies, expectations) would be upheld by—would be consistent with—the aggregate patterns these caused. It asked in other words what patterns would call for no changes in micro-behavior, and would therefore be in stasis, or equilibrium. (General equilibrium theory thus asked what prices and quantities of goods produced and consumed would be consistent with—would pose no incentives for change to—the overall pattern of prices and quantities in the economy’s markets. Classical game theory asked what strategies, moves, or allocations would be consistent with—would be the best course of action for an agent (under some criterion)—given the strategies, moves, allocations his rivals might choose. And rational expectations economics asked what expectations would be consistent with—would on average be validated by—the outcomes these expectations together created.)

This equilibrium shortcut was a natural way to examine patterns in the economy and render them open to mathematical analysis. It was an understandable—even proper—way to push economics forward. And it achieved a great deal. ...  But there has been a price for this equilibrium finesse. Economists have objected to it—to the neoclassical construction it has brought about—on the grounds that it posits an idealized, rationalized world that distorts reality, one whose underlying assumptions are often chosen for analytical convenience. I share these objections. Like many economists I admire the beauty of the neoclassical economy; but for me the construct is too pure, too brittle—too bled of reality. It lives in a Platonic world of order, stasis, knowableness, and perfection. Absent from it is the ambiguous, the messy, the real.

Here I think Arthur has perfectly described the limitation of Levine's position. Levine is happy with rational expectations because he is willing to restrict his field of interest only to those very few special cases in which peoples' expectations do correspond to collective outcomes. Anything else he thinks is uninteresting. I'm not even sure that Levine realizes he has so restricted his field of interest only to equilibrium, thereby neglecting the much larger and richer field of phenomena outside of it.

One other final comment from Arthur, with which I totally agree:

If we assume equilibrium we place a very strong filter on what we can see in the economy. Under equilibrium by definition there is no scope for improvement or further adjustment, no scope for exploration, no scope for creation, no scope for transitory phenomena, so anything in the economy that takes adjustment—adaptation, innovation, structural change, history itself—must be bypassed or dropped from theory. The result may be a beautiful structure, but it is one that lacks authenticity, aliveness, and creation.

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LIBERTY STREET (FED'S BLOG)// If Interest Rates Go Negative . . . Or, Be Careful What You Wish For

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August 29, 2012

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If Interest Rates Go Negative . . . Or, Be Careful What You Wish For

Kenneth Garbade and Jamie McAndrews

The United States has slid into eight recessions in the last fifty years. Each time, the Federal Reserve sought to revive economic activity by reducing interest rates (see chart below). However, since the end of the last recession in June 2009, the economy has continued to sputter even though short-term rates have remained near zero. The weak recovery has led some commentators to suggest that the Fed should push short-term rates even lower—below zero—so thatborrowers receive, and creditors pay, interest.

    One way to push short-term rates negative would be to charge interest on excess bank reserves. The interest rate paid by the Fed on excess reserves, the so-called IOER, is a benchmark for a wide variety of short-term rates, including rates on Treasury bills, commercial paper, and interbank loans. If the Fed pushes the IOER below zero, other rates are likely to follow.

    Without taking a position on either the merits of negative interest rates or the Fed's statutory authority to fix the IOER below zero, this post examines some of the possible consequences. We suggest that significantly negative rates—that is, rates below -50 basis points—may spawn a variety of financial innovations, such as special-purpose banks and the use of certified bank checks in large-value transactions, and novel preferences, such as a preference for making early and/or excess payments to creditworthy counterparties and a preference for receiving payments in forms that facilitate deferred collection. Such responses should be expected in a market-based economy but may nevertheless present new problems for financial service providers (when their products and services are used in ways not previously anticipated) and for regulators (if novel private sector behavior leads to new types of systemic risk). This post supplements an earlier post in Liberty Street Economics that reviewed possible disruptions that could result from zero interest rates.


Cash and Cash-like Products
The usual rejoinder to a proposal for negative interest rates is that negative rates are impossible; market participants will simply choose to hold cash. But cash is not a realistic alternative for corporations and state and local governments, or for wealthy individuals. The largest denomination bill available today is the $100 bill. It would take ten thousand such bills to make $1 million. Ten thousand bills take up a lot of space, are costly to transport, and present significant security problems. Nevertheless, if rates go negative, the U.S. Treasury Department’s Bureau of Engraving and Printing will likely be called upon to print a lot more currency as individuals and small businesses substitute cash for at least some of their bank balances.

    If rates go negative, we should also expect to see financial innovations that emulate cash in more convenient forms. One obvious candidate is a special-purpose bank that offers conventional checking accounts (for a fee) and pledges to hold no asset other than cash (which it immobilizes in a very large vault). Checks written on accounts in a special-purpose bank would be tantamount to negotiable warehouse receipts on the bank’s cash. Special-purpose banks would probably not be viable for small accounts or if interest rates are only slightly below zero, say -25 or -50 basis points (because break-even account fees are likely to be larger), but might start to become attractive if rates go much lower.


Early Payments, Excess Payments, and Deferred Collections
Beyond cash and special-purpose banks, a variety of interest-avoidance strategies might emerge in connection with payments and collections. For example, a taxpayer might choose to make large excess payments on her quarterly estimated federal income tax filings, with the idea of recovering the excess payments the following April. Similarly, a credit card holder might choose to make a large advance payment and then run down his balance with subsequent expenditures, reversing the usual practice of making purchases first and payments later.

    We might also see some relatively simple avoidance strategies in connection with conventional payments. If I receive a check from the federal government, or some other creditworthy enterprise, I might choose to put the check in a drawer for a few months rather than deposit it in a bank (which charges interest). In fact, I might even go to my bank and withdraw funds in the form of a certified check made payable to myself, and then put that check in a drawer.

    Certified checks, which are liabilities of the certifying banks rather than individual depositors, might become a popular means of payment, as well as an attractive store of value, because they can be made payable to order and can be endorsed to subsequent payees. Commercial banks might find their liabilities shifting from deposits (on which they charge interest) to certified checks outstanding (where assessing interest charges could be more challenging). If bank liabilities shifted from deposits to certified checks to a significant degree, banks might be less willing to extend loans, because certified checks are likely to be less stable than deposits as a source of funding.

    As interest rates go more negative, market participants will have increasing incentives to make payments quickly and to receive payments in forms that can be collected slowly. This is exactly the opposite of what happened when short-term interest rates skyrocketed in the late 1970s: people then wanted to delay making payments as long as possible and to collect payments as quickly as possible. Some corporations chose to write checks on remote banks (to delay collection as long as possible), and consumers learned to cash checks quickly, even if that meant more trips to the bank, and to demand direct deposits. However, if interest rates go negative, the incentives reverse: people receiving payments will prefer checks (which can be held back from collection) to electronic transfers. Such a reversal could impose novel burdens on payment systems that have evolved in an environment of positive interest rates.


Conclusion
The take-away from this post is that if interest rates go negative, we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation. Financial service providers are likely to find their products and services being used in volumes and ways not previously anticipated, and regulators may find that private sector responses to negative interest rates have spawned new risks that are not fully priced by market participants.


Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

---

Kenneth Garbade is a senior vice president in the Money and Payments Studies Function of the Federal Reserve Bank of New York's Research and Statistics Group.



Jamie McAndrews is an executive vice president and the director of research for the Bank.

Posted by Blog Author at 07:05:00 AM in Financial Institutions, Financial Markets,Monetary Policy

There's even bigger problems in the Reinhart-Rogoff Thinking?

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SELECTED ARTICLE-OUTLOOK //PIMCO'S WILLIAM H. GROSS //There Will Be Haircuts

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INVESTMENT OUTLOOK

May 2013

There Will Be Haircuts

William H. Gross

“Good as Money,” proclaimed the ad for Twenty Grand Vodka infused with Cognac. Being a beer drinker, and never having cashed in a Budweiser to pay for a fill-up at the local gas station, I said to myself “Man, that must be really good stuff!” Even in a financial meltdown I thought, you could use it in place of cash, diamonds, gold or Bitcoins! And if the Mongol hordes descend upon us during a future revolution, who wouldn’t prefer a few belts of Twenty Grandon the way out, instead of some shiny rocks and a slingshot?

Well, not being inebriated at that moment I immediately shifted focus to a more serious topic. What IS money? A medium of exchange and a store of value is a rather succinct definition, but we generally think of it as cash or perhaps checks that reflect some balance of “ready” cash at a friendly bank. Yet as technology and financial innovation have progressed over the past few decades, and as central banks have tenuously validated the liquidity and price of various forms of credit, it seems that the definition of money has been extended; not perhaps to a bottle ofTwenty Grand Vodka, but at least to some other rather liquid forms of near currency such as money market funds, institutional “repo” and short-term Treasuries “guaranteed” by the Fed to trade at par over the next few years.

All of the above are close to serving as a “medium of exchange” because they presumably can be converted overnight at the holder’s whim without loss and then transferred to a savings or checking account. It has been the objective of the Fed over the past few years to make even more innovative forms of money by supporting stock and bond prices at cost on an ever ascending scale, thereby assuring holders via a “Bernanke put” that they might just as well own stocks as the cash in their purses. Gosh, a decade or so ago a house almost became a money substitute. MEW – or mortgage equity withdrawal – could be liquefied instantaneously based on a “never go down” housing market. You could equitize your home and go sailing off into the sunset on a new 28-foot skiff on any day but Sunday.

So as long as liquid assets can hold par/cost with an option to increase in price, then these new forms of credit or equity might be considered “money” or something better! They might therefore represent a “store of value” in addition to serving as a convertible medium of exchange. But then, that phrase “Good as Money” on the vodka bottle kept coming back to haunt me. Is all this newfangled money actually “money good?” Technology and Fed liquidity may have allowed them to serve as modern “mediums of exchange,” but are they legitimate “stores of value?” Well, the past decade has proved that houses were merely homes and not ATM machines. They were not “good as money.” Likewise, the Fed’s modern day liquid wealth creations such as bonds and stocks may suffer a similar fate at a future bubbled price whether it be 1.50% for a 10-year Treasury or Dow 16,000.

But let’s not go there and speak of a bubble popping. Let’s perhaps more immediately speak about current and future haircuts when we question the “goodness of money.” Carmen Reinhart has said with historical observation that we are in an environment where politicians and central bankers are reluctant to allow write-offs: limited entitlement cuts fiscally, no asset price sink holes monetarily. Yet if there are no spending cuts or asset price write-offs, then it’s hard to see how deficits and outstanding debt as a percentage of GDP can ever be reduced. Granted, the ability of central banks to avoid a debt deflation in recent years has been critical to stabilizing global economies. And too, there have been write-offs, in home mortgages in the U.S., for example, and sovereign debt in Greece. But the cost of these strategies, which avoid what I simplistically call “haircuts,” has been high, and their ability to reduce overall debt/GDP ratios is questionable. Chairman Bernanke has admitted that the cost of zero-bound interest rates, for instance, extracts a toll on pension funds and individual savers. Some of his Fed colleagues have spoken out about the negative aspects of QE and future difficulties of exit strategies should they ever take place. (They won’t!) So current policies come with a cost even as they act to magically float asset prices higher, making many of them to appear “good as money” – shots of vodka notwithstanding.

But the point of this Outlook is that even IF… even IF QEs and near zero-bound yields are able to refloat global economies and generate a semblance of old normal real growth, they will do so utilizing historically tried and true “haircuts” that rather surreptitiously “trim” an asset holder’s money without them really knowing they had entered a barbershop. These haircuts are hidden forms of taxes that reduce an investor’s purchasing power as manipulated interest rates lag inflation. In the process, governments and their central banks theoretically reduce real debt levels as well as the excessive liabilities of levered corporations and households. But they represent a hidden wealth transfer that belies the vaunted phrase “good as money.”

Before drinking up, let’s examine these haircuts to see why they do not represent an authentic store of value even if their bubbly prices never pop. I will give each haircut a symbolic name – I welcome your suggestions as well via e-mail reply: outlook@pimco.com

(1) Negative Real Interest Rates – “Trimming the Bangs”

During and after World War II most countries with high debt overloads resorted to artificially capping interest rates below the rate of inflation. They forced savers to accept negative real interest rates which lowered the cost of government debt but prevented savers from keeping up with the cost of living. Long Treasuries, for instance, were capped at 2½% while inflation was soaring towards double-digits. The resulting negative real rates together with an accelerating economy allowed the U.S. economy to lower its Depression-era debt/GDP from 250% to a number almost half as much years later, but at a cost of capital market distortions.

Today, central banks are doing the same thing with near zero-bound yields and effective caps on higher rates via quantitative easing. The Treasury’s average cost of money is steadily grinding lower than 2%. If current policies continue to be enforced in future years it will eventually be less than 1% because of the inclusion of T-bill and short maturity financing. The government’s gain, however, is the saver’s loss. Investors are being haircutted by at least 200 basis points judged by historical standards, which in the past offered no QE and priced Fed Funds close to the level of inflation. Large holders of U.S. government bonds, including China and Japan, will be repaid, but in the interim they will be implicitly defaulted on or haircutted via negative real interest rates.

Are Treasuries money good? Yes. But are they good money? Most assuredly not, when current and future haircuts are considered. These rather innocuous seeming (-1%) and
(-2%) real rate haircuts are not a bob or a mullet in hairstyle parlance. More like a “trimming of the bangs.” But at the cut’s conclusion, there’s a lot of hair left on the floor.

(2) Inflation / Currency Devaluation – “Don Draper”

Inflation’s sort of like your everyday “Mad Men – Don Draper” type of haircut. It’s been around for a long time and we don’t really give it a second thought except when it’s on top of a handsome head like Jon Hamm’s. 2% ± a year – some say more – but what the heck, inflation’s just like breathing air … you just gotta have it for a modern-day levered economy to survive. Sometimes, though, it gets out of control, and when it is unexpected, a decent size hit to your bond and stock portfolio is a possibility. If our TV idol Don Draper lives another decade or so on the airwaves, he’ll find out in the inflationary 70s. Such was the example as well in the Weimar Republic in the 1920s and in modern day Zimbabwe with its One Hundred Trillion Dollar bill shown below. As central banks surreptitiously inflate, they also devalue their currency and purchasing power relative to other “hard money” countries. Either way – historical bouts of inflation or currency devaluation suggest that your investment portfolio may not be “good as the money” you might be banking on.

(3) Capital Controls – the “Uncle Sam Cut”

Uncle Sam with his rather dapper white hair and trimmed beard serves as a good example for this type of haircut, if only to show that even the U.S. can latch on to your money or capital. Back in the 1930s, FDR instituted a rather blatant form of expropriation shown above. All private ownership of gold was forbidden (and subject to a $10,000 fine and 10 years in prison!) if it wasn’t turned into the government. Today we have less obvious but similar forms of capital controls – currency pegging (China and many others), taxes on incoming capital (Brazil) and outright taxation/embargos of bank deposits (Cyprus). Governments use these methods to keep money out or to keep money in, the net result of which is a haircut on your capital or your potential return on capital. Future haircuts might even include a wealth tax. Are gold and/or AA+ sovereign bonds good as money? Usually, but capital controls can clip you if you’re not careful.

(4) Outright Default – the “Dobbins”

Ah, here’s my favorite haircut, and I’ve named it the “Dobbins” in honor of this 5-year bond issued in the 1920s with a beautiful gold seal and payable, in dollars or machine guns! Bond holders got neither and so it represents the historical example of the ultimate haircut – the buzz, the shaved head, the “Dobbins.” As suggested earlier, the objective of central banks is to prevent your portfolio from resembling a “Dobbins.” I have tweeted in the past that the Fed is where all bad bonds go to die. That is half figurative and half literal, because central banks are typically limited from purchasing bonds payable in machine guns or subprime mortgages (there have been exceptions and Bloomberg reported that nearly 25% of global central banks are now buying stocks believe it or not)! But by purchasing Treasuries and Agency mortgages they have rather successfully incented the private sector to do their bidding. This behavior reflects the admission that modern-day developed economies are asset-priced supported. Unless prices can continuously be floated upward, defaults and debt deflation may emerge. Don’t buy a Dobbins bond or a Dobbins-like asset or a bond from a country whose central bank is buying stocks. They probably aren’t “good as money!”

Investment Strategy

So it seems as if the barber has you cornered, doesn’t it? Sort of like Sweeney Todd! Let’s acknowledge that possibility, along with the observation that all of these haircuts imply lower-than-average future returns for bonds, stocks, and other financial assets. If so, the rather mixed metaphor of “money’s goodness” and “avoiding haircuts” is still the question of our modern investment age. The easiest answer to the question of what to buy is to simply take your ball and go home. If the rules aren’t fair, don’t play. That endgame however, results in a Treasury bill rate of 10 basis points or a negative yield in Germany, France and Northern EU markets. So a bond and equity investor can choose to play with historically high risk to principal or quit the game and earn nothing. PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond. While this Outlook has indeed claimed that Treasuries are money good but not “good money,” they are better than the alternative (cash) as long as central banks and dollar reserve countries (China, Japan) continue to participate.

The same conclusion applies to credit risk alternatives such as corporate bonds and stocks. Granted, this sounds a little like Chuck Prince and his dance floor metaphor does it not? His example proved that dancing, and full heads of hair are not forever. So give your own portfolio a trim as the year goes on. In doing so, you will give up some higher returns upfront in order to avoid the swift hand of Sweeney Todd. There will be haircuts. Make sure your head doesn’t go with it.

Quick Read

1) Central banks and policymakers are acting like barbers. They haircut your investments.

2) Negative real interest rates, inflation, currency devaluation, capital controls and outright default are the barber’s scissors.

3) Gradually reduce duration, risk positions and “carry” as the year proceeds.

William H. Gross
Managing Director

​
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investors should consult their financial advisor prior to making an investment decision.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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SELECTED NEWS : BBG//Near-Record NYSE Margin Debt Leads to Caution: Chart of the Day

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Near-Record NYSE Margin Debt Leads to Caution: Chart of the Day

By David Wilson - May 2, 2013 6:00 AM GMT+0200

• Q

Borrowing to buy U.S. stocks is close enough to a record to cause concern that prices may not rise much longer, according to Cullen Roche, founder of Orcam Financial Group LLC.

The CHART OF THE DAY compares the total amount of margin debt at New York Stock Exchange member firms, according to data compiled by the exchange, with the performance of the Standard & Poor’s 500 Index.

Enlarge image

Traders share a laugh at the New York Stock Exchange. Photographer: Scott Eells/Bloomberg

Margin debt amounted to $379.5 billion in March, the latest month available. The total was the second-highest in the history of the NYSE’s figures, going back to 1959. The highest was the $381.4 billion recorded in July 2007.

“It’s rather alarming to see NYSE margin debt just shy of its all-time high,” Roche wrote yesterday in a posting on his Pragmatic Capitalism blog. The borrowing points to “a fragile foundation” for the current advance in stocks, he wrote.

The 2007 record was set three months before the end of a five-year bull market, which sent the S&P 500 to an all-time high. The index surpassed its peak five weeks ago, after more than doubling from its March 2009 low, and later closed as much as 2.1 percent higher.

Investors owed $92.2 billion in March after subtracting credit balances in cash and margin accounts, according to the NYSE’s data. Holders of cash accounts have to pay the entire purchase price for stocks up front, while those with margin accounts can borrow as much as 50 percent of the price.