# The Behavioural Impossibility Theorem

It’s been a few years since I’ve posted here but here goes…

Many non-economists (and economists alike) seem to think that behavioural economics is the new and important big thing in economics. I’m writing this blog post for myself as a quick reference I can send to people on why I think behavioural economics is fundamentally limited, but it might be interesting to others. The fundamental limitation I will describe is what I call `The Behavioural Impossibility Theorem’. David K. Levine has a great and accessible discussion here too.

The Impossibility Theorem of Behavioural Economics is the simple insight that a behavioural theory of beliefs cannot simultaneously be believed and true. Or, more strictly, a behavioural economic theory cannot be acted upon and be true. The only theories that can be both acted upon and true at the same time are those that satisfy rational expectations (RE).

Why is this the case? Consider an example of forecasting a stock-market crash. Suppose there were a theory that could accurately predict that the stock market was mis-priced and that there would be a crash in a week. This theory can only be true if it is not widely believed or acted upon. If it were believed, then everyone would short the stock market and asset prices would fall today rather than in a week. Thus the theory now becomes false.

Such a theory would be predicated on a systematic flaw in agents’ reasoning. When agents correct the reasoning by adopting the theory they then disprove the theory they now believe. By contrast, in a rational expectations theory, agents necessarily reason as best they can. They do not have perfect foresight or anything like that, but rather, they agree on on an underlying probability distribution for events which is optimal. In this world, the only possible shocks to the stock market that can occur are those which are essentially unpredictable (or predictable only at great cost of things like information acquisition or skill).

Mathematically this idea can be described as follows (ignore this italic text if you don’t want the math). Consider a mathematical space, $X$, where theories describing the world are objects of the space and agents’ beliefs are functions on the space, $f$. Since the economy is composed of peoples’ actions following their beliefs, the belief functions map to real world outcomes, $Y$, i.e

$f:X \to Y$.

In particular, $f$ is a bijection from beliefs, $X$, to outcomes, $Y$. Formally you might have to appropriately condense the belief space into equivalence classes blah blah but that’s by-the-by. Since the bijection exists, beliefs and outcomes can be considered isomorphic spaces, so $X=Y$. In this space, behavioural theories are never fixed points i.e $f(a) \neq a \in X$. Only rational expectations theories are fixed points, i.e $f(a^*)=a^*$. Fixed points are the theories which can be both true and believed.

This is why I, and many others, think that RE theories are the most beautiful and likely to endure. They embrace the intrinsic randomness of human civilization. Much commentary focuses on Economists’ inability to forecast the financial crisis of 2008, but that’s the whole point! If Economists could forecast such a thing then it would signal a much deeper disfunction in our economy and our theories. Rational expectations is the truest embrace of randomness. It is our abyss in which to float, as Professor Mark Fabian would perhaps phrase it.

Note that Rational Expectations is also not efficiency. Perhaps the stock market is mis-priced, and that everyone knows it is but that there are short-sale constraints.* Then the stock market is mispriced, everyone knows that, but the mispricing persists for a while due to frictions. This is why economists like frictional explanations for things (including informational frictions).

David K. Levine nicely analogises economists’ RE theory to the Heisenberg uncertainty principle in physics. The Heisenberg uncertainty principle arises because the physicists’ very act of measuring a quantum system disturbs the quantum system in an unpredictable way. The same thing happens to economists. The act of generating a theory which is acted upon changes people’s behaviour and potentially disturbs the theory. Luckily, economists have Rational Expectations where physicists don’t!

*Actually, short-sale constraints cannot keep the price elevated in a world of pure RE, so the example is technically wrong (you need belief dispersion). I think the example is instructive nonetheless so I’ll keep it.

# The Strength of Strong Form

The Efficient-market hypothesis, developed by Eugene Fama, is probably one of the most contested topics in the history of financial economics. Both on an empiric and theoretical basis economists, traders and media pundits often claim to have the truth that either supports or undermines the observations of Fama dating back to the 1960s. The EMH states that asset market prices reflect all available information and hence obey a ‘random walk’ on a ‘fat-tailed’ distribution.

But when financial economists say ‘reflect all available information’ what exactly do they mean? There are 3 possible interpretations:

Weak form- traded assets reflect all past public information.
Semi-strong form- traded assets reflect all past information but also adjust instantaneously to reflect all present public information.
Strong form- traded assets, in addition to having the properties of semi-strong form also reflect current and past ‘insider information’.
To most people, if one of the above forms is the most plausible it is either the weak or the semi-strong. By my intuition at least, it seems implausible that markets are able to completely price information that cannot even be acted on by most agents. Eugene Fama himself describes access to information on a continuum, where at first the cost is quite flat before quickly skewing off to infinity as more information is obtained on the margin. Hence, by his own admissions it may seem that ‘insider information’ is too costly to attain for most agents.

Nevertheless, Fama and others in favour of the EMH insist that more statistical evidence was found in favour of the strong strand of EMH than for the weaker forms. How can this be? I am by no means well-trained enough to devour the reams of statistical evidence on both sides of the debate and hence will refrain from offering a general opinion on whether the EMH is inherently flawed or a beautiful prophecy; but I will attempt to explain how the Strong-Form of the EMH has more going for it than is commonly assumed. In fact, it seems that Strong-Form is to be expected from some classic financial economics theorems which expose the vulnerabilities of using ‘economic intuitions’ alone. Contrary to popular belief, in this vein a “strong-form” of the EMH is probably more consistent with highly volatile markets than the weaker versions.

The clue to understanding why the ‘strong-form’ may be empirically sound comes from an unlikely source. Nothing really needs to be said about investors obtaining fundamental information for themselves. Rather, it has something to do with the effect that asset trading itself has on the dispersion of information.

A formal and somewhat abstract way of thinking about price information dispersal throughout a market comes from the No-trade theorem. Informally, this theorem states that under conditions whereby the market is composed completely of rational traders (no-noise) and operating at an efficient equilibrium there is no scope to profit off of private information. This is because given that all traders are rational with acknowledgement of collective rationality, any attempt to initiate a trade will reveal the private agent’s informational advantage and hence change market expectations in line with that. Consequently, all insider information is automatically reflected in prices as if it were public information.

Note that the assumptions behind the No-trade theorem are obviously not met by reality, and that theorems themselves are only strictly true when their assumptions are met. However, when thinking about information diffusion in an economy notice the game theoretic nature of asset trading in the hyper-rational world of the No-trade theorem.

Implicitly there is some strategic interaction, where each agent attempts to anticipate the motives of the others, and due to strict rationality ends up concluding that their own information is less accurate. If any forms of the EMH are to be taken seriously then there is the inevitable recognition roughly speaking the market will be at some kind of ‘perceived’ efficient equilibrium with noise traders not having the financial capital to issue the largest trades.

Hence, whilst the assumptions of the No-trade theorem are not completely met even when the EMH holds, the No-trade theorem still provides a context for understanding how Strong-Form may actually be more plausible than expected.

The idea is that using Fama’s model of an information-cost continuum, only agents with access to substantial capital have the capacity or incentive to actually obtain that information and then trade on it. Following this, the trade using insider information is likely to be quite large, often issued by a known Hedge Fund which can ‘lever’ the information up to the hilt. The fact that the private information holder is only likely to exist if they are agents with an ability to trade large volumes implies that they are often sophisticated agents whose valuations are more likely to be perceived as fundamental rather than noise by the rest of the market. Thus, using the game theoretic analysis from the No-trade theorem it would be quite rational for other agents to reprice their own valuations in line with the offer/bid by the private information holder.

It can be expected that in a world of fast paced traders trailing behemoth funds there is little to be gained from trading on insider information which serves as a signal more than anything else. Practically, it may even be in the public’s interest to permit insider trading where there is scope to maintain the information-cost continuum (via an excise tax perhaps); seeing as it can signal an efficient pricing mechanism.

Furthermore, the existence of these ‘game theoretic’ patterns whereby smaller traders attempt to piggy-back off the information of more sophisticated ones in a world of Strong-Form EMH could also be more prone to volatility of the sort first identified by Mandelbrot. In this context, the ‘fat tails’ of financial markets can represent the cascading of less sophisticated agents attempting to bid immediately after large sophisticated ‘shock trades’. In turn, quick readjustments may be the realisations that high-frequency ‘trailing’ is often misplaced since large trades may simply reflect internal dynamics of the leading firm. This fits the observable facts that shocks are often random, and readjustments follow seemingly unimportant information.

Note, that none of the above discussion is bullet-proof financial theory, nor is it an exposition of the strength of the EMH. Rather, I have attempted to explain practically how insider information can be priced effectively in markets, and how it is linked to seemingly unexplainable volatility that may otherwise be used as evidence for irrationality.

# Formalising ‘Trickle Down’ Economics

Note I am not an advocate of trickle down, I just want to make the definition meaningful. I apologise for the slap dash structure.

Looking at the Wikipedia definition of trickle down economics one can get a broad sense of the kind of policies that it might imply. My contention is that the term is just a euphemism used by left-wing audiences, with little actual substance in its current popular usage. I propose an alternative interpretation here which is more in line with the original conception.

When people normally think of trickle down they think of things like tax cuts on the rich, financial deregulation and union busting. Tracing back to 1896 the term was popularised by a Presidential candidate as being “you just legislate to make the well-to-do prosperous, that their prosperity will leak through on those below.”

This is a purely rhetorical point, but it is possible to think about how this framework can work from a technical economic perspective. There are a few ways. From a supply-side point of view we might just think of deregulation. But this is not really ‘trickle down’. It already has a term- deregulation.

The notion of ‘trickle down’ that I would understand from the 1896 definition is one where we conceptualise that by funding the business and wealthy interests we can boost economic growth for all. Deregulation may or may not be in the interests of businesses, so it’s not a useful way of thinking of it.

So let’s think about this formally. Why would helping rich people boost economic growth? Milton Friedman in a famous video described the argument as being “When you give money to a rich entrepreneur, they’ll put it back into the business and create investment and jobs for all. By contrast if you give it to a poor person, they will tend to consume rather than invest”.
This idea can be made more rigorous as follows. Rich people and businesses have a lower marginal propensity to consume. Therefore they have a higher propensity to save. Under standard macro assumptions, these savings in turn go through the financial sector to create investment. Thus by allowing the rich to retain more income you can grow the economy faster for long term benefit to everyone, at the cost of short term consumption. The point is that you try and take from agents that spend, and give to agents that save to boost the pool of savings. In turn you boost the pool of investment.

The precise mechanisms which lead to this can be found in an intro macroeconomics textbook if the reader is interested.

I contend that this is the most meaningful way to approach the definition of trickle down. Don’t think of it as a bunch of policies with uncertain impacts on the rich. That is just pure political rhetoric with no meaning. Think of it as a framework to grow the economy by affording businesses and the rich more opportunities.
Now that we are thinking of trickle down in a more formal and precise framework, what are some examples.

Let’s look at Reaganism. Is that trickle down? I contend that it is NOT. Reagan’s economic reforms involved large scale financial deregulation. One impact of this was to allow the US economy to borrow more from international capital markets. This in turn via some technical trade theory forced a current account deficit on the US economy. This borrowing surge overall probably lowered the total pool of investment in the US and dramatically lowered savings rates. (Interest rates would have stayed roughly the same though.). Hence yes while in some ways the rich benefited from these policies, the impact on US business profits is uncertain. We can look at this some more, but I think I have illustrated my point.

Now let’s look at China and Germany. In a certain sense these two economies have similar structure, but China would be the one to focus on here. Both via a large swathe of economic policies give huge implicit subsidies to business. Things like energy subsidies, infrastructure spending and currency devaluation take money from consumers and give money to businesses. The result is a strong pool of savings that have created highly industrial economies. Consequently we get faster (though distorted) growth, and a widening of income inequality. Note that both these economies are very different from Reagan’s conceptualisation of the ideal US economy. They both have high regulation. But it is this regulation that captures the ‘trickle down’ effect at its most potent.

If we look at trickle down this way, then in a sense it definitely does lead to fast growth. Japan, China, Germany, the UK, Taiwan, South Korea all used a form of high regulation trickle down to reach record levels of growth, though with large negative consequences. This is not to say that ‘trickle down’ is good in any normative sense. I don’t really have a view on that, as the morality is extremely complex. But it certainly seems like it works from a ‘boosting growth’ perspective if we have a formal definition.

The point of this rant is to give a shitty rhetorical tactic some substance, and address a pet peeve of mine. Helping business interests actually does boost growth in developing nations, and the left cannot simply ignore this inconvenience.

# Some simple thoughts on international trade

On the campaign trail and now in the Oval Office, Trump has continually talked about trade. One of the first executive orders was a withdrawal from the Trans-Pacific Partnership, and one of his most influential means of getting the US rust belt to ‘vote red’ was by threats of tariffs on China and increased border taxes on Mexican imports.

Missing in this post-election landscape has been a nuanced discussion on trade policy. Instead of exploring the complexities of trade properly, policy wonks and establishment politicians blindly jump on the free trade bandwagon, whilst populists equally shout that ‘trade deficits are bad’. What is the middle ground between these two echo chambers, and were there potentially areas where Trump was right instead of wrong?

In general, arguments for free trade are supported by the principle of comparative advantage — the idea that some individuals or nations are relatively better at producing certain goods than others. This is a strong argument that can be found in any Microeconomics textbook. Moreover, the magnitudes of excess productivity involved in specialisation are often larger than our intuitions would imply. The world would genuinely be far worse off if China were to specialise in mineral exports and Australia in manufacturing. In this context, Trump’s protectionist rhetoric seems silly on a macro level, akin to the behaviour of a lobbyist institution that wants to protect its particular sector to the detriment of the rest of humanity.

Whilst free trade in goods and services is crucial to boosting people’s standards of living, free trade in financial capital can be even more important. My view on the subject is that it is usually capital flows that drive goods rather than the obverse, at least in the extreme cases. Unfortunately the capital flow aspects of trade policy are often ignored by pundits and establishment politicians to the detriment of policy outcomes. It is for that reason that I will focus in particular on the dynamics of capital flows in this article to expose some missing pieces of the trade puzzle.

In light of this it is important to recognise that one cannot have free trade in goods without free trade in capital. At the risk of oversimplification, basic arithmetic requires trade in goods to be matched by trade in capital — if $10 of goods are shipped from Europe to the US, then the US must ‘ship’$10 (which is capital) to pay for those goods to Europe. Thus, when the Eurozone exports goods to the USA it in turn imports ownership of USD, and then must decide to do something with that USD. In the case that the Eurozone then spends the USD on US goods, the export is netted out and nothing happens. In the other case, where the Eurozone buys US financial securities and assets, the underlying structure of both economies will shift in a few ways which I will outline below.

(For intuition’s sake I will refer to the purchase of foreign assets as a ‘capital export’. In economics broadly capital exports can mean a few different things but here it is assumed to just mean the purchase of foreign financial securities.)

To see why capital flows can be what drives international economies instead of goods, consider the case of the post-war Atlantic world. At the end of WW2, the USA had huge stocks of physical and financial capital at its disposal with little marginal return to be had at home. Just across the Atlantic Ocean however was an entire continent that had been decimated by war and desperately needed investment. Europeans were educated and productive agents that had no capital stock to utilise. Under a free trading Atlantic partnership the production imbalance was solved almost instantly. Here the USA was allowed to flood Europe with finance and capital so that the Europeans could rebuild their economies in a mere decade with an investment surge. All the while Europeans could maintain high levels of consumption and continue investment in education under the proviso of continued American financial support. This created the bedrock of an Atlantic world which quickly resumed its position as the global economic centre.

There are many similar examples to this in economic history, but this one should illuminate why thinking about free capital flows is often more powerful than thinking about free flows of goods.

With all this in mind, it seems like capital exports and free trade form an amazing and dynamic duo. But there is more to the story.

In the last few decades, international trade has witnessed huge volumes of capital shift between countries in a way that is fundamentally not free. Superficially, goods have been traded in a free market, but capital flows have been distorted hugely by China and Northern Europe. The ways in which China and Germany have managed to distort global trade are not simple, but are nevertheless well understood by economists. In general the way in which these countries distort trade involves a cohort of policies which force up domestic savings rates. Some example policies are currency devaluation, interest rate repression, union busting, wage repression and industrial subsidies. All of these policies implicitly shift income from consumers to producers. That is, households to firms. I will henceforth call this system of policies “industrial policy”.

By forcing up savings rates, these economies are able to make investment cheaper at home, since income that is saved goes through the banking sector to become loans for investment. Moreover, by shifting incomes from households to firms economic growth can be accelerated and low unemployment maintained. This arrangement forms the foundation under which the Chinese political system operates. Chinese citizens implicitly accept less political freedom and income redistribution to firms in exchange for sky-high growth and low unemployment. In a world in which firms are desperate to invest and productive opportunities abound there isn’t a huge problem here. Indeed, I think this model is by far the best if one’s aims are to bring a country out of poverty and into middle-income status. Example countries that have used this model to great benefit are Japan, Taiwan, South Korea, Germany, Britain, Sweden, China and the USA when they underwent their growth miracles. (If there is demand I may go into greater depth on this model in another article).

But the world in which firms are hungry to invest and financial opportunities are numerous does not describe the current global economy. It is my contention that this has not actually described international economics since at least 1990. The world today is one in which desire to save exceeds desire to invest, and thus countries that are growing quickly due to their manipulated policy environments do not suck up their own savings but rather push it out into the rest of the world. When a country ‘pushes savings’ abroad what they are doing is exporting at artificially high levels due to their industrial policies. The result is an accumulation of foreign currency which is then used to underwrite capital exports with the purchase of foreign securities.

We therefore need to rethink the impacts of policies that force up the savings rate for a context where the world seems over-inundated by financial capital. In particular let’s think over what happens when a country begins a capital export surge and accumulates foreign currency in 3 key scenarios.

For the first scenario, consider an importing country which is hungry for investment- for instance a country with large, productive firms that can’t get domestic finance. In this instance, the capital from the exporting countries will go to fund this arrangement. Both parties benefit and we have a situation akin to the post-war Atlantic.

In the second scenario let’s think about an importing country without too much need for investment but with flexible financial markets, and consumers that want more credit. In this instance, the households generally borrow the capital from the capital surge and therefore boost household consumption. What should be noted is that debt cannot rise indefinitely, so this scenario is thought to lead to financial pressures that induce the next scenario.

Finally, there is the case of an economy that lacks the willingness to boost investment but that also has households which are paying down debt rather than accumulating it. Normally, such economies would not import capital, as there is no demand and there is excess supply, but international industrial policy can give rise to capital imports in these economies.

Note that the second scenario in many ways describes the USA in the lead up to the GFC, whilst the third describes it post-GFC. It is a common thread among international economists that international trade policies were crucial factors influencing the GFC.

One example policy is the Chinese devaluation of the renminbi (RMB). Since the late 80s, the People’s Bank of China has managed to accumulate trillions of dollars in US reserves by printing and selling RMB and then buying dollars. By then using these dollars to buy treasury securities — essentially a long-term loan to the US government — it can force the Chinese economy to lend to the US economy. This then allows China to be more competitive against the US since the capital import must be matched by a goods import, where the US then covers the import gap with the finance provided by China’s purchase of treasuries.

In a context where US consumption and investment doesn’t rise but imports do rise there is only one way to weather this trade distortion: decreased consumption of US goods and decreased investment, which creates unemployment and slower growth.

It is in this environment of an artificially cheap euro and renminbi that the current global trading arrangement has been detrimental to southern Europe and the US, while being hugely profitable to Northern Europe and East Asia. Consequently, it is easy to see how Trump could actually solve the situation, and how protectionism could be the key to rebalancing the world economy. But Trump’s proposals seem to fundamentally miss the mark.

Take tariffs on China. This doesn’t really address the route of the problem since China is using capital to drive goods, so a tariff could have uncertain efficacy. Moreover this ‘solution’ it is also coming too late in the game. Since late 2014, China’s purchase of US dollar reserves has gone into reverse, with the head of its central bank expressing interest in avoiding another devaluation of the RMB. China is still manipulating trade to its advantage, but the moment to oppose them was back in 2008. Trump’s tariffs look much like beating a dog with a stick just as it starts to behave well.

Trump simply came too late to the party. Potentially, his policies would have worked in ’08, but now he is just likely to just increase global confusion more on the issue of trade. Likewise, Hillary Clinton and the establishment are equally to blame for not actually addressing the many capital market distortions that have devastated swathes of the US economy. In 2012, Hillary even went to China to reinforce the notion of safe US-bonds, thereby encouraging the Politburo to lobby the PBoC to buy more USD. It is this kind of dumb rhetoric from both sides that has left the West in shambles, with left and right wing populism on the rise as far as the eye can see.

One cannot help but be depressed by the lack of nuance in today’s economic discourse. This article should be seen as a call to arms for more Paul Keating-esque figures to reinvent politics in the West. Electorates have the capacity to be informed and nuanced, but politicians need to lead the charge.

# The Strength of Strong-Form

The Efficient-market hypothesis, developed by Eugene Fama, is probably one of the most contested topics in the history of financial economics. Both on an empiric and theoretical basis economists, traders and media pundits often claim to have the truth that either supports or undermines the observations of Fama dating back to the 1960s. The EMH states that asset market prices reflect all available information and hence obey a ‘random walk’ on a ‘fat-tailed’ distribution.

But when financial economists say ‘reflect all available information’ what exactly do they mean? There are 3 possible interpretations:

Weak form- traded assets reflect all past public information.
Semi-strong form- traded assets reflect all past information but also adjust instantaneously to reflect all present public information.
Strong form- traded assets, in addition to having the properties of semi-strong form also reflect current and past ‘insider information’.
To most people, if one of the above forms is the most plausible it is either the weak or the semi-strong. By my intuition at least, it seems implausible that markets are able to completely price information that cannot even be acted on by most agents. Eugene Fama himself describes access to information on a continuum, where at first the cost is quite flat before quickly skewing off to infinity as more information is obtained on the margin. Hence, by his own admissions it may seem that ‘insider information’ is too costly to attain for most agents.

Nevertheless, Fama and others in favour of the EMH insist that more statistical evidence was found in favour of the strong strand of EMH than for the weaker forms. How can this be? I am by no means well-trained enough to devour the reams of statistical evidence on both sides of the debate and hence will refrain from offering a general opinion on whether the EMH is inherently flawed or a beautiful prophecy; but I will attempt to explain how the Strong-Form of the EMH has more going for it than is commonly assumed. In fact, it seems that Strong-Form is to be expected from some classic financial economics theorems which expose the vulnerabilities of using ‘economic intuitions’ alone. Contrary to popular belief, in this vein a “strong-form” of the EMH is probably more consistent with highly volatile markets than the weaker versions.

The clue to understanding why the ‘strong-form’ may be empirically sound comes from an unlikely source. Nothing really needs to be said about investors obtaining fundamental information for themselves. Rather, it has something to do with the effect that asset trading itself has on the dispersion of information.

A formal and somewhat abstract way of thinking about price information dispersal throughout a market comes from the No-trade theorem. Informally, this theorem states that under conditions whereby the market is composed completely of rational traders (no-noise) and operating at an efficient equilibrium there is no scope to profit off of private information. This is because given that all traders are rational with acknowledgement of collective rationality, any attempt to initiate a trade will reveal the private agent’s informational advantage and hence change market expectations in line with that. Consequently, all insider information is automatically reflected in prices as if it were public information.

Note that the assumptions behind the No-trade theorem are obviously not met by reality, and that theorems themselves are only strictly true when their assumptions are met. However, when thinking about information diffusion in an economy notice the game theoretic nature of asset trading in the hyper-rational world of the No-trade theorem.

Implicitly there is some strategic interaction, where each agent attempts to anticipate the motives of the others, and due to strict rationality ends up concluding that their own information is less accurate. If any forms of the EMH are to be taken seriously then there is the inevitable recognition roughly speaking the market will be at some kind of ‘perceived’ efficient equilibrium with noise traders not having the financial capital to issue the largest trades.

Hence, whilst the assumptions of the No-trade theorem are not completely met even when the EMH holds, the No-trade theorem still provides a context for understanding how Strong-Form may actually be more plausible than expected.

The idea is that using Fama’s model of an information-cost continuum, only agents with access to substantial capital have the capacity or incentive to actually obtain that information and then trade on it. Following this, the trade using insider information is likely to be quite large, often issued by a known Hedge Fund which can ‘lever’ the information up to the hilt. The fact that the private information holder is only likely to exist if they are agents with an ability to trade large volumes implies that they are often sophisticated agents whose valuations are more likely to be perceived as fundamental rather than noise by the rest of the market. Thus, using the game theoretic analysis from the No-trade theorem it would be quite rational for other agents to reprice their own valuations in line with the offer/bid by the private information holder.

It can be expected that in a world of fast paced traders trailing behemoth funds there is little to be gained from trading on insider information which serves as a signal more than anything else. Practically, it may even be in the public’s interest to permit insider trading where there is scope to maintain the information-cost continuum (via an excise tax perhaps); seeing as it can signal an efficient pricing mechanism.

Furthermore, the existence of these ‘game theoretic’ patterns whereby smaller traders attempt to piggy-back off the information of more sophisticated ones in a world of Strong-Form EMH could also be more prone to volatility of the sort first identified by Mandelbrot. In this context, the ‘fat tails’ of financial markets can represent the cascading of less sophisticated agents attempting to bid immediately after large sophisticated ‘shock trades’. In turn, quick readjustments may be the realisations that high-frequency ‘trailing’ is often misplaced since large trades may simply reflect internal dynamics of the leading firm. This fits the observable facts that shocks are often random, and readjustments follow seemingly unimportant information.

Note, that none of the above discussion is bullet-proof financial theory, nor is it an exposition of the strength of the EMH. Rather, I have attempted to explain practically how insider information can be priced effectively in markets, and how it is linked to seemingly unexplainable volatility that may otherwise be used as evidence for irrationality.

# Potential Limits on Monetary Transmission

In the classical model of monetary theory, central banks are able to affect real economic activity through control of interest rates. In practice, it is thought that control over short-term rates such as the cash and federal-funds rates is potent due to a mechanism known as the ‘lending channel’.

According to the lending channel model, central bank control of reserves affects the supply of deposit financing available to banks. In turn, this allows the commercial banks to greatly expand their lending capacities.

Whilst this mechanism is widely known by economists, the assumptions that underlie it are not so familiar. In particular there are 3 critical requirements for the model. (I use vocabulary corresponding to a contraction in reserves)

• banks can do stuff. The neutrality postulate of money breaks down in the short term. Price adjustments are imperfect such that that nominal changes have large bearings on real outcomes.

• Demand for banks. Firms in the economy are reliant on the efficiency of banks such that bank loans and public finance via bonds are not perfect substitutes. In other words, the Modigliani-Miller theorem breaks down in a particular way implying firms cannot offset decreased credit from commercial banks with public credit.

• Supply of bank credit is affected by the Central Bank. Commercial banks do not insulate their lending actions from central bank operations. This is interpreted as a reluctance from the banking sector to switch from deposit funding to other forms of finance such as commercial paper and equity which are less reserve-intensive.

(These assumptions were identified by Kashyap and Stein (1994))

Both empirically and intuitively conditions 1) and 2) are likely valid, but the 3rd is not self-evidently sound. In fact, it relies on the assumption that for commercial banks debt instruments such as commercial paper are not good substitutes for reserves. The substitutability between these two instruments is thus the focus of this post.

Luckily, the extreme monetary conditions of this decade have provided a clearer view of the situation which I hope will become the topic of more analysis going into the future.

To see how extreme monetary conditions can give us a clear view of the fault lines in condition 3, we must first look at how Quantitative Easing (QE) worked in the U.S. I will not give the full mechanistic exposition (though at some point I probably should since it is a frequently asked question), but rather will attempt to explain some stylistic elements which shed light on the Monetary Transmission mechanism.

When the Federal Reserve embarked on QE3, the most expansive and concentrated of the QE iterations, it underwent a series of huge purchases of long term government debt (to the tune of $80 billion per month). In exchange for these purchases of government debt it credited the equivalent amount of reserves into the banking sector. In addition, as a precaution to stop runaway credit growth, the Fed paid 0.25% interest on ‘excess reserves’ (the reserves that banks held above their 10% requirement). The goal of course was to reduce long term rates via the purchase of long term assets. But there is something else here. Now that the Fed was paying 0.25% interest on excess reserves, reserves themselves had become a highly liquid asset that in all but name resembled short-term bonds issued by the Fed. Hence, what we would expect to see is not just a series of purchases that pull down the yield curve on the long end; but rather a series of purchases balanced by sales which should push up the yield curve on the short end. In other words, this operation should not have just compressed the term structure of interest, but actually twisted it. One can think of it as an increase of short term debt supply as well as an increase in long term debt demand. Nevertheless, throughout QE3 there was a persistent fact that came to the surprise of quite a few monetary economists. Namely, the yield curve in the US did not actually twist, but in fact was compressed in many markets- contrary to expectations. Commercial paper markets for example in commercial banks fell quite dramatically over the period 2011-13. Thus, on balance there was likely a reduction in the issuance of commercial paper by financial institutions who instead financed operations through the deposit account as availability of reserves increased. Thus, the new reserves served simultaneously as debt issuances by the Fed but to some extent also capitalised bank balance sheets just as commercial paper would in other contexts. Remarkably, the increased issuance of debt by the Fed via QE was offset by decreased issuance of commercial paper by banks to fund their assets. If this analysis is right, and there are no other factors at work, (even if there are I think the scope of QE3 would be enough to swamp most other financial forces) the conclusion of such an unexpected repression of the yield curve is that financial institutions may perceive commercial paper issuance as a substitute for deposit funding. This gives a view into the financing of assets which actively undermines the idea that banks do NOT insulate their balance sheets from central bank operations. The lending channel may be less potent than we think. # The Return of MMT at the ANU I recently saw a very interesting debate over the merits of Modern Monetary Theory and Post-Keynesian ideas amongst some economics students at the ANU. The Modern Monetary Theorist (MMTer) claims can be summarised as follows: Government taxation need only be driven by the need to force convertibility of the currency. Past that point, taxation as a means of revenue sourcing is unnecessary since the central bank can just monetise debt. Given that under MMT models, monetary policy is just an exchange of financial assets, such monetisation would not have an inflationary impact as long as the economy stays just below the NAIRU. Furthermore, if there were a small inflationary impact resulting from such policy, the evidence suggests that unemployment is a far greater burden on society than inflation. I will not go over the basic principles of MMT. Such resources can be found here. Rather, I wish to respond more broadly to the debate at hand, without delving too much into the specifics. As I perceive it, the crux of this argument stems from a misunderstanding of monetary theory that ignores the role of expectations and confuses the definitions of credit and money. My aim is to illustrate some of the nuance lacking in the argument above, whilst also confirming that once we look at the situation from the framework of modern macroeconomics the inflationary impacts of such an MMT policy proposal would be far more severe than alleged. Firstly, the idea that government debt can be monetised without inflationary impact is one that can be answered by monetary theory alone. When we discuss the monetisation of deficits we are talking uniquely about the creation of base money in exchange for Treasury bills that would otherwise be sold to the market. Thus, the tangential idea that government spending cannot be inflationary since any government deficit must imply a foreign/private surplus is not relevant. This common retort, simply uses real demand side analysis to peer into the world of nominal relationships, and in facts relies on the assumption that the deficit itself is not being funded by seigniorage. In this light, one does not need to talk about the monetisation of deficits in some isolated theoretical vacuum; rather we just need to look at the conduct of monetary policy more generally and in particular the theory underlining Quantitative Easing (QE). As I see it, the monetisation of a government deficit over time is the effective equivalent to a bout of QE, with the added proviso that the central bank commits to never unwinding the purchase. With this clarification comes what Scott Sumner coined as ‘The Achilles Heel of MMT’. Let’s assume that the central bank opted to monetise a deficit via an expansion of its balance sheet that would never be unwound. As an example, let’s say they doubled the stock of base money. Neither banks nor the public are going to hold twice as much base money at the same interest rate, the opportunity cost is too high. Additionally, anticipating that such injections are permanent with other agents rebalancing their portfolios to clear off excess liquidity one would expect a flow of funds into asset and debt markets. This would irrefutably drive interest rates down to zero and inflate asset prices across the economy. Hence, we are left with an economy far outside its Wicksellian equilibrium. Continuing in this vein Sumner has noted: “MMTers forget that the nominal interest rate is the price of credit, not money. The Fed can’t determine that rate, it reflects the forces of saving supply and investment demand. Hence an attempt to set interest rates far below their correct level in savings/investment terms (the Wicksellian natural rate), would trigger an explosion in AD, and much higher inflation. Central banks know this, which is why after the inflationary 1965-1981 period they adopted the Taylor Principle.” In response to this argument, many MMTers would cite cases of Japan post 1990 and the USA in 2009, situations where the economy was far below the NAIRU. But this is a dishonest citation with an insincere framework. Before these case studies can be addressed, two fundamental distinctions have to be made. Firstly, the process of expanding central bank balance sheets is one that is primarily concerns bond, not labour, markets. Thus, the NAIRU framework for looking at monetary operations is not an accurate one. Rather, we need to look at these cases through the lens of a good ol’ fashioned liquidity trap. Whilst changing this criteria may seem somewhat trivial, when it comes to the distortion of facts it is an important distinction. MMTers assert far too often that since an economy is almost never at the NAIRU inflationary pressures are not a concern. From the perspective of monetary policy nevertheless, inflationary concerns are always present when expanding the balance sheet unless the economy is in a liquidity trap. Liquidity traps however, are a far rarer observation than economies with employment below the NAIRU. Thus, MMTers claiming that balance sheet expansions are anywhere and everywhere inflation neutral are either insane or dishonest. The second distinction however is even more important. It is true that in both Japan’s lost decade and the US’ post-GFC stagnation central banks greatly expanded their balance sheets, increasing the supply of base money by trillions of dollars. Nevertheless, in both these situations the QE operations were perceived by the market to be temporary operations. The distinction between temporary central bank expansions of the balance sheet and a permanent increase via the monetisation of deficits is an important one. Let us consider an example. In the first case, consider a financial institution temporarily credited by the central bank with base money. Optimally, it wants to profit off of this credit, and as such it may purchase some financial assets. Given that this operation is temporary though, at some point this purchase must be unwound with a corresponding sale. As a group, all financial institutions will have to unwind purchases with sales at some point. With arbitrage accordingly the fundamental demand for assets over time will remain unchanged. Now consider a financial institution that is permanently buffeted by central bank liquidity injections. In this case, the purchase of an asset doesn’t have to be unwound at any point, so any current purchases need not be met by future sales. Here, there is no scope for arbitrage and asset markets witness a tangible increase in demand. Consequently, the difference between a temporary and permanent expansion of central bank balance sheets is immense. Since monetisation of fiscal deficits must imply a permanent iteration of QE the effects would diverge considerably from those observed in Japan and the US. At this point we are left with just a reiteration of the standard rebuttal that “unemployment is worse than inflation, so even if MMT policy proposals would result in higher inflation, the benefits of reducing unemployment would far out-weigh the costs.” At this point we are beating a dead horse. The notion that there is a long-run trade-off between inflation and unemployment is one that has been repeatedly rejected by both theory and empirics since the 1950s. In the short run, I am sure that MMT proposals could boost output, especially in Europe where a credible commitment to increase the money supply is desperately needed. But in the long run, such ideas are of no merit whatsoever. It is for these reasons that I see the position of MMTers as untenable when it comes to deficit monetisation. The proposals put forward are invariably inconsistent with the current monetary theory and offer no alternative framework of their own. # A Word Against the Gold Standard Now that we’re now warming up for another GOP and democrat debate in the US, I thought it was time to expound some more economic consensus. Namely, discussion over the Gold Standard. To be honest, I find it surprising that the Gold Bug continues to consume many fringe elements of the political spectrum given what we’ve observed in Europe since 2009. Economically, Europe’s problems are almost wholly due to the difficulties of holding a fixed exchange rate over sub-optimal currency zones. The Gold Standard, in light of this, has all the features of such a fixed exchange rate with the added inflexibility of weakened central banks. Is this what the world needs in the future? The contention of most economists is that it is not; that it is a ‘barbarous relic belonging to the dustbin of history’. This is insisted for the following reasons: • Capital flow Bias. As suggested by Peter Temin, a fundamental structural flaw of the Gold Standard was the asymmetry of price-specie flows between surplus and deficit countries. In theory, the Gold Standard should have corrected trade imbalances since a country with trade surpluses (deficits) would receive capital inflows (outflows) in the form of gold. These specie inflows in turn would expand (contract) the money supply and raise (dampen) the price level. Thus, correcting the imbalance of competitiveness between countries and balancing trade. In practice however, it was very easy for trade surplus nations to sterilise inflows whilst deficit nations were forced to contract the domestic money supply in an effort to ‘catch-up’. Overall this had the effect of pronouncing the demand-side impact of trade imbalances rather than alleviating them, in turn creating a deflationary bias.Sound familiar? This line of thought, whereby deficit nations are forced into internal devaluation as surplus nations sterilise the inflows, is the key issue underlying Europe’s sovereign debt crisis. • Macroeconomic contagion. Picture what happens when an economy that forms part of the Gold Standard enters a recession. Wages and prices fall as per usual, and competitiveness is increased. This all happens under floating exchange rates as well. The difference in the Gold Standard however is that this fall in wages and prices, through the trade account, creates an inflow of specie domestically that must be matched by a global outflow. Thus, though the domestic money supply may be allowed to expand as per usual, overseas markets are forced into a contraction. In this sense, economic contraction in a few major markets has an added contagion effect that is wholly divorced from economic fundamentals; caused instead by monetary rigidities. • Short-Term Volatility. Whilst it is true that the under the Gold Standard the world witnessed a more stable long-run price level, in the short run there was far greater volatility. This came from the fact that the conduct of monetary policy would be subjected to supply-side concerns amounting from the industrial demand and supply of gold. In addition, financial speculation on commodity prices would tangibly affect coverage ratios and thus monetary policy. Overall, this had the effect of destabilising commercial balance sheets and frustrating macroeconomic management. • Practicality According to recent estimates by the Federal Reserve, M2 in the U.S alone today is estimated at about$10.5 trillion, whilst the value of all gold ever mined amounts to around $8.2 trillion. If the Gold Standard were to be implemented today, it would require one of two things. In the first instance, central banks across the globe could contract the money supply by a huge quantity and inflate the price of gold past all industrial applications. Or, central bank reserve requirements could fall precipitously. The trade-off is most definitely between a calamitous recession on the one hand and a destabilisation of global finance on the other. • Speculative Attack. We’ve all seen what happens to central banks that can’t maintain their pegs, or fall victim of severe financial speculation. It has happened in both the developed and developing economies in the post-war era. When foreign reserves fall to levels that make effective coverage of the exchange rate impossible they fall victim to sharp and intense financial panics. The Gold Standard would entail a Global Return to policies that risk the same situation. # Finance Under Attack As the topic of financial stability becomes increasingly important in the Australian political landscape I have increasingly found myself confronted by 2 indubitably populist arguments that claim to undermine the consensus in financial economics. The 2 claims that I have been confronted with go as follows: 1. The crash of September 15, 2008 is a perfect counterexample to the efficient market hypothesis. Clearly, innovation creates an information asymmetry in finance since sellers can deceive buyers via the ‘complexification’ of products. 2. Bailouts provide an implicit subsidy to institutions that desire to take on excessive risk. First off, it is probably helpful to recognise that there is a vast amount of misinformation circulating with respect to TARP and the Federal Reserve’s emergency liquidity facilities. In many political circles I hear the claim that the response of the Fed in 2008 was an implicit subsidy to the financial sector at the expense of the taxpayer. This claim however, is dubious at best. In fact, if one looks at the actual cash flows from the emergency loan facilities it is clear that the Fed has ostensibly profited off of the crisis. From October 2008 onwards Bernanke made it clear that the Fed would constrain credit support to illiquid institutions only, and would not fund insolvent corporations. I would also claim that the Treasury department’s TARP has delivered a substantial profit. Thus, the position that bailouts are everywhere and anywhere a phenomenon of corporatist greed is not tenable in my view. Interestingly enough though, the conservatorship of Fannie Mae and Freddie Mac (prior to TARP), did indeed involve substantial transfers of losses from the private to the public sector. These losses on the whole could amount to over$300 billion if the worst forecasts are to be believed.

This opens the argument, is there an actual case for central bank and treasury intervention on behalf of insolvent institutions? On the surface, it appears difficult to justify such an action given that it would involve the creation of moral hazard to some extent.

But how does this moral hazard actually manifest? Moral hazard undoubtedly develops from the class of agents that are shielded from risk by public policy. In the vast majority of conservatorship arrangements these agents are the senior creditors. Equity holders and the managerial class classically get wiped out and as such, those who are directly insured are not those who are direct risk takers. Instead the implicit subsidy takes an ancillary form, where creditors will generally be inclined to lend to risky institutions at lower rates. The insensitivity of interest to risk thence creates a profit spread that is conducive to leverage and risky investments.

But notice the implicit assumptions here. In the real world it is not the sellers of derivatives that are insured, but rather a distant group of savers. To assume that these saver understand their government insurance policy we assume a kind of hyper-rationality. These creditors can not only perceive the levels of risk embedded in investment bank assets, but can also foresee the chance that the public will insure against any possible downside. Here, the level of moral hazard emanating from public policy is directly proportional to the informational efficiency of financial markets. In other words, a world in which the odd bailout can create huge moral hazard problems is also the world in which markets have high informational efficiency.

Hence, argument (1) is completely inconsistent with argument (2) unless one can make the claim that the makeup of CDOesque consumers is less sophisticated than the makeup of creditors. I am not going to come out in favour of any position on financial regulation here, but I encourage those who take issue with the whole paradigm of financial economics to reconsider their dogma.

# Promoting Economic Development- The Role of Financial Intermediation

In their somewhat recent publication “This Time is Different: 5 Centuries of Financial Folly” Harvard Professors Kenneth Rogoff, and Carmen Rhinehart developed a number of interesting conclusions regarding financial crises, macroeconomics, and the business cycle. Notably, they came to the conclusion that downturns in the economic cycle that were characterised by widespread financial stress would engender much slower recoveries. Speaking with Joshua Bolten just this year Ben Bernanke affirmed that this was, broadly speaking, due to the fact that after a crisis, it takes some time for the financial sector to return to normal operations (in particular, risk evaluations) even as the rest of the economy pulls out of the headwinds. In these testimonies Bernanke, Rogoff and Rhinehart all implicitly note that finance plays an important role in growth trends. Yet whilst the role of a healthy financial sector has been widely identified for its importance to short-term recoveries, the wider role of finance in longer term growth paths has been grossly underrated.

This brings us to the central role of banking and finance in an economy. For continued economic growth to be a reality, investment demand and savings supply must be in equilibrium.* That is a central premise of modern macroeconomics. Logically, investment and savings cannot be unequal, or else the economy will fall into a disequilibrium of frothy expansion, or rapid contraction. The role of financial institutions in a modern economy, is to ensure that this relationship is upheld. By establishing a financial equilibrium between lenders and borrowers through interest rates, the financial sector ‘recycles’ the supply of savings and liquidity in the economy into lending and investment. This is known as ‘financial intermediation’, and without it, economic savings would show up as leakages from the flow of income, serving to depress the forces of economic growth.

Under the current situation, the financial sector in the US has acted as a constraint on economic recovery to some extent by failing to mediate savings and liquidity with investment at levels associated with higher growth. This is basically because since the fall of 2008, financial institutions have placed an enormous price on risk, refusing to recycle savings and money into credit and investments that appear dangerous. Whilst this phenomenon is a bonus for financial stability, allowing these firms to clear up their balance sheets, it also means that monetary policy needs to take an almost impossibly expansionary position to ward off deflation.

Yet compared to the position of many emerging markets and developing economies, even over the long term, the risk appetite and lending availability in US financial markets appears almost surreal. Even in times of stable leverage, a sturdy macroeconomic policy mix, and microeconomic innovation, banking systems in emerging markets are inefficient, sluggish, and cronyist. In these circumstances, with corporate relations extending well into the sphere of policymakers and state owned enterprises, profitability can be assured without institutions having to make full use of their capital buffers. In other words, there is almost always a barrier to the proper intermediation of savings and investment in the less advanced economies. This also happened in the old industrial economies of the post-war era. Whilst corruption in this instance was not key, a lack of technological capacity meant a perfect intermediation of capital throughout the economy was impossible; even as monetary policy was similarly hampered by ‘liquidationist’ doctrines that refused to expand liquidity as compensation.

With this in mind it should come as no surprise that until humanity began to develop prototype financial institutions, production never really rose above subsistence levels. Without financial development, if enough income was generated to create a pool of savings, that income would essentially be destroyed as it was taken out of the circulation of spending. Hence, society would invariably revert to agricultural barter and underdevelopment. Taken to its logical conclusion, an understanding of the role of finance across economies also helps clear up a lot of the muddled empiricism levelled at various economic policies. For example, the vast majority of literature emanating from the Washington Consensus on economic growth would seem to indicate that Cuban economic policies tinker on the brink of disaster. Yet Cuba enjoys one of the highest standards of living in all of Latin America. Whilst policies like land-reform inspired urban gardening, and universal healthcare are obviously beneficial, the policy mix of other states should imply a better performance relative to Cuba. A performance that is yet to arise.

But although policy mixes are indeed important, they are essentially secondary to institutional functionality. With Cuba the counterfactuals are not obvious, however, the Castro dictatorship has proven adept (when compared with Argentina, and Bolivia) at rooting out and persecuting corruption, whilst implementing heavy penalties on inefficient workers. As a result, it is likely, that despite widespread misallocation of production, there is less financial resistance force on the Cuban economy when compared to less militaristic parts of South America.

In this context, if one takes the framework of modern macroeconomics seriously, financial innovation and efficiency plays a huge role in human and economic development. Societies that find themselves with stagnant growth despite conventional policy mixes and concentrated industrial policies should often look to the most basic elements of macroeconomic theory. Financial intermediation is one such element whose place in the short-term needs to be extended to long-term development. Bernanke and the intellectual giants of our age implicitly recognise this issue, but for much of the debate on development policy, it is overlooked.

*Note that the premise that savings must be ‘lent out’ towards investment, so as to create a macroeconomic equilibrium, is not completely accepted by the Post-Keynesian schools of economic thought. I share the Post-Keynesian concerns that there are incompatibilities between the ‘loanable funds’ mechanisms of savings-investment intermediation, and the modern functioning of a monetary economy. Nevertheless, I have not been able to logically prove the Post-Keynesian case to myself, and thus remain in the orthodox camp for the time being.