Friday, December 9, 2016

Noah Smith — A Better Theory to Explain Financial Bubbles

But to gain wide acceptance, extrapolative expectations will have to overcome years of entrenched convention in the economics profession. The near-ban on using anything other than rational expectations is still very strong. In the hunt for truth, sociology is often the greatest barrier.
The problem is equating nominal market price with underlying value, "the fundamentals."

Nominal market price is determined at the margin and can therefore vary both rapidly and widely.

While it is a truism that "in the long run" prices must approximate fundamentals, in the short run a lot of people can be ruined, and there is no model available that is conclusive — because "animal spirits" (Keynes). Traders call it "momo," signifying "momentum," which measured as changes in velocity and acceleration of trends.

The assumptions involved in current models based on rational expectations are too restrictive to account for observed phenomena which include bubbles and busts. The scope of the models are too narrow and miss the "action."

Economics hate to admit that they don't have a model, so they stick with the "best explanation" — which doesn't work at crucial points.

This is a problem affecting regulation and policy since regulators are often economists‚ think Allan Greenspan and Ben Bernanke, and policy is heavily influenced by conventional economic theory and models. Worse, regulators that warn about uncertainty and overextension are sometimes let go as result of being honest.

Bloomberg View
A Better Theory to Explain Financial Bubbles
Noah Smith, Contributor

4 comments:

Matt Franko said...

Maybe they are let go because they are incompetent...

"overextended" is a figure of speech for instance...

You want to pay people to continuously babble figures of speech?

Bill said...

"While it is a truism that "in the long run" prices must approximate fundamentals,"

While it is an assumption that "in the long run" prices must approximate fundamentals,

There. Fixed that for you. ;) Multiple equilibria exist. In the long run, prices approximate equilibrium prices. When there are multiple equilibria, which equilibrium prices are fundamental?

Tom Hickey said...

When there are multiple equilibria, which equilibrium prices are fundamental?

In the way the conventional economics operates, whichever equilibrium prevails.

In the long run, prices approximate equilibrium prices. When there are multiple equilibria, which equilibrium prices are fundamental?

The fundamentals are defined by the equilibrium.

"Fundamental value" is defined in terms of mean regression.

That is why it is a "truism."

It's a self-fulfilling prediction involving circular reasoning.

Same with employment. Doesn't share with the facts. Then change the definition of employment.

How can you lose? In conventional economics this isa feature instead of a bug.

Tom Hickey said...

Speaking of multiple equilibria this is the issue that Noah Smith is dealing with in the failure of rational expectations. The mainstream as accepted multiple equilibria. The issue is causation. According to the mainstream view, the causal factor is exogenous shock to which the system adapts in terms of a "new normal."

The heterodox view is that the causal factor is not necessarily exogenous to the system but rather arises endogenously. The issue is whether endogeneity can be modeled to give a more satisfactory result than the ad hoc exogenous explanation, which is outside the scope of the model by definition.

Smith is saying that its time to rethink the model and move away from a strict rational expectations assumption.

It's generally accepted that an approximation of the value of a unit of capital is its return discounted for risk and including a premium based on exceptions of growth. Obviously, this is a calculation, and analysts don't arrive at the same result nor do buyers and sellers that meet in every trade.

The prevailing idea is that every trade is best approximation of "value" given the level of information available to market participants. Variation in market price is assumed to even out over time, revealing the market's best estimation of future earning power. Think moving averages. However, the occurrence of exogenous factors can result in shifts in the equilibrium price both at the micro and macro levels. A new normal is only detectable over time, since the markets are susceptible to false breakouts, for example, and over time fall back to the old trading pattern.

The Important matter to note here is that the controversy over exogeneity v. endogeneity. This is a fundamental distinction and controversy between conventional and heterodox views.