Critiquing and defending Keynes

Scott Sumner has a recent post in which he argues, among many other things:

1. “If the Fed had paid attention to the 1929 stock market crash maybe they wouldn’t have let the US monetary base fall sharply between October 1929 and October 1930.”

2. “Or how about last October’s crash? You may recall that at that time the Fed (and for that matter Paul Krugman) did not expect the unemployment rate to get anywhere near 9.4% this year. To be honest, neither did I. But I knew the markets were saying that Fed policy was far too contractionary.”

3. “In the first 4 months of FDR’s administration we were in a much worse financial crisis than today, and yet industrial production rose 57%.” (#26, in comments.)

4. “Remember that Keynes considered fiat money the worst possible monetary system.” (Also #26, in comments.)

5. “…where he [Keynes] tries to shoot down the efficient market hypothesis…Suppose investors only cared about the short run, as they only intended to hold shares for 5 years. What would be the value of a biotech company that did not expect a breakthrough to occur for 15 years? To estimate its value, let’s suppose that the breakthrough is expected to be worth $10 billion, if the patent were sold to a big pharma company. So would the stock be worth anything today? Yes, because investors today would know that 10 years from now (if investors still had a 5 year horizon) the stock would be worth the present value of $10 billion earned 5 years later. Through backward induction we can see that the current value of the stock would be exactly the same as if investors had a long term focus. In case you don’t believe me, contrast the difference in value between a 20 and 30 year bond with equal coupon payments. All the differences occur in the out years, and yet those differences get correctly priced into the current market values of the bonds. If anything, history suggests that investors have too much of a long term focus, as they have been remarkably patient with biotech stocks lacking any earnings at all. So Keynes’ views on investment are superficially witty and sophisticated, but on closer examination are intellectually empty.”

Let’s look at these more-or-less in sequence.

1. Did the Fed ignore the 1929 stock market crash? Did the monetary base "fall sharply between October 1929 and October 1930”? It’s difficult, at this remove, to determine whether the Fed ignored the crash. But the data on the monetary base (from the St. Louis Fed) do not suggest a sharp decline in the monetary base. It fell from $6.122 billion in October 1929 to $5.867 billion in October 1930, or a 4.1% decrease. During that same period, bank reserves fell by 1.9% and M1 fell (as well as I can tell) by about 1.9%. The CPI fell by 4.6%. Between 1929 and 1930, real GDP fell by about 8.6%. Personal Consumption Expenditures fell by about 6.9%. Industrial production fell by 24.6%. So the monetary base fell, and fell by enough to notice. But “sharply”? That’s not so clear.

2. Was Federal Reserve policy in the fall of 2008 “too contractionary”? Let’s see. Between August 2008 and October 2008:
The monetary base rose by 30.4%.
Bank reserves rose by 258%.
The 3-month T-bill rate fell from 1.83% (week of August 15) to 0.45% (week of October 17).
(The 1-year rate fell from 2.11% to 1.20%.)
Monetary aggregates, on the other hand, didn’t move much:
M1 rose by 5.6%.
M2 grew by only 2.9%.
MZM (Money, Zero Maturity) rose by only 0.7%.
The Fed appears to have been pushing really, really hard, but to little effect.

3. Did industrial production rise by 57% between March 1933 and July 1933? In fact, yes, up from 4.2381 to 6.6728. This was, however, 24.7% below its cyclical peak (July 1929).

4. Did Keynes regard “fiat money [as] the worst possible monetary system”? I don’t think so. A fairly direct reading of A Tract on Monetary Reform suggests he had even less kind things about the gold standard. He particularly noted that under the gold standard a country was more-or-less forced to maintain the (long-run average) foreign exchange value of its currency, which could lead to extreme swings in the domestic price level. On the other hand, a fiat money system allowed the monetary authority to maintain either the foreign excnage value of its currency or the purchasing power of its currency.

5. Was Keynes targeting the Efficient Market Hypothesis (EMH)? That’s harder to say. The EMH had not been what you might call clearly formulated in the early 1930s, so, unless Keynes was truly psychic, I doubt that he was. What’s clear is that Sumner wants to defend a strong version of the EMH. He doesn’t do the job in this blog post, but that wasn’t his intention (his intention was to argue (a) that Woodrow Wilson was a disastrous president and (b) that Keynes was not a great investor or a great economist). If one wanted to defend a strong version of the EMH, what would the requirements be?

The EMH, in its strong version, essentially argues that prices (especially of financial assets, but there’s no reason why one would restrict its applicability to such assets) incorporate all relevant information and are, in principle, correct.

I would suggest the following mental experiment. Let’s leave aside long secular movements in the prices of things and look instead at abrupt changes in prices. The EMH says that something happened to the information environment that makes the initial prices and the final prices both correct. So, for example, consider these changes:

Between October 22 and October 29, 1929, the Dow Jones Industrial Average fell by 36%.
Between October 16 and October 20, 1987, the DJIA fell by 26% and the S&P 500 fell by 24%.
Between January 19 and January 25, 1998, the Indonesian Rupiah fell by 41% relative to the US dollar.

That's three large and abrupt changes in the price of financial assets.

Now, I don’t think it’s reasonable to expect the EMH to predict these abrupt changes. But it would be nice if it could explain them. But what do we want an explanation to do? Three things, I think. First, to identify the change that occurred in the information environment. Second, to explain why that change led to the observed outcome. And third, to validate that explanation by identifying other, similar changes in the information environment leading to similar changes in asset values. And, by “similar changes in the information environment,” I mean a fairly close similarity. Note that my emphasis is on explaining changes in asset prices.

We can explain this mathematically, fairly easily in the case of the price of an individual company’s stock price. A fundamentalist view of stock prices relates them to the present value of future net cash flows. So the present price will change is there is a change (a) in the expected net cash flow or (b) in the discount rate used to evaluate that future net cash flow. It’s somewhat harder in the case of large movements of virtually all stock prices simultaneously. In this case, something has happened that leads buyers and sellers of stocks to simultaneously change their valuations of (almost) all companies. We could still attribute it to changes in net cash flows or in discount rates. But what we now need is a cause for that change in attitudes.

For Keynes, the explanation was easy, if perhaps unsatisfying. He saw investors’ expectations of the future as being highly uncertain, fragile, and strongly affected by the opinions of other investors (hence his metaphor of choosing stocks as being like choosing, not the prettiest woman, but the woman that everyone else would think is the prettiest woman). So a small change in something in the present could lead to a large change in expectations, and he didn’t necessarily feel that it was necessary to identify what that change was. Of crucial importance, is that, for Keynes, the changes in asset prices need not (necessarily be "rational."

The EMH faces, in this respect, a stronger burden. It argues that prices are rational and consistent with the information environment. If we cannot identify a change in the information environment that leads to the observed change in prices, then we have a problem. And if all our explanations are one-time explanations (that is, we cannot identify other, very similar changes in the information environment leading to similar changes in asset prices), then what we have are “just so” stories, not, I would argue, support for a theoretical propositionThe floor is open for EMH explanations. And, good luck.
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This is what happens when I stay up too late at night reading.