Arnold Kling  

Finance and Macroeconomics

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Tyler Cowen recommends two articles by Perry Mehrling on the relationship between the theory of finance and monetary theory/macroeconomics.
One of the articles is a nice summary of the work of Fischer Black.

What Black did was to conceive of the assets not as financial assets but as real assets, which moreover arise endogenously because someone chooses to make a real investment. In equilibrium, both quantity and price are determined, hence it is a model of general equilibrium not partial security price equilibrium. Even so, the model inherits the essential feature of CAPM that the prices of all capital goods derive from just two fundamental prices of capital, the rate of interest and the price of risk. These two prices, and two prices only, are sufficient statistics that summarize production opportunities and investor preferences throughout the entire economy.

I first encountered Black's model of macroeconomics about 1979 or so. He wrote that any macro model should postulate that the agents in the model understand exactly how it operates. I commented that "the assumption that agents in the economy understand its operations is contradicted by the paper under discussion." Although I doubt that my insult was particularly significant, in general Black felt rejected by the profession. Meanwhile, I had not yet studied finance. When I did, I could appreciate Black's perspective.

The problem that Black's work addresses is that modern finance theory is at odds with Keynesian macroeconomics. Financial markets provide very efficient means for people to diversify risk. As Merhling points out, this means that Federal Reserve open market operations should have no effects on the economy. The classical critique of Keynesian economics is that monetary policy should only determine the price level. The finance-theory critique goes even further and asks why financial markets would not have built in expectations and hedges concerning open market operations.

All of this may sound like "inside baseball" in macroeconomic theory, and it is to some extent. However, I believe that in practice the diversity, complexity, and efficiency of financial markets does make the Fed much less potent than is commonly assumed. It seems to me that changes in long-term interest rates often lead changes in the Fed Funds rate that is controlled by the central bank. See Can Greenspan Steer?

For Discussion. Would considerations of finance theory appear to strengthen fiscal policy, even as such considerations weaken monetary policy?

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COMMENTS (6 to date)
no one who matters writes:

Considering that I'm just some joker who stumbled onto your site and does not have a formal education on economics....I'd say yes. After the Fed has been loosening for the last three years it seems to have taken fiscal stimulus (tax cuts and increased spending) to actually get the economy going. But then, maybe the trend was already changing. :)

I've bookmarked this site...I think I might learn something here.

Robert Schwartz writes:

"Would considerations of finance theory appear to strengthen fiscal policy, even as such considerations weaken monetary policy?"

I don't know why. I can hedge fiscal policy just as well as I can hedge monetary.

This last recession (I assume its over) was very interesting. It was not a classic 1950's inventory build up cyclical slowdown type recession. Consumer spending held up very well and unemployment was quite mild by historic standards. In the meantime, the Fed and the treasury pushed as hard as they could, with seemingly little effect.

My guess, and IAANE, is that the effects of the 90's dot bomb bubble and the 9/11 attack had to be amortized. The bad debts written off, the excess servers and Aereon chairs auctioned off and the usual susspects perp-walked. Now that has occured and things are getting back to normal.

One observation on the fiscal side is that the tax system has become so highly leveraged to the fortunes of the well-to-do that there is little that fiscal policy can do in a pro-active manner.

See Dan Weintraubs discussion about California's tax system at:

I would expect the same to be true for the Federal government.

Lawrance George Lux writes:

Fed activity has always seemed quite less effective in practice, as foretold in theoritical outline. Monetary policy could be simply degraded by Finance operation. Monetary policy, thereby, would have a rapid 'half-life', as financial markets responded to it. lgl

Ray writes:

The Fed is plenty potent in its particular function but not in the sense that many assume it be or wish it were.

So in short, a government mechanism with its hand on certain critical economic levers such as the Fed is, can only be of limited potency in a relatively free, and thus efficient market.

dsquared writes:

I think it's the other way round; the observable fact of the efficacy of monetary policy shows that there's something wrong with finance theory. In particular, the bits of Black's general equilibrium work I've scrounged from the Web (I have his 1987 book on order) seem to rely very heavily indeed on the existence of well-behaved probability distributions of all sorts of economic variables which I'd argue are extremely like to be the subject of genuine (Keynesian/Knightian) uncertainty.

Arnold Kling writes:

My guess is that you will find the Merhling article on Black a much better exposition than anything Black himself wrote.

As to his beliefs about financial markets, Black famously said that he believes that markets are efficient within a factor of 2. That is, prices will be between 1/2 and double what they should be. That creates a rather wide range. Of course, as Merhling points out, Black shocked people when he made that statement, because most people assumed (probably correctly) that he held a much tigher view of efficient markets.

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