Ben Bernanke Must Be Hoping Rational Expectations Doesn’t Hold…


In the theory of rational expectations, human predictions are not systematically wrong. This means that in a rational expectations model, people’s subjective beliefs about the probability of future events are equal to the actual probabilities of those future events.

Now, I think that rational expectations is one of the worst ideas in economic theory. It’s based on a germ of a good idea — that self-fulfilling prophesies are possible. Almost certainly, they are. But expressed probabilities are really just guesses, just expressions of a perception. Or, as it is put in Bayesian probability theory: “probability is an abstract concept, a quantity that we assign theoretically, for the purpose of representing a state of knowledge, or that we calculate from previously assigned probabilities.”

Sometimes widely-held or universally-held beliefs turn out to be entirely irrational and at-odds with reality (this is especially true in the investment industry, and particularly the stock market where going against the prevailing trend is very often the best strategy). Whether a belief will lead to a reality is something that can only be analysed on a case-by-case basis. Humans are at best semi-rational creatures, and expectations effects are nonlinear, and poorly understood from an empirical standpoint.

Mainstream economic models often assume rational expectations, however. And if rational expectations holds, we could be in for a rough ride in the near future. Because an awful lot of Americans believe that a new financial crisis is coming soon.

According to a recent YouGov/Huffington Post survey:

75 percent of respondents said that it’s either very or somewhat likely that the country could have another financial crisis in the near future. Only 12 percent said it was not very likely, and only 2 percent said it was not at all likely.

From a rational expectations perspective, that’s a pretty ugly number. From a general economic perspective it’s a pretty ugly number too — not because it is expressing a truth  (it might be — although I’d personally say a 75% estimate is rather on the low side), but because it reflects that society doesn’t have much confidence in the recovery, in the markets, or in the banks.

Why? My guess is that the still-high unemployment and underemployment numbers are a key factor here, reinforcing the idea that the economy is still very much in the doldrums. The stock market is soaring, but only a minority of people own stocks directly and unemployed and underemployed people generally can’t afford to invest in the stock market or financial markets. So a recovery based around reinflating the S&P500, Russell 3000 and DJIA indices doesn’t cut it when it comes to instilling confidence in the wider population.

Another factor is the continued and ongoing stories of scandal in the financial world — whether it’s LIBOR rigging, the London Whale, or the raiding of segregated accounts at MF Global. A corrupt and rapacious financial system run by the same people who screwed up in 2008 probably isn’t going to instill much confidence in the wider population, either.

So in the context of high unemployment, and rampant financial corruption, the possibility of a future financial crisis seems like a pretty rational expectation to me.


There Is No Surer Way To Destroy A Banking System Than Giving Depositors A Haircut

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No, not that kind of haircut.

I’m talking about the kind of haircut where depositors lose a portion of their money. This can destroy confidence in a fractional reserve banking system, as depositors in other banks and other countries fear that they too might be forced to take a haircut, leading to mass withdrawals, leading to illiquidity. And — as part of an E.U. bailout of the Cypriot financial system this just happened in Cyprus:

Eurozone finance ministers have agreed a 10bn-euro (£8.7bn) bailout package for Cyprus to save the country from bankruptcy.

The deal was reached after talks in Brussels between the ministers and the International Monetary Fund (IMF).

In return, Cyprus is being asked to trim its deficit, shrink its banking sector and increase taxes.

For the first time in a eurozone bailout, bank depositors are facing a levy on their savings.

This attack on depositors will have clear implications for depositors and banks in other bailout-prone areas of the Eurozone — Spain, Italy, Greece, Portugal. If the EU is prepared to impose haircuts of up to 10% on depositors in Cyprus as part of a bailout package, which countries’ depositors will be forced to take a haircut next? Mattress-stuffing Cypriots will be 10% better-off than their compatriots with confidence in the banking system. Even if only 10% or 20% of bank customers in Spain choose to withdraw their funds, that has the potential to cause serious liquidity problems.

Whether or not this actually happens is another question — although with unemployment running high throughout the Eurozone, those with savings may be particularly wary of losing them. This decision — no matter how many times Draghi and Merkel and Barroso reassure the crowds — makes bank runs throughout the Eurozone much more likely as savers seek to avoid the possibility of a haircut by moving to cash or tangible assets.

And this madness was totally avoidable.

The Burden of Government Debt

There has been an awful lot of discussion in recent months about whether government debt is a burden for future generations. The discussion has gone something like this: those who believe government debt is a burden claim that it is a burden because future generations have to repay taxes for present spending, those who believe that it is not claim that every debt is also credit, and so because the next generation will inherit not only the debt but also the credit, that government debt is not in itself a burden to future generations, unless it is largely owed to foreign creditors.

It is relatively easy to calculate what the monetary burden of government debt is. Credit inheritance and debt inheritance are not distributed uniformly. The credit inheritance is assumed strictly by bondholders, and the debt inheritance is assumed strictly by taxpayers. Each individual has a different burden, equalling their tax outlays, minus their income from government spending (the net tax position).

For an entire nation, everyone’s individual position is summed together. In a closed economy where the only lenders are domestic, the intergenerational monetary burden is zero. But that is by no means the entire story.

First, debts to foreign lenders are a real monetary burden, because the interest payments constitute a real transfer of money out of the nation. Second, while there may be little or no debt burden for the nation as a whole, interest constitutes a transfer of wealth between citizens of the nation, specifically as a transfer payment from future taxpayers to creditors. This adds up, at current levels, to nearly half a trillion of transfer payments per year from taxpayers to creditors. So while the intergenerational burden may technically add up to zero for the nation, it will not for individuals. The real burden is huge transfers from those who pay the tax to those who receive the spending, and those who receive the interest. So who loses out?

Here are the figures for 2009 showing net tax position for each income quintile:

Bottom quintile: -301 percent
Second quintile: -42 percent
Middle quintile: -5 percent
Fourth quintile: 10 percent
Highest quintile: 22 percent

Top one percent: 28 percent

The negative 301 percent means that a typical family in the bottom quintile receives about $3 in transfer payments for every dollar earned.

What this data does not show are the reverse transfers via interest payments. There is no data (that I can find) on treasury interest payments received by income quintile, but assuming that the top quintile dominates income from interest (as they dominate ownership of financial assets, owning over 95% of all financial assets) this leaves the lower income quintiles benefiting from transfer payments, the top quintile benefiting from interest (as well as policies like bank bailouts, corporate subsidies, and quantitative easing, whose benefits overwhelmingly benefit the top quintile), and squeezing the taxpaying middle quintiles who receive neither the benefits of interest payments, nor significant welfare transfers.

To misquote George Orwell, when it comes to the national debt and who takes its burden, some pigs are definitely more equal than others.