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

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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.

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Stocks Priced in Real GDP

Since the 1990s, priced in Real GDP the Dow Jones Industrial Average (as well as the S&P500) has been far above their 20th-century norm:

STockspricedinRealGDP

There is an unsurprising coincidence — as stock prices (and corporate profits) have soared above their historical norm, wage growth has been very stagnant. The economy has come to be tilted toward bankers, financiers, insurance brokers and away from wage-earners, manufacturers and artisans. 

Does that mean that as Hassett and Glassman projected in Dow 36,000, stock prices have climbed to a new plateau? Well, while it is impossible to say exactly what prices will do in future (nominal, or otherwise) the “new plateau” has been very much supported by the Federal Reserve, first by lowering rates and keeping them low:

DJIAFederalFunds

And second through expanding the monetary base by buying securities directly (Bernanke estimates a simulated interest rate decrease of 0.25% for each 250 billion dollars of quantitative easing):

DJIABASE

Each time stocks have turned cheaper, the Fed has stepped in and eased, and stocks have reversed upward.

Some might take that as a sign that stocks aren’t going to get much cheaper, because the Fed won’t let them get much cheaper. First under Greenspan, and second under Bernanke the Fed has succeeded at reinflating the bubble. But the secular trend is back toward the pre-1990s norm. Gravity is against the Fed. The Fed (to use a tired old metaphor) is Atlas, holding stock prices up on its shoulders. Will it be third-time unlucky for the Fed, hell-bent on wealth-effecting and financialising the US economy to prosperity?