Piorot on Madrick

[Paul Davidson <pdavidson@xxxxxxx>]

 Poirot has written a thoughtful response to the Jeff Madrick
article in the New York Times.

Here are some comments of mine on Poirot'

Poirot writes: As I have suggested before, such rules of
thumb as historical P/E ratios are useful as general rules of thumb, with
no guarantees of proving true. That said, unless there is reason to
believe to believe that long run expectations of fundamentals had
fundamentally changed, there was every reason to believe stock prices
were being fed by irrational expectations. Paul argues that stock market
prices are not fed by fundamentals or future expectations of earnings. I
argue (in contrast) that over the long haul, there is a
subjective/objective connection between earnings, real underlying assets
and stock market prices. However, in my view, Paul's theory applies in
specific cases in that when markets stray into speculative and Ponzi
territory, then Paul is correct. The market disconnects fundamentals and
financial asset prices. 

PAUL's RESPONSE.  The trouble is that most of the time asset prices
are either above or below the historical average of P/E ratios. 
 Similarly  in a flexible exchange rate system, the actual spot
exchange rate is usually either undervalued or overvalued relative to a
measure of Purchasing Power Parity. [For several years for example THE
ECONOMIST has measured the different costs of a BIG MAC from MacDonald's
in various countries in terms of the dollar.  What could be more
homogeneous than a Big Mac? -- but THE ECONOMIST's statistics shows that
it still does not follow the neoclassical  "law of
on-price" -- where Purchasing Power Parity is the
"fundamental" underlying exchange rates in classical theory.

Merely to talk about fundamentals determining the current price of
financial assets (where the current price is equal to the present value
of future stream of quasi-rents) is to bring in classical theory by the
back door for it implies that future price/earnings ratios are already
programmed into the economic system in and are predetermined by
historical price/earnings ratios.
My response is that the search for historical P/E benchmark is merely a
convention where, in "normal times", each market participant
believes that other market participants are going to judge the beauty
queen by her price/earnings  (36-24-36?) measurements.  -- As
Keynes noted (GT, p. 152) "In practice we have tacitly agreed, ass a
rule, to fall back on what is, in truth, a convention".

MADRICK: But when stocks were in a bubble and the political pressure was
to keep the good times rolling, he consistently retreated to his deepest
belief that the markets were basically efficient and should not be
interfered with. A few economists have even asserted that stock bubbles
are entirely rational. 
PIOROT response: That of course is the rub in the EMH. Prices must
reflect all available information, and markets always process that
information correctly, then any price is by definition, efficient, and
only unanticipated information can move the market. Thus a value of 5000
for the NASDAQ was not too high, and a value of the NASDAQ of 1200 is not
too low. But these people cannot explain what unanticipated news caused
this dramatic movement in the NASDAQ in a relatively short time span-or
even why indexes move as much as 10-20% over the space of one to two
months-with no real change in the outlook.

PAUL: Then why think in terms of a fundamental determining the long-run
financial asset price? If the NASDAQ at 12oo exceeds historical P/E
rations, then , according to Poirot the NASDAQ is STILL too high!

MADRICK: A highly respected mainstream economist has issued one of the
strongest criticisms yet of such thinking. George Akerlof, a professor at
the University of California at Berkeley, won the 2001 Nobel in economic
science, with Joseph Stiglitz and Michael Spence. In his Nobel acceptance
speech, reprinted in the June issue of The American Economic Review, Mr.
Akerlof uses behavioral economics to criticize oversimplified
laissez-faire theories. 

POIROT response: It seems we have beaten discussions about asymmetric
information to death, 

PAUL: Asymmetric information about the future is a contradiction in terms
if you believe that financial asset prices are generated by a nonergodic
stochastic process

POIROT: so let me point to what I think is an interesting aspect of
behavioral economics for Post-Keynesians. Behavioral economics takes into
account interdependencies in decision making. So you can get outcomes
such as Keynes pointed to (and that Paul, as I understand it, bases much
of his argument on)in which stock markets resemble beuaty contests where
participants vote on what they think other people's votes will be. As I
said above, I believe this leads to situations where the market is
dominated by this type of thinking, rather than by fundamentals-though
this does not preclude the long run role of fundamentals.

PAUL:  Fundamentals in the long run-- are you assuming that the P/E
ratios in the future are drawn from the same universe as the P/E ratios
of past and current samples? If you are you are assuming the future is
predetermined; if you are not then the future is uncertain and there is
NO information regarding P/E ratios over the life of long-lived capital
assets. You must choose which side of the street you are working
Chip.

MADRICK:  [Akerlof] argues that monetary and fiscal policies do
matter in creating jobs and raising incomes. The starting point for Mr.
Akerlof and his colleagues is to make the central assumption of economics
realistic. People are often not rational, maybe even most of the time.
Consider investors in stocks. Keynes implied long ago in his
"General Theory of Employment, Interest and Money," Mr. Akerlof
notes, that investors are subject to fads and fashions. Behavioral
economists have developed a lot of evidence to support this idea. For
example, Robert Shiller of Yale has carefully shown that stock prices are
much more volatile than corporate profits and dividends. An important
conclusion is that when stock prices are historically far out of line
with profits, there is a good chance that it is a bubble, not a "new
economy" of ever-higher profits, as Mr. Greenspan often suggested in
the 1990's. 

POIROT response: Interestingly, I think this interpretation leads the New
Keynesians down the primrose path to Minsky-though not all the way to
Davidson. I would be interested in hearing from Paul whether or not he
thinks fundamentals play any role at all in determining asset prices,
what role the FED should (should not) play in providing liquidity to a
potential bubble situation. 

PAUL: The above indicates what I think about the role of
fundamentals.  Regarding the role of the FED my article in the
GUARDIAN suggests what should be done if the bears attack. [I would have
encouraged Saint Alan of Greenspan to raise margin requirements to 100%
if he really believed in "inrrational exhuberance" in 1996 when
the Dow rose above 6000!.]  But when asset prices plunge then the
role of the monetary  and the State is to stabilize the market --

Even Hoover understood this when he instituted the RFC; and the Federal
Government recognized this when it removed from the market much of the
real  estate that had been foreclosed in the wake of the S&L
collapse a little over ten years ago. 

 The important point to note is that in a certain sense, the
public's portfolio decisions in combination with the operation of the
banking system will determine what proportion of the community's total
real wealth is owned by households and what proportion is looked after by
the banking system. 

MADRICK: Similarly, new classical economists argue that markets are so
efficient that unemployment is largely voluntary. For the most part, they
say, people who are out of work can find jobs if they are willing to work
for less. Government cannot really help them. Mr. Akerlof argues that in
real life, businesses often pay more than the market wage to retain good
workers, bolster morale or create incentives to work harder. 

PAUL: But if that is the case then increasing the money wage rate will
increase the productivity of workers by giving them an incentive to work
harder!!  Why should not the wage  per worker be raised to that
paid the CEO of the company?

MADRICK: Thus, jobs are actually rationed, and many job seekers are shut
out. 

POIROT response: I do agree that this can in fact occur. I disagree that
elimination of job rationing would lead to full employment. At least
Stiglitz (I am not sure about Akerlof) seems to argue that the Keynes
effect of falling wages and prices (though he does not call it this) can
swamp the Pigou effect of falling wages and prices (though again he does
not put it quite this way), thus creating either a) additional
unemployment and further falls in income or b) a very, very, very long
time before the pigou effect finally takes over. This is an important
point because Paul keeps asking (and it is a good question) why, if
sticky wages and prices cause unemployment, why not advocate flexible
wages and prices as the solution to unemployment. 


This gives us two good reasons: a) in an economy of coordination
failures, income adjusts faster than wages and prices, 

PAUL:  This is just the old Leijonhufuvd argument that what Keynes
did was reverse the speed of reaction between prices and quantities --
emphasizing a faster quantity speed of reaction.  But in 1974 (after
being a referee on an article of mine) Leijonhuvud recanted  in an
article in HOPE and argued that Keynesian unemployment had nothing to do
with reversing the speeds of reaction.  I have also demonstrated
this in several places but perhaps the most  complete demonstration
is my article in the Festshrift for G. C. Harcourt. [ Even Frank Hahn in
an article in the 1977 book THE MICROFOUNDATIONS OF MACROECONOMICS edited
by Harcourt argues that Keynesian unemployment does NOT depend on
reversing the Marshallian price and quantity speeds of reaction.  So
Chip I am afraid we must disagree here Keynesian unemployment has NOTHING
to do with coordination failures and a faster income speed of reaction to
a disturbance!

POIROT CONTINUES: so that even downwardly flexible wages and prices do
not create full employment or correct for the deficiency in aggregate
demand. This certainly creates a good argument for corrective policy. b)
even if the pigou effect will eventually work, the resultant instability
and dislocation will simply be too costly for society.

PAUL:  Even Patinkin admitted  that the real balance effect was
empirically insignifcant so we do not need this foolish argument.


MADRICK: "In the spirit of Keynes," Mr. Akerlof writes,
"behavioral macroeconomists are rebuilding the microfoundations that
were sacked by the new classical economists." 

POIROT response: I am pleased to see that at least some of the New
Keynesians are returning to the aggregate analysis of Keynes, while
trying to build, logical, consistent explanations that take agency into
account. 

PAUL:  Unfortunately Chip they are not returning to the aggregate
analysis of Keynes where involuntary unemployment is nested in liquidity
issues!! They do not see liquidity as an issue!!

MADRICK: To be fair, economists from other schools of thought, including
post-Keynesians, structural economists and gender economists, have tried
to explain the same observations with other interesting theories, and
they deserve more of a hearing. 

POIROT: response: I think this same author was responsible for the
earlier piece a couple of weeks ago citing Minsky, and among some other
people currently working on these issues, Charles Whalen. So it is
gratifying to see someone in the NYT acknowledging that there are
"other" people working on these issues.

PAUL: A mention is not enough-- a discussion of these other people's
ideas is what is required.

MADRICK:. But Mr. Akerlof and his colleagues have attacked today's
conventional wisdom, which dominates the halls of power, on the basis of
its own assumptions and values. Mr. Akerlof's side, I believe, is winning
this battle of ideas. The battle for power may be another matter. 

POIROT response: There does seem to be a cautious revival of
"respectability" for some Keynesian type ideas. {Poirot follows
this with a very important story about a student of his and her professor
who told her that Keynes was a "socialist" and just
"wrong".]

PAUL: But not Keynes's ideas.  When I was in Cambridge, in 1970
Nicky Kaldor asked me "Now that we [Cambridge England] had won the
reswitching controversy [ over Cambridge Mass] , how long will it be
before the marginal productivity theory of income distribution will no
longer be taught in  American Universities?"

My response was " Not in your lifetime Nicky; nor in my
lifetime.  Why?  Because classical oriented theorists could
always introduce new assumptions, ad hoc restrictions, etc to assure that
the results that they "know" is the absolute truth results will
be the long run fundamental targets of the economic process".

All though I believe the future is uncertain and unpredictable -- this is
one prediction that was easy to make!!


Paul

Paul Davidson

Editor, JOURNAL OF POST KEYNESIAN ECONOMICS

Economics Department - University of Tennessee

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