PKT message, Re: Piorot on Madrick

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.
[Clifford Poirot]

PPP applies to all traded commodities, assuming no barriers to trade (government imposed or otherwise). As John Travolta's character said in Pulp Fiction-"Everything' s different over there. In france, they call a quarter pounder Le Royale..." . Production costs will vary for Big Mac's for many reasons. Even so, such conventions as PPP provide a basis by which speculators such as Soros decide whether to take long or short positions on currencies. Large diversions from anticipated PPP's for exchange rates, especially when coupled with a sharp rise in short term public international debt, are very good predictors of currency crises.

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.
[Clifford Poirot]

It implies no such thing, especially since I continue to emphasize that it is *EXPECTED* present value.
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".
[Clifford Poirot]

Where do conventions or rules of thumb come from? Why do they emerge? Are they purely arbitrary? My view is that conventions reflect actual experience, which may prove to be true, or untrue in the future. Again, there is a difference between predicting the earnings of XYZ corporation over the next five years vs. predicting the aggregate performance of the economy as a whole, and thus the expected long run average rate of return on equity. The latter depends on established behavioral and institutional regularities.

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!

[Clifford Poirot]

This is a very, very real possibility. By some models, the DOW should fall to about 5,000. Of course, these models depend on current earnings. The actual trend could be lower or higher. A rebound in earnings due to higher growth would suppot the current valuation. Of course, one of the currently remarked on problems about the torpor of the DOW and NASDAQ is in fact that normally recessions and bear markets lead to undervalued stocks, but have not done so in this case. Perhaps we are in fact seeing an historical realignment of these conventions. Perhaps.

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.
[Clifford Poirot]

As I keep arguing, I am saying that P/E ratios for the market as a whole, over long periods of time, are based on behavioural regularities and assumed behavioral responses, well established within the context of a specific set of institutions that we conventionally call, capitalism. As Marx, Schumpeter, Keynes, Minsky, North, Veblen, Kalecki, Kaldor, Robinson, Dow, Chick, Sraffa, the Mass Amherst Social Structure of Accumulation Theorists, Tobin-and even Hayek, Mises and Bohm-Bahwerk and an incredibly long list of others (some classical some not) have recognized-this historically specific set of institutions which we conventionally call "capitalism" (or a market economy) depends on the constant reinvestment of liquid surpluses, accumulated out of the process of production and resale, with viable markets to transfer liquid capital in order to achieve growth. Calculating rates of profit ( or rates of return to capital) is of couse difficult due to aggregation, measurement and accounting difficulties. You can calculate different rates of profit based on which base year you use or whether you use current value or replacement value. Nonetheless, in order for this process to work, real rates of return must be realized. These rates of return can be temporarily inflated. They can deviate from the long run historical average. If we want, we can even complicate matters by noting that periods of "crisis" may reflect where an economy is in the kondratieff cycle.

But slice this complexity anyway which way you will, and I argue that prices of financial assets will, in the long run (despite periodic deviations above and below) reflect expected rates of return on non-liquid capital. If this puts me on the same side of the street as Marx, Schumpeter, Keynes, Minsky, North, Veblen, Kalecki, Kaldor, Robinson, Dow, Chick, Sraffa, the Mass Amherst Social Structure of Accumulation Theorists, Tobin-then I will gladly work it-even if I have to share a corner with Bohm Bawerk's disciples.

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 --
[Clifford Poirot]

I completely and totally agree. The question is whether or not the FED can really "stabilize" the market, or if it can merely keep the selloff orderly and avoid panic selling and a freezing up of markets due to a liquidity crisis.

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?
[Clifford Poirot]

I thought that the previous post on this addressed this issue very well. I might add that an awful lot of labor economists, Ingrid Riima to mention only one, have developed the theory and applicability of job rationing and segmented labor markets.

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!
[Clifford Poirot]

I cannot speak for Akerloff. And I am not sure what you mean by they do not see liquidity as being an issue. Certainly the theory of credit rationing makes liquidity an issue. If I understand you correctly, you see liquidity preference decisions, governed by uncertainty, as determining the level of effective aggregate demand, and hence the level of employment. I agree with this, as far as it goes. But I ask the next question? Where do these liquidity preference decisions come from? IMO, it comes back to the Marginal Efficiency of Capital and the long run rate of profit and the ability of capitalists to accumulate liquid capital. When the expected MEC falls, Investment demand falls, leading to a decline of income (rather than falling prices). Clearly, this can lead, as you quite rightly point out, to liquidity crises. Increasing the level of liquidity may avert a panic and maintain aggregate demand. But it still comes back to the fundamental, underlyiing observable behavioral regularity of the panoply of institutional conventions we call "capitalism". That of course, is not to argue that this institutional convention will continue ad infinitum, but that as long as it does, people will form expectations and behavioral responses within those parameters-thus making the long run operation of the system understandable. Or, put another way, the set of behavioral responses we conventionally call laws, can be reasonably expected to continue in operation.

Paul