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Forget about those black swans
It has become highly fashionable to talk about “black swans” since the crisis began in 2008 and now even Scott Sumner talks about it in his recent post “Don’t forget about those black swans”. Ok, Scott is actually not obsessed with black swans, but his headline reminded me how much focus there is on “black swans” these days – especially among central bankers and regulators and to some extent also among market participants.
What is a black swan? The black swan theory was popularized by Nassim Taleb in 2007 book “The Black Swan”. Taleb’s idea basically is that the financial markets underprice the risk of extreme events happening. Taleb obviously felt vindicated when crisis hit in 2008. The extreme event happened and it had clearly not been priced by the market in advance.
Lets go back to back to Scott’s post. Here he quotes Matt Yglesias:
Here’s a fun Intrade price anomaly that showed up this morning. The markets indicate that there’s more than a 3 percent chance that neither Barack Obama nor Mitt Romney will win the presidential election. That’s clearly way too high.
Scott then counter Matt by saying that we should not forget “something unusual happening”:
1. One of the two major candidates is assassinated, and the replacement is elected (as in Mexico’s 1994 election.)
2. Ditto, except one pulls out due to health problems, or scandal.
3. A third party candidate comes out of nowhere to get elected.
Scott is of course right. All this could happen and as a consequence it would obviously be wrong if the market had price a 100% chance that nobody else than Obama or Romney would become US president.
Scott and I tend to think that financial markets are (more or less) efficient and as a consequence we would not be gambling men. Scott nonetheless seem to think that the odds are good:
“But 3% is low odds. It’s basically saying once in ever 130 years you’d expect something really weird to happen in US presidential politics during an election year. That’s a long time! Given all the weird things that have happened, how unlikely is it? Some might counter that none of the three scenarios I’ve outlined have occurred in the US during an election year (my history is weak so I’m not certain.) But mind-bogglingly unusual things have happened on occasion. On November 10, 1972, what kind of odds would Intrade have given on neither Nixon nor Agnew being President on January 1 1975?”
Scott certainly have a good point, but I will not question the market on this one. The market pricing is the best assessment of risk we have. If not there would be money in street ready to pick up for anybody – and there is not. Obviously Taleb disagrees as he believe that markets tend to underprice risk. However, I fundamentally think that Taleb is wrong and I don’t see much evidence that market underprice black swan events. The fact that rare events happen is not evidence that the market on average underprice the likelihood of this events.
The fashion long-shot bias and central banks
In the evidence from betting markets seem to indicate that if anything bettors tend to have a favourite-longshot bias meaning that they tend to overprice the likelihood that the favourite will loose elections or sport games. Said in another way if anything bettors tend to overprice the likelihood of a black swan events. I happen to think that this is not a market problem in markets in general, but it nonetheless indicates that if anything the problem is too much focus on black swan events rather than too little focus on them.
This to a very large extent has been the case of the past 4 years – especially in regard to central banking and banking regulation. There seem to be a near-obsession among some policy makers that a new black swan could turn up. How often have we heard the talk about the major risk of bubbles if interest rates are kept too low too long and most of the new financial regulation being push through across the world these days is justified by reference to the risk of some kind of black swan event.
Media and policy makers in my view have become obsessed with extreme events happening – you will be reminded about that every time you go through the security check in any airport in the world.
The obsession with black swan events is highly problematic as the cost of policy makers obsessing about very unlikely events happening lead them to implement very costly regulation that lead to massive waste of resources. Again just think about how many hours you have spend waiting to get through airport security over the last couple of years and if you think that is bad just think of the cost resulting from excessive new regulation of the global financial markets. So my suggestion is clearly to forget about those black swans!
Finally three book recommendations:
Risk by Dan Gardner that tells about the “politics of fear” (of black swans).
The Myth of the Rational Voter by Bryan Caplan explains why democracy tend to lead to irrationality while market lead to rationality. Said in another way policy makers would be more prone to focus on black swans than market participants in free markets would be.
Risk, Uncertain and Profit – Frank Knight’s classic. If you are really interested in the issues of risk and uncertainty then there is no reason at all to read Taleb’s books (I have read both The Black Swan and Fooled by Randomness – they are “fun” and something you can read while you are waitin in line at the security check in the airport, but it is certainly not Nobel prize material). Instead just read Knight’s classic. It is much more insightful. It is actually something that frustrates me a great deal about Taleb’s books – there is really nothing new in what he is saying, but he claims to have come up with everything himself.
Posted in Efficient-Market Hypothesis, Financial markets, Reading recommendations, Scott Sumner
Tagged Black swan, Bryan Caplan, Dan Gardner, Efficient-Market Hypothesis, Frank Knight, Matt Yglesias, Nassim Taleb, Scott Sumner
https://marketmonetarist.com/2012/05/04/forget-about-those-black-swans/
Higher oil prices and higher bond yields – good or bad news?
Recently (since December) we have seen US bond yields start to inch up and at the same time oil prices (and other commodity prices) have also inched up. This seem to be a great worry to some commentators – “Higher oil prices and higher bond yields will kill the fragile recovery” seem to be the credo of the day. This, however, reveals that many commentators – including some economists – have a hard time with basic demand-and-supply analysis. Said, in another way they seem to have a problem distinguishing between moving the supply curve and moving the demand curve along the supply curve.
Oil prices can increase for two reasons. First, oil prices can increase because there has been a drop in the supply of oil or expectations that that will happen in the future – for example due to war somewhere in the Middle East. Or second oil prices can increase because of increased global demand due to easier monetary conditions globally (an increase in global NGDP growth). The first effect is a move of the supply curve to the left. The second is move on the supply curve. This difference is extremely important when we talk about the impact on the global economy – first is bad news and the second is good news for the global economy.
What we need to know when we look at market action is to know why asset prices are moving and the best way to do that is to compare how different asset markets are moving.
As I have shown in my previous post higher long-term bond yields is an indication of higher future growth in nominal GDP. Therefore, if both oil prices and long term bond yields are inching upwards then it is probably a pretty good indication that monetary conditions are getting easier – and NGDP growth is expected to increase. To further confirm this is might be useful to look at equity prices – if global equity prices also are inching upward then I think one can safely say that that reflect a shift in the global AD curve to the right – hence global NGDP growth is expected to increase. This actually seem to be what have been happening since the ECB introduced the so-called 3-year LTRO in December.
On the other hand if oil prices continue to rise, but equity prices start to decline and bond yields inch down – then it is normally a pretty good indication that a negative supply shock just hit the global economy. That, however, does not seem to be the case right now.
I continue to find it odd that so many economists are not able to use the most useful tool in the the economist’s toolbox – the supply-and-demand diagram. It is really pretty simple. However, how often have we not heard that rising inflation will hurt the consumer and kill the recovery? This is really the same story. Inflation can increase because of higher nominal demand or because of lower supply. If demand is increasing – monetary conditions are becoming easier – then there really is no need to worry about the recovery. In fact we know that there is a close positive correlation between NGDP growth and RGDP growth in the short-run so any indication of higher NGDP growth in the present situation should really be expected to lead to higher RGDP growth.
So next time you hear somebody say that higher oil prices or higher bond yields might kill the recovery ask them to explain what they mean in a demand-and-supply diagram. If they move the supply curve to the left – then you need to ask them how they explain that global stock prices have been increasing as well…of course is stock prices indeed been falling then their analysis is of course correct…
PS needless to say we can of course have a situation where both the supply curve and the demand curve is moving at the same time. This often happens when central banks are unable to distinguishing between demand and supply shock. Hence, if inflation increase due to a negative supply shock as was the case in 2011 and then central banks react by tightening monetary conditions as the ECB did in 2011 then you get both the supply curve and the curve moving…(The ECB obviously made this policy mistake because somebody forgot to draw supply-and-demand diagrams…).
UPDATE: Our friend Jason Rave has a comment on a similar topic over at his blog Macro Matters. As me Jason is not worried about rising oil prices if they indeed do reflect higher global demand.
Posted in ECB, Financial markets, General economic theory, Inflation, Monetary policy
Tagged ECB, Oil prices
https://marketmonetarist.com/2012/03/21/higher-oil-prices-and-higher-bond-yields-good-or-bad-news/
You say that when you have a hammer everything looks like a nail. Reading the Market Monetarist blogs including my own one could easing come to the conclusion that we are the “hammer boys” that scream at any problem out there “NGDP targeting will fix it!” However, nothing can be further from the truth.
Unlike keynesians Market Monetarists do think that monetary policy should be used to “solve” some problems with “market failure”. Rather we believe that monetary policy should avoid creating problems on it own. That is why we want central banks to follow a clearly defined policy rule and as we think recessions as well as bad inflation/deflation (primarily) are results of misguided monetary policies rather than of market failures we don’t think of monetary policy as a hammer.
Rather we believe in Selgin’s Monetary Credo:
So monetary policy determines nominal variables – nominal spending/NGDP, nominal wages, the price level, exchange rates and inflation. We also clearly acknowledges that monetary policy can have real impact – in the short-run the Phillips curve is not vertical so monetary policy can push real GDP above the structural level of GDP and reduce unemployment temporarily. But the long-run Phillips curve certainly is vertical. However, unlike Keynesians we do not see a need to “play” this short-term trade off. It is correct that NGDP targeting probably also would be very helpful in a New Keynesian world, however, we are not starting our analysis at some “social welfare function” that needs to be maximized – there is not a Phillips curve trade off on which policy makers should choose some “optimal” combination of inflation and unemployment – as for example John Taylor basically claims. In that sense Market Monetarists certainly have much more faith in the power of the free market than John Talyor (and that might come to a surprise to conservative and libertarian critics of Market Monetarism…).
What we, however, do indeed argue is that if you commit mistakes you fix it yourself and that also goes for central banks. So if a central bank directly or indirectly (through it’s historical actions) has promised to deliver a certain nominal target then it better deliver and if it fails to do so it better correct the mistake as soon as possible. So when the Federal Reserve through its actions during the Great Moderation basically committed itself and “promised” to US households, corporations and institutions etc. that it would deliver 5% NGDP growth year in and year out and then suddenly failed to so in 2008/9 then it committed a policy mistake. It was not a market failure, but rather a failure of monetary policy. That failure the Fed obviously need to undo. So when Market Monetarists have called for the Fed to lift NGDP back to the pre-crisis trend then it is not some kind of vulgar-keynesian we-will-save-you-all policy, but rather it is about the undoing the mistakes of the past. Monetary policy is not about “stimulus”, but about ensuring a stable nominal framework in which economic agents can make their decisions.
Therefore we want monetary policy to be “neutral” and therefore also in a sense we want monetary policy to become invisible. Monetary policy should be conducted in such a way that investors and households make their investment and consumption decisions as if they lived in a Arrow-Debreu world or at least in a world free of monetary distortions. That also means that the purpose of monetary policy is NOT save investors and other that have made the wrong decisions. Monetary policy is and should not be some bail out mechanism.
Furthermore, central banks should not act as lenders-of-last-resort for governments. Governments should fund its deficits in the free markets and if that is not possible then the governments will have to tighten fiscal policy. That should be very clear. However, monetary policy should not be used as a political hammer by central banks to force governments to implement “reforms”. Monetary policy should be neutral – also in regard to the political decision process. Central banks should not solve budget problems, but central banks should not create fiscal pressures by allowing NGDP to drop significantly below the target level. It seems like certain central banks have a hard time separating this two issues.
Monetary policy should not be used to puncture bubbles either. However, some us – for example David Beckworth and myself – do believe that overly easy monetary policy under some circumstances can create bubbles, but here it is again about avoiding creating problems rather about solving problems. Hence, if the central bank just targets a growth path for the NGDP level then the risk of bubbles are greatly reduced and should they anyway emerge then it should not be task of monetary policy to solve that problem.
Monetary policy can not increase productivity in the economy. Of course productivity growth is likely to be higher in an economy with monetary stability and a high degree of predictability than in an economy with an erratic conduct of monetary policy. But other than securing a “neutral” monetary policy the central bank can not and should not do anything else to enhance the general level of wealth and welfare.
So monetary policy and NGDP level targeting are not some hammers to use to solve all kind of actual and perceived problems, but who really needs a hammer when you got Chuck Norris?
Marcus Nunes has a related comment, but from a different perspective.
Posted in Bubbles, Chuck Norris, Chuck Norris Effect, David Beckworth, Federal Reserve, Financial markets, George Selgin, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Selgin's Monetary Credo
Tagged Bubbles, David Beckworth, Federal Reserve, NGDP Targeting, Nominal Income Targeting, Selgin's Monetary Credo
https://marketmonetarist.com/2011/12/22/monetary-policy-cant-fix-all-problems/