Financial markets arbitrage: reassuring or lovely?

John Cochrane has a new blog post summarizing recent research by Budish, Cramton and Shim on the effects of high frequency trading. The paper shows that as high frequency trading spreads the correlation of a particular asset price across two US markets (Chicago and New York) has become higher at intervals that are very short. Any price deviations across the two markets disappear in less than one second. As Cochrane puts it,

It is lovely to see the effect of "arbitrageurs" making markets "more efficient."

As an academic I enjoyed reading the post as it provides a very nice example of a clean empirical test of how high frequency trading makes the comovements of two markets stronger. This is what we look for in academic papers, a clean test of a very simple theory that produces very credible and robust results.

But as much as I enjoyed reading the post, it also reminded me of how limited is the ability of academic research to help us understand phenomena that really matter. In this particular case, the analysis compares the price of the same security in two nearby markets (geographically but also linked by very fast communications). As communications and trade become faster and faster, price deviations between the two markets disappear in a shorter period of time. This is really nice to see but is this a big surprise? One would expect that at a minimum, very basic arbitrage opportunities do not exist in integrated financial markets. So it is reassuring that arbitrageurs help markets be more efficient but I am not sure I would go as far as saying that this is "lovely".

What would be more interesting (at least to me) is understand whether high frequency trading helps getting financial prices right. And by "right" I mean prices that are consistent with economic fundamentals, prices that do not generate volatile dynamics and bubble-type behavior. If we could prove that this is the case then I would find the result "lovely".

Antonio Fatás

The permanent scars of economic pessimism

Gavyn Davies at the Financial Times reflects on the growing pessimism of Central Banks regarding the growth potential of advanced economies. In the US, the Euro area or the UK, central banks are reducing their estimates of the output gap. They now think about some of the recent output losses as permanent as opposed to cyclical.

It output is not far from what we consider to be potential, there is less need for central banks to act and it is more likely that we will see an earlier normalization of monetary policy towards a neutral stance.

Why did they change their mind? Is this evidence consistent with the standard economic models that we use to think about cyclical developments?

Measuring potential output or the slack in the economy has always been challenging. One can rely on models that capture the factors that drive potential output (such as the capital stock or productivity or demographics) or one can look at more specific indicators of idle capacity, such as capacity utilization or unemployment rate.

Narrow measures of idle capacity do signal a potential permanent reduction in output. For example, unemployment rates, in particular in the US, are coming down. Capacity utilization is also approaching levels that can be considered as close to normal. As an example, in the most recent Inflation Report, the Bank of England writes "Surveys suggest that the margin of spare capacity within companies narrowed in 2013 such that companies were, on average, operating at close to normal levels of capacity utilization".

But both of these measures while they might be ok are capturing short-run idle capacity are very problematic as indication of potential growth . In the case of unemployment, one of the main reasons why it has decreased in the US is because of the fall in participation rates. But some of these permanent changes in the labor force are the result of a long recession. There is evidence that in the US long-term unemployed workers are giving up, and leaving the labor market at increasing rates. A similar argument can be made about capacity utilization: it might be that we are getting close to normal utilization levels, but is capacity at a normal level? A long period of low investment rates will naturally lead to lower installed capacity. This is Say's Law backwards, demand (investment reacting to cyclical conditions) creates its own supply (capacity). [Several years ago I wrote a paper with a model and some empirical evidence in favor of this hypothesis].

Both of these arguments point in the same direction: business cycles can leave permanent (or at least very persistent) scars on output through the effects they have on the capital stock or the labor force. But it is important to understand that the permanent effects are the consequence of the recession itself. If we could manage to reduce the length and depth of the recessions we would be minimizing those permanent effects. And in that sense, accepting these changes as structural and unavoidable is too pessimistic, leads to inaction and just makes matters worse. If you read the evidence properly, you want to do the opposite, you want to be even more aggressive to avoid what it looks at a much bigger cost of recessions.

Antonio Fatás

ECB and its excuses for inaction

Mario Draghi showed great skills in handling all questions in yesterday's press conference. When pressed about why the ECB is not doing more in the presence of low inflation and possibly deflationary pressures he answered that they are are doing enough and that there is no deflation in the Euro area but simply a period of "low inflation from a protracted period of time". Technically he is right, inflation is low but remains positive and expectations of inflation do not point in the direction of immediate deflation.

But what remains unclear is the message that he is giving about future actions. How low should inflation be and for how many months before the ECB considers that it is necessary to have more expansionary monetary policy? And why is the ECB ignoring the second pillar of its strategy (the money supply) when the numbers show growth rates that are clearly below target? [I am not a fan of the monetary pillar but it is always fascinating to see how the ECB feels compelled to report M3 growth numbers and then ignores them.]

Draghi gives two reasons to justify his inaction. One is the usual statement that there are risks on both sides:

"Both upside and downside risks to the outlook for price developments remain limited, and they continue to be broadly balanced over the medium term."

This sentence reminds me of the language used by the Bank of Japan to defend their inaction during the many years with deflation. Here is a quote from the minutes of the Bank of Japan monetary policy meeting in April 2010:

"Regarding risks to prices, some members said that attention should continue to be paid to a possible decline in medium- to long-term inflation expectations. One member expressed the view that attention should also be paid to the upside risk that a surge in commodity prices due to an overheating of emerging and commodity-exporting economies could lead to a higher-than-expected rate of change in Japan's CPI."

How could it be that in 2010 in Japan, after more than 20 years of struggling with deflation and in the middle of a global crisis, the perception of risks looked balanced and that some had the fear of overheating? And even if risk look balanced, what about erring once on the other side of this balance?

The second reason that Draghi gives is that the situation is very complex and that they need to wait for more data in March. Maybe this was a way of saying that action is coming, but it is confusing and it remains unclear why uncertainty should lead to inaction.

Draghi is right, the Euro area does not have deflation today, but if the risks to price developments are perceived as balanced by the ECB, and uncertainty is another excuse for inaction it looks as if the ECB is doing its best to ensure that the Euro area remain close enough to deflation (not to 2%) and Draghi can be sure that he will get the same exact questions in future press conferences.

Antonio Fatás

The conservative bias of economic models

Chris House has an interesting post on why economists tend to be more conservative than academics in other fields. His argument is that many economic facts have a conservative bias (e.g. when you look for evidence on politically loaded questions such as the effects of the minimum wage or high taxes).

Noah Smith replies and argues that there is no such bias in economic facts, quite the opposite, the evidence is weak for some of these questions. So where is the bias coming from? My sense is that it is coming from models to which most economists feel very attached to. And this is partly the case because these models and their economic logic is the one that allows us to show the value that our profession adds. Let me explain.

Economists do not have a great reputation when it comes to forecasting. Given the number of jokes about the inability of economists to forecast anything, about how we assume away any interesting real world phenomena, many macroeconomists stay away from practical questions about policy [As an example, when Chris Sims was awarded the 2011 Nobel Prize in economics, he was very reluctant about giving policy recommendations to get out of the economic crisis.]

But even if you avoid those difficult empirical questions you can still impress your friends by showing how the logic of simple economic concepts can go very far in understanding complex real world phenomena. Talking about opportunity cost, the difference between nominal and real variables, introducing a general equilibrium effect in a macroeconomic question or using game theory to help improve the analysis of a strategic situation are examples where economists thrive and show the added value of the discipline.

And in this spirit, when someone asks us why don't we raise wages to increase demand we use our economic logic to explain that this does not work, that increases in wages will do the opposite by reducing employment and GDP because of the effects on labor costs. And when someone suggests that the central bank should print money and distribute it to every household so that we are all richer, we explain to them that this will only create inflation. This is the origin of the conservative bias of economists, the conservative nature of the benchmark model that economists use. Of course we also have models where increases in wages could lead to higher GDP and there are situations where large increases in the money supply could not generate much inflation but those are much more complex models and they represent an exceptions to the benchmark model that economists tend to start with when they teach or explain their subject to others.

And what is interesting is that this bias does not always show in casual conversations. Many macroeconomists do not use the intuition of the benchmark model when having a casual conversation about economic policy. For example, as Paul Krugman argues today in his blog, most economists share the view that during the current crisis monetary and fiscal policy should have been more aggressive. Similarly, in casual conversations and when confronted with questions about efficiency of financial markets or labor markets or health care economists tend to describe a world full of inefficiencies and where government intervention makes sense. But it is rare that you hear the same strong message when you read their research or when they speak about it in public. Paul Krugman is right in the sense that his views are in many ways mainstream today but it is the fact that he expresses them in such an open manner that sets him aside from many other macroeconomists. I can see why some feel uncomfortable about making such strong policy recommendations given the uncertainty we have about our models or the evidence. I personally find it very refreshing to see more academics being willing to share their views to a broader audience through blogs or articles in a way that enriches the economic debate (even if, unfortunately, it might not have such a big impact on economic policy).

Antonio Fatás

The anti-demand coalition

In yesterday's blog post Paul Krugman summarizes very well the position of some academic economists who deny the potential role that aggregate demand might have in explaining business cycles and, as a result, they reject any policies that might have an effect via the demand channel. Their models are only driven by changes in the productive capacity of an economy which means that the Great Recession (or the Great Depression) must have been the result of some destruction in our capital stock or our inability to remember how to work or produce or somehow our technology got worst than in previous years.

It might be that these economists are just describing an ideal world using assumptions that are very far from the real world but how is it possible that these ideas seem to have such a strong influence in economic policy and even support among the general public? Why is it that countercyclical policy (fiscal or monetary) has been challenged so much during the current crisis? Most policy makers and certainly the public at large do not share the assumptions used by those economic models. In fact, when most people are asked to describe the dynamics of economic crisis, they immediately refer to some notion that shortages of demand cause recessions. When I teach about recessions and I ask my students about the cause of business cycles they immediately tell a story that sounds like the very basic keynesian multiplier (spending reduces income which further reduces spending...). But when the same students are asked to give their views about appropriate economic policies during a crisis, they immediately show their distrust in governments and central banks in their ability to help smooth business cycles. Somehow, expansionary fiscal policy or monetary policy cannot work because it is driven by the government.

So we end up with an odd coalition of views against countercyclical economic policy: those who rely on models where by definition countercyclical policy is ruled out and those who do not believe in these models (they laugh at them if you explain all the assumptions) but because they have no trust in governments they end up reaching the same conclusion.

The increasing number of Euro fools.

Via the Irish Economy Blog I find this very interesting interview of Mario Draghi with Der Spiegel. I was first surprised by the aggressive responses from Draghi every time he is asked about the German negative assessment of recent ECB monetary policy. I like his honesty and clarity when he asserts that all German fears about increasing inflation in the Euro area have turned to be wrong. Here is one of his answers:

"DRAGHI: No, but the fears felt by some sectors of the public in Germany have not been confirmed. What haven’t we been accused of? When we offered European banks additional liquidity two years ago, it was said there would be a high rate of inflation. Nothing has happened. When I made my comment in London, there was talk of a violation of the central bank’s mandate. But we had made ​​clear from the beginning that we are moving within our mandate. Each time it was said, for goodness’ sake, this Italian is ruining Germany. There was this perverse Angst that things were turning bad, but the opposite has happened: inflation is low and uncertainty reduced."

Of course, the journalist is not convinced and continues asking questions about the potential damage that ECB policies are inflicting in Germany. He follows with a set of questions on how the low interest rate policy of the ECB is hurting savers in Germany. Here is the first one:

"SPIEGEL: In Germany, ECB policy is unpopular because you have now pushed the interest rates for investments down so far that they are often no longer enough to compensate for inflation. In other words, only fools save."

This question reflects a really poor level of understanding of some basic economic principles. The statement "only fools save" can only be consistent with the data if the number of fools has increased dramatically in recent years. Interest rates are low because saving is high (and investment is low). Not the other way around.

And here is the next one:

"SPIEGEL: People can see in the statements from their life insurance companies that they are getting ever smaller payouts from year to year because of the interest rates. The truth is that savers are paying the price for rescuing the euro."

Savers are paying the price of fear and a long-lasting crisis. Both have reduced spending and as a result the equilibrium (real) interest rate. And more so in countries that are perceived as safe (as in the case of Germany).

Draghi is good at responding to both of these questions but I find his tone less aggressive than when he answers the questions on inflation. Maybe central bankers need to be more explicit about their (limited) influence on interest rates. The (wrong) perception among many is that interest rates, both nominal and real, for all maturities and risk profiles are determined by central bank policies.

Antonio Fatás

Four missing ingredients in macroeconomic models

It is refreshing to see top academics questioning some of the assumptions that economists have been using in their models. Krugman, Brad DeLong and many others are opening a methodological debate about what constitute an acceptable economic model and how to validate its predictions. The role of micro foundations, the existence of a natural state towards the economy gravitates,... are all very interesting debates that tend to be ignored (or assumed away) in academic research.

I would like to go further and add a few items to their list that I wished could become part of the mainstream modeling in economics. In random order:

1. The business cycle is not symmetric. Most macroeconomic models start with the idea that fluctuations are caused by a succession of events that are both positive and negative (on average they are equal to zero). Not only this is a wrong representation of economic shocks but is also leads to the perception that stabilization policy cannot do much. Interestingly, it was Milton Friedman who put forward the "plucking" model of business cycles as an alternative to the notion that fluctuations are symmetric. In Friedman's model output can only be below potential or maximum. If we were to rely on asymmetric models of the business cycle, our views on potential output and the natural rate of unemployment would be radically different. We would not be rewriting history to claim that in 2007 GDP was above potential in most OECD economies and we would not be arguing that the natural unemployment rate in Souther Europe is very close to its actual.

2. As much as the NBER methodology emphasizes the notion of recessions (which, by the way, is asymmetric in nature), most academic research is produced around models where small and frequent shocks drive economic fluctuations, as opposed to large and infrequent events. The disconnect comes probably from the fact that it is so much easier to write models with small and frequent shocks than having to define a (stochastic?) process for large events. It gets even worse if one thinks that recessions are caused by the dynamics generated during expansions. Most economic models rely on unexpected events to generate crisis, and not on the internal dynamics that precede the crisis.

[A little bit of self-promotion: my paper with Ilian Mihov on the shape and length of recoveries presents some evidence in favor of these two hypothesis.]

3. There has to be more than price rigidity. Keynesian models rely on price rigidity to explain business cycles and why demand matters. There is plenty of evidence that price rigidities are important and they help us understand some of the features of the business cycle. But there must be more than that. There are other frictions in the real economy that produce a slow adjustment and are responsible for the persistence of business cycles. They might not be easy to measure or model, they might be different across different economies but it is difficult to imagine that an adjustment of prices and wages to its optimal level would automatically restore full employment. Larry Summers referred to these frictions in his recent IMF conference speech although he did not elaborate on them.

4. The notion that co-ordination across economic agents matters to explain the dynamics of business cycles receives very limited attention in academic research. It some times appear in our economic policy debate (e.g. Olivier Blanchard (at the IMF) has referred to multiple equilibria as a way to explain the sovereign-debt crisis in Europe) but it does nor receive the credibility it deserves in academia.

I am aware that they are plenty of papers that deal with these four issues, some of them published in the best academic journals. But most of these papers are not mainstream. Most economists are sympathetic to these assumption but avoid writing papers using them because they are afraid they will be told that their assumptions are ad-hoc and that the model does not have enough micro foundations (for the best criticism of this argument, read the latest post of Simon Wren-Lewis). Time for a change?

Antonio Fatás