slides roman frydman oecd june 5 2014

T H E I N E T P R O G R A M O N I M P E R F E C T K N O W L E D G E E C O N O M I C S

What Can Economists Know?Rethinking the Foundations of Macroeconomics and Finance

Roman FrydmanDepartment of Economics, New York University

OECD, June 5th, 2014

OECD, June 5th, 2014 — Slide 1/39


Roman Frydman and Michael Goldberg (2007), Imperfect KnowledgeEconomics: Exchange Rates and Risk, Princeton University Press.

———————(2011), Beyond Mechanical Markets: Asset Price Swings,Risk, and the Role of the State, Princeton University Press.

———————(2013), “Opening Models of Asset Prices and Risk toNon-Routine Change,” in Roman Frydman and Edmund S. Phelps (eds.),Rethinking Expectations: The Way Forward for Macroeconomics, PrincetonUniversity Press.

———————(2014a), “The Contingent Expectations Hypothesis:Conditional Rationality in Macroeconomics and Finance Theory,” April.

———————(2014b), “The Contingent Market Hypothesis:Understanding Financial Markets’ Essential Role,” May.

———————and Nicolas Mangee (2104), "Is the Present Value ModelReally so Bad?, in preparation.

Roman Frydman and Edmund Phelps (2013), “Which Way Forward forMacroeconomics and Policy Analysis?,”in Roman Frydman and Edmund S.Phelps (eds.)

R. Frydman — What Can Economists Know? — OECD, June 5th, 2014 — Slide 2/39


The global financial crisis has triggered an intense debateabout

• the relevance of contemporary macroeconomics andfinance models;

• how well (badly) financial markets help society allocateits capital;

• whether and how the state should intervene into theirfunctioning.

Two views have dominated the debate

• conventional REH view

• the behavioral-finance view



Conventional view:

• REH models, for example DSGE models, should beretained as relevant for macroeconomic and policyanalysis,

• but they need to be improved by adding to them• a link between the financial sector and the real economy;

or• participants’ learning about the economy’s structure.



Behavioral-finance view:

• REH, with its emphasis on fundamental considerations,does represent

• how rational individuals understand and forecastoutcomes.

• But, owing to participants’ deficient cognitive abilitiesand psychological biases,

• REH fails to represent forecasting in real world markets.

• Participants’ forecasts and prices are driven bypsychological and other factors largely unrelated tofundamentals.



These views have extreme implications concerning the role offinancial markets and state’s intervention in them.

REH-based efficient market hypothesis:

• market prices reflect future prospects of alternative usesof capital nearly perfectly;

Behavioral-finance:

• swings in asset prices are largely unrelated to their futureprospects

• the state should intervene to eliminate them as soon asthey arise.



Frydman and Goldberg:Both REH and behavioral-finance models rest on the flawedpremise;

• unanticipated change in the economy’s structure isunimportant for understanding outcomes.

Imperfect Knowledge Economics (IKE) jettisons this premise.

Intermediate view:

• financial markets play an essential role in helping societyassess prospects of assets

• but they do so imperfectly, even in the course of theirnormal functioning.



IKE:

• reconciles the importance of both fundamental andpsychological considerations in driving outcomes,

• without presuming that market participants areirrational.

• resolves many so-called puzzles

• posed by viewing empirical evidence through the lens ofmodels that

• ignore unanticipated change in the economy’s structure.



The Exchange-Rate Disconnect “Puzzle”

One of the core puzzles that contributed to the emergence ofbehavioral-finance.

International macroeconomists have estimatedexchange-rate relationships with time-invariant models:

• fixed coefficients that are attached to unchanging sets offundamentals:

• such as interest rates, national income, and tradebalances.

Messe and Rogoff (1983) estimated such time-invariantmodels for the DM/$, BP/$, and the JY/$ exchange rates.



Main finding: even with ex post values of fundamentalvariables,

• all of the major exchange-rate models producedpredictions inferior to those implied by flipping a faircoin.

Frydman and Goldberg (2007) examine whether exclusion ofunanticipated structural change can explain the Meese andRogoff’s finding.

• We used statistical procedures that approximate whenthe exchange-rate relationship may have changed

• without prespecifying the timing or nature of this change.

• Figure 1 plots the exchange rate and reports results ofchange tests, where dotted vertical lines indicate breakpoints.



1

1,5

2

2,5

3

3,5

Figure 1Structural Change Results

Exchange Rate Relationship

1974

:07

1978

:08

197

9:10

198

4:08

198

5:10

1987

:09

DM/$

Source: Frydman and Goldberg (2007).



Six structural breaks in the sample, which includes the 1970’s,1980’s, and 1990’s.

• Some of the breaks are proximate to major shifts ineconomic policy:

• October 1979; the US Federal Reserve de-emphasized thefederal funds rate in favor of monetary aggregates as itsprimary operating target,

• October 1985; the month following the Plaza accord,which aimed at lowering the dollar’s value.

• However, others are related to factors other than policychanges.



Disconnect Puzzle as an Artifact of Determinate Models

Meese and Rogoff tested the predictive efficacy of models thatwe call determinate:

• such models rule out unanticipated structural change.

• the time-invariant models tested by Meese and Rogoff area particularly restrictive subclass of determinate models.

Allowing for such change shows that

• in each regime, many of the fundamentals implied byeconomists’ exchange-rate models matter in ways thatare consistent with these models’ qualitative predictions.

• Different fundamentals with different influences drivethe exchange rate across the two regimes.



0

0,025

0,05

0,075

0,1

0,125

0,15

Figure 2Pre- and Post-Break Performance of

Fundamental Model for DM/$ Exchange Rate

1978

:09

'

%

The graph shows the root-mean squared error from the model estimated up until thestructural break found in 1978:09. Model variables are in logs. Source: Frydman andGoldberg (2007).



The disconnect puzzle stems from ruling out unanticipatedstructural change.

• Messe and Rogoff average very different forecast errorsimplied by the model prior to and after the break:

• the forecast error of the estimated model prior to thebreak point deteriorates markedly once structuralchange occurs.



Missing Fundamentals in Stock Prices

Ignoring unanticipated structural change has also led to awidespread belief that

• equity prices are driven by psychological factors that arelargely unrelated to fundamental considerations.

Finance theorists often suppose that the equity price, Pt , isdetermined by the following equilibrium relationship:

Pt =Dt +F M

t (Pt+1|Zt)

1+ r(1)

• F Mt [Pt+1|Zt] represents an aggregate of market

participants’ (the market’s) forecast;

• Zt represents the union of information variables andother factors that participants consider relevant.



Conditional Rationality

To turn this equilibrium condition into a theory of equityprices,

• an economist must represent the market’s forecast.

Muth’s (1961) insight: the market’s forecast should beconsistent with that of an economist.

• Equilibrium condition in (1) formalizes an economist’sand the market’s understanding of Pt .

Iterating this condition forward:

Pt =∞∑

k=0

(1

1+ r

)k+1

F Mt (Dt+k|Zt) (2)



Equity Prices in REH Models

Rational expectations hypothesis (REH): “expectations areessentially the same as the predictions of the relevanteconomic theory” (Muth, 1961, p. 315).

Relevant economic theory: determinate models

• the process driving the prospects of companies neverchanges in unanticipated ways:

Dt = Dt−1(1+g)+εt (3)

Pt =∞∑

k=0

(1

1+ r

)k+1

Et (Dt+k|Zt) = Dt

r−gfor all t (4)



Missing Financial Markets’ Essential Role

REH implies that there is only one right way to forecastcompany prospects and market prices;

In his prescient critique of socialist planning, Friedrich Hayekargued that

The economic problem of society is...a problem of theutilization of knowledge which is not given to anyonein its totality. (Hayek, 1945, pp. 519-520)

By ruling out diversity, REH models miss markets’ raison d’être

• to help society take advantage of the diversity ofindividuals’ knowledge and information

• in assessing the prospects of alternative uses of itscapital.



Efficient Market Hypothesis

Because it relies on REH, efficient market hypothesis portraysmarkets as

• able to assess the actual (ex post) prospects of assetsnearly perfectly,

• setting prices nearly perfectly at ex post fundamentalvalue, except for a mean-zero error term, ηt :

Pft =

∞∑k=0

(1

1+ r

)k+1

Dt+k = Pt +ηt (5)



Figure 3 Real S&P Stock Price Index (P) and

the ex post “Rational Price” (P*), both detrended

Source: Shiller (1981).R. Frydman — What Can Economists Know? — OECD, June 5th, 2014 — Slide 21/39


Interpreting the Failure of REH Models

Shiller’s findings have been confirmed by other studies:

• REH models fail to account for asset prices and risk.

Two interpretations of the failure of EMH:

1 Behavioral-finance:

• Determinate models are relevant for understandingoutcomes.

• on purely logical grounds, REH represents rationalforecasting.

• Failure of REH models points to market participants’irrationality.

• their forecasts and outcomes are largely driven bynon-fundamental considerations.



2 Our research:

• a very different interpretation of the failure of EMH;• the process driving company prospects in real-world

markets is driven by fundamental considerations,

• but it undergoes structural change that cannot be fullyforeseen in advance in probabilistic terms.

• REH models do not represent conditionally rationalforecasting in real-world markets.

• REH models represent decision-making by irrationalparticipants, who forego profit opportunities.



Imperfect Knowledge Economics (IKE)

An approach to building models that are open tounanticipated structural change. (Frydman and Goldberg,2007).

• Jettisons determinate models;

• but it does presume that the process driving outcomesexhibit qualitative and contingent regularities.

An IKE model is only partly open to unanticipated structuralchange

• it hypothesizes that there are protracted intervals of timeduring which

• such change can be characterized with qualitativeconstraints.



Contingent Expectations Hypothesis

CEH models (Frydman and Goldberg, 2014a):

• like their REH counterparts

• impose internal coherence within an economist’s model.

• in sharp contrast to REH,

• represent conditionally rational forecasting on the basisof (IKE) models that are partly open to unanticipatedstructural change.

• characterize market participants’ understanding ofchange with qualitative and contingent conditions.



Contingent Market Hypothesis

Like EMH,

• CMH represents an economist’s and the market’sunderstanding of prospects of assets with the presentvalue model:

Pt =∞∑

k=0

(1

1+ r

)k+1

F Mt (Dt+k|Zt) for all t



In sharp contrast to EMH, CMH

• recognizes that no one can fully foresee when and howthe process underpinning company prospects mightchange:

Dt+k = bt,kXt +εt+k for all t and k (6)

• leaves open the precise quantitative values that the bt,k

parameters might take.

• may restrict at time t = 0 the algebraic signs of some ofthese parameters so that,

• for example, a rise in current earnings or national outputwill lead to a subsequent rise in dividends.



Like EMH,

• CMH relies on internal coherence (CEH) to represent themarket’s forecast and equity prices at a point in time

F Mt (Dt+k|Zt) =βt,kZt for all t and k (7)

Pt =∞∑

k=0

(1

1+ r

)k+1

F Mt (Dt+k|Zt) =βtZt (8)

Zt , represents a broad set of factors that market participantsrely on to forecast companies’ profitability and prospects.



Opening the Present Value Model toUnanticipated Structural Change

∆Pt+1 =βt∆Zt+1 +∆βt+1Zt+1 (9)

• structural change effects, ∆βt+1Zt+1 represent

• the impact on price movements of participants’ revisionsof their forecasting strategies

• direct informational effects, βt∆Zt+1 represent theimpact of new information.



Unless structural change effects are constrained ex ante, themodel has no implications.

• for the time-series regularities (co-movements) betweenstock prices, ∆Pt+1, and informational variables,∆Zt+1.

To illustrate, suppose that βt is positive and represents thedirect impact, of say, company earnings.

Movements in earnings and prices (between adjacentperiods) may or may not be (associated with movements ofprices) in the same direction.

• depends on the structural change effects in ∆βt+1Zt+1.



Determinate versus Partly Open Models of Change

Determinate:

• structural change and informational effects fullyspecified in advance in probabilistic terms

• predict quantitative regularities that are hypothesized tolast from t = 0 to infinity.

Partly open:

• constrain unanticipated structural change withqualitative and contingent conditions.

• predict that qualitative regularities characterizetime-series movements during intervals

• that begin and end at times that cannot be fully known inadvance, even in probabilistic terms.



Example: ∣∣∆βt+1Zt+1∣∣< ∣∣βt∆Zt+1

∣∣ (10)

Suppose that there is only one variable, say earnings, and thatβt > 0 in every period.

• Whether the model implies that equity prices co-movepositively with earnings depends on

• the structural change effects in ∆βt+1Zt+1.

• If structural change is moderate (condition (10) holds),

• prices and earnings co-move positively.

• if the condition does not hold,

• no prediction.



Swings and Fundamentals

Frydman and Goldberg (2013):

• If fundamental variables, such as earnings trend in onedirection

• and unanticipated change is moderate (condition (10)holds),

• CEH model implies that

• equity prices tend to co-move with earnings.



0

10

20

30

40

50

60

70

80

90

100

0

200

400

600

800

1000

1200

1400

1600

1800

2000

Figure 4S&P 500 Stock Price and Earnings

1992-2009

E

P

Source: Frydman and Goldberg (2011) with data from Robert Shiller’s website.



CEH’s Interpretation of Shiller (1981)

Frydman and Goldberg (2007, 2011, 2013):

• Although psychological considerations play a role,

• equity price movements are largely driven byfundamentals.

• Because the process driving prices and fundamentalschanges in unanticipated ways,

• equity prices tend to depart for long stretches of timefrom benchmark values.

Long swings of equity prices from ex post fundamental value,such as those in Shiller (1981); figure 3,

• can be understood in terms of the movements offundaments, such as earnings.



Intermediate View of Markets

Essential:

• provide valuations of relative prospects of alternativeuses of capital

• that no single individual can arrive at on his own.

• enable society to take advantage of the diversity ofinterpretations by and information of many individuals.

Figure 3, swings around ex post fundamental values

• suggesting that in terms of longer-term averages, marketprices reflect prospects fairly well.

• such averages cannot guide allocations ex ante; they canonly be assessed ex post;



Inherently imperfect:

• Beyond short horizons, prospects can, at best, be dimlyunderstood,

• equity prices tend to be driven by short-term movementsin fundamentals. (figure 4)

• asset prices can sometimes become excessive.



Markets’ Imperfection and the State’s Role

To mitigate the costs of excessive swings the state couldimplement policies (Frydman and Goldberg, 2011)

• to dampen such swings

• to protect the banking system from their consequences.

CMH also provides a foundation for designing newinternational exchange rate arrangements

• intermediate: between floating and fixed exchange-rateregimes



In order to improve the market’s role in valuing alternativeuses of capital, the state should

• reform corporate governance rules with an aim

• to provide incentives for corporate managers to considerlonger-term consequences of uses of company’s retainedearnings and other financing.

• reform taxes (increase the wedge between longer andshorter term capital gains)

• to shift investors’ focus toward evaluating companieslonger-term prospects,

• so the market prices better reflect such prospects.


slides roman frydman oecd june 5 2014

Economy & Finance