Fasten your seat belts; the ride is about to get choppy.

Chinese policy makers are concerned with the dramatic recent falls in the value of the Chinese Stock Market. They are right to be concerned. Although we can, and should, allow financial markets to allocate capital across sectors, the market as a whole is a creature of sentiment. And U.S. experience suggests that market crashes often precede deep recessions.

Today, the Peoples Bank of China was given the authority to purchase shares in the Chinese Stock Market. This is a bold experiment; but it is not unprecedented. In 1998, in the midst of the Asian Financial Crisis, the Hong Kong Monetary Authority engaged in a similar exercise. That intervention was large and successful and was the beginning of the end of the Asian crisis.

Chinese stocks are not dramatically overvalued and prospects for growth have recently picked up. I have advocated in the past for  the policy that the Peoples Bank is now engaged in. But the devil is in the details.

Stock market intervention could unfold in two ways. A purchase of shares by the central bank might be financed by money creation (Quantitative Easing). Or it might be accomplished by swapping short-term debt for risky securities (Qualitative Easing). Chinese interest rates, at 4.8%, are still in positive territory although inflation is currently at 1.2% and falling if official statistics are to believed. That leaves room for purchase of shares financed by money creation and it is an option that I would not rule out.

Buying stocks through money creation is not the only avenue. The Peoples Bank also has the option to purchases shares without increasing the monetary base through swaps of shares, either for foreign exchange or through domestic government borrowing.

China is holding more than $1.2 trillion dollars of U.S. government debt. If the Bank were to tap those funds to stabilize the Chinese stock market it could not simultaneously maintain an exchange rate peg. If China goes that route, look out for upheaval in the foreign exchange markets.

An alternative strategy would be to issue domestic debt and use it to purchase stocks. That would leave the Bank with liabilities, short-term debt, offset by assets, shares in the Chinese stock market.

It would be a mistake to bet against a Central Bank that is committed to dampening market volatility and a national treasury that is backed by the present value of future tax revenues. But an intervention of the magnitude that China is now contemplating cannot fail to spill over into world financial markets. Fasten your seat belts; the ride is about to get choppy.

Behavioural Economics is Rational After All

There are some deep and interesting issues involved in the debate over behavioural economics. Greg Hill posted a comment on my previous blog where he says:

Now, you really have to ask yourself whether the kind of rationality involved in [Thaler's idea of a nudge], where a minimal change in cost results in a significant change of behavior, is same kind of rationality Lucas and Sargent have in mind.

That led me to explain my views a little further.

The most interesting issue [with behavioural economics] is whether we should continue to accept the neoclassical assumption that preferences are fixed. Let's go with that assumption for a moment.

If preferences are fixed, then we face a second question. What form do they take? For a long time, macroeconomists assumed that people maximize the discounted present value of a time and state separable von Neumann Morgenstern expected utility function. The narrow version of behavioural economics asserts that this assumption is wrong; but people are still utility maximizers.

Finance economists seeking to reconcile macroeconomics with finance theory have already taken up that challenge (see the survey here on Exotic Preferences in Macroeconomics). The dominant view in finance theory is that people maximize the present discounted value of a subclass of preferences first formalized by Epstein and Zin. These preferences drop one of the key assumptions of Von-Neumann Morgenstern; that the date at which information is revealed is irrelevant. There are also more radical possibilities. The original version of the Epstein Zin utility function also allows for dropping a more fundamental assumption, called the independence axiom.

My point here, is that neoclassical economics can absorb the criticisms of the behaviourists without a major shift in its underlying assumptions. The 'anomalies' pointed out by psychologists are completely consistent with maximizing behaviour, as long as we do not impose any assumptions on the form of the utility function defined over goods that are dated and indexed by state of nature.

There is a deeper, more fundamental critique. If we assert that the form of the utility function is influenced by 'persuasion', then we lose the intellectual foundation for much of welfare economics. That is a much more interesting project that requires us to rethink what we mean by individualism.

Greg also asks

“can we understand all the failures of classical macroeconomics without giving up both rational choice and the premise that all markets clear?” If anyone can make a persuasive case for the “yes” answer, I believe you can."

My response. Yes we can and should maintain rational choice, rational expectations and market clearing: but that requires a radical change in the way we define equilibrium. As I have done here.

The Economics of George Orwell

Diane Coyle has a nice review of Richard Thaler's new book,  Misbehaving. Diane's review is, for the most part, appropriately laudatory. But she does voice a concern that I share. Here is Diane...

"Behavioural economics is now one of the most popular areas of the subject, ... but the new embrace by economists makes me uneasy. This is not just because of the well-known debate about paternalism (as discussed by Gilles St Paul in The Tyranny of Utility or Julian LeGrand and Bill New in Government Paternalism: Nanny State or helpful Friend?) It is because the sight of economists delighting in a new tool to engineer society is alarming –"

I agree. Here is a quote from my review of Akerlof and Shiller's 2009 book Animal Spirits, another piece that draws on behavioural economics to engage in social engineering. 

Akerlof and Shiller want to replace rational choice with behavioural economics. And here is what they mean by that...

“Behavioural economists assert that what makes individuals truly happy can be different from what they in fact choose to do. In Akerlof and Shiller’s words, ‘...capitalism...does not automatically produce what people really need; it produces what they think they need...’ (p. 26).”

To a classical liberal like me, this is a scary proposition since it gives a licence to someone else, someone who knows my true preferences, to act on my behalf. Is this the government or the church? Both institutions have claimed that right in the past, with disturbing outcomes. The idea that the government knows my preference better than I do is a little too  Orwellian for me. 

I went on to criticize Akerlof and Shiller for tearing down too much of classical theory and failing to replace it with a credible alternative. You can read my full review here. 

In my view, we can understand all of the failures of classical macroeconomics without giving up on rational choice. Heres what I said in 2009

I personally find it much more credible to believe that markets may sometimes misallocate resources and that this misallocation is directed by self-fulfilling crises of confidence. There is an existing agenda (part of neo- classical economics) that integrates psychology with economics by constructing economic models in which market fundamentals do not uniquely determine outcomes. In these models, it is the self-fulfilling beliefs of market participants that fill the gap. In my view, this idea of a self-fulfilling belief is a more appropriate candidate for what one should mean by animal spirits than the ... alternative meanings proposed by the authors. This narrower established definition is already widely used by a large existing body of researchers.

Here is a link to a survey paper that discusses this alternative approach.

Multiple Equilibria and Financial Crises

In May of this year, Jess Benhabib and I organized a conference at the Federal Reserve Bank of San Francisco with much help from Kevin Lansing at the Fed. Many thanks Kevin!

Kevin has just sent me a link to a website put together by the Fed with links to all of the papers, including slides of presenters and discussants plus a video of Karl Shell's dinner talk on the history of sunspots. The conference was sponsored by the NBER, UCLA and NYU. Many thanks to all who helped make this possible. 

Running a Surplus in Normal Times is Keynesian

In a recent letter to The Guardian, a coterie of mainly English academics has criticized George Osborne's Mansion House speech in which he proposed to run a budget surplus in normal times. 

Mansion House

According to the letter writers, 

The chancellor’s plans, announced in his Mansion House speech, for permanent budget surpluses [my italics] are nothing more than an attempt to outmanoeuvre his opponents (Report, 10 June). They have no basis in economics. Osborne’s proposals are not fit for the complexity of a modern 21st-century economy and, as such, they risk a liquidity crisis that could also trigger banking problems, a fall in GDP, a crash, or all three.

I have searched for details on the Osborne plan, but they are sketchy. There is no mention in the speech of 'permanent budget surpluses'. Instead, the Chancellor proposes that the Treasury should run surpluses in 'normal times'. He suggests that the Office for Budget Responsibility, should define what 'normal' means. The OBR may not be the best independent body to fulfill this role, but I can certainly see a role for some independent body to recommend when it makes sense to run a current account deficit.

As far as I can see, Chancellor Osborne is proposing to relinquish political control of the fiscal reins in much the same way that Gordon Brown relinquished control of the monetary reins when the Bank of England gained independence in 1997. There is a clear temptation for elected governments to spend in response to electoral cycles and some kind of independent body that keeps that temptation in check is, in my view, a good idea.

Sensible fiscal policy demands that a government should be prepared to run deficits in recessions, but that during normal times, expenditures on non-capital items should be in surplus. Interpreted in this way, the Chancellor's proposal is one that is very much in line with Keynesian economics. 

Keynes' views on fiscal policy are summarized in Volume 27 of his collected works, to which I do not have immediate access. The following is a second-hand quote from the article by Brown-Collier and Collier, "What Keynes Really Said about Deficit Spending", published in the Journal of Post-Keynesian Economics.

Keynes distinguishes public investment, which he wants to be chosen on a cost-benefit basis, from current expenditure, which should not be financed from deficit spending.

Lets not judge the Osborne plan before it is fleshed out in more detail. Running a surplus in normal times is, after all, an essentially Keynesian proposition.