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 Frydman
Department of Economics, New York University
OECD, June 5th, 2014
OECD, June 5th, 2014 — Slide 1/39

Roman Frydman and Michael Goldberg (2007), Imperfect Knowledge
Economics: 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 to
Non-Routine Change,” in Roman Frydman and Edmund S. Phelps (eds.),
Rethinking Expectations: The Way Forward for Macroeconomics, Princeton
University 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 Model
Really so Bad?, in preparation.
Roman Frydman and Edmund Phelps (2013), “Which Way Forward for
Macroeconomics 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 debate
about
• the relevance of contemporary macroeconomics and
finance models;
• how well (badly) financial markets help society allocate
its capital;
• whether and how the state should intervene into their
functioning.
Two views have dominated the debate
• conventional REH view
• the behavioral-finance view

Conventional view:
• REH models, for example DSGE models, should be
retained as relevant for macroeconomic and policy
analysis,
• 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 forecast
outcomes.
• But, owing to participants’ deﬁcient cognitive abilities
and psychological biases,
• REH fails to represent forecasting in real world markets.
• Participants’ forecasts and prices are driven by
psychological and other factors largely unrelated to
fundamentals.

These views have extreme implications concerning the role of
financial markets and state’s intervention in them.
REH-based efficient market hypothesis:
• market prices reflect future prospects of alternative uses
of capital nearly perfectly;
Behavioral-finance:
• swings in asset prices are largely unrelated to their future
prospects
• the state should intervene to eliminate them as soon as
they arise.

Frydman and Goldberg:
Both REH and behavioral-finance models rest on the flawed
premise;
• unanticipated change in the economy’s structure is
unimportant for understanding outcomes.
Imperfect Knowledge Economics (IKE) jettisons this premise.
Intermediate view:
• financial markets play an essential role in helping society
assess prospects of assets
• but they do so imperfectly, even in the course of their
normal functioning.

IKE:
• reconciles the importance of both fundamental and
psychological considerations in driving outcomes,
• without presuming that market participants are
irrational.
• resolves many so-called puzzles
• posed by viewing empirical evidence through the lens of
models that
• ignore unanticipated change in the economy’s structure.

The Exchange-Rate Disconnect “Puzzle”
One of the core puzzles that contributed to the emergence of
behavioral-finance.
International macroeconomists have estimated
exchange-rate relationships with time-invariant models:
• fixed coefficients that are attached to unchanging sets of
fundamentals:
• such as interest rates, national income, and trade
balances.
Messe and Rogoff (1983) estimated such time-invariant
models for the DM/$, BP/$, and the JY/$ exchange rates.

Main finding: even with ex post values of fundamental
variables,
• all of the major exchange-rate models produced
predictions inferior to those implied by flipping a fair
coin.
Frydman and Goldberg (2007) examine whether exclusion of
unanticipated structural change can explain the Meese and
Rogoff’s finding.
• We used statistical procedures that approximate when
the exchange-rate relationship may have changed
• without prespecifying the timing or nature of this change.
• Figure 1 plots the exchange rate and reports results of
change tests, where dotted vertical lines indicate break
points.


1
1,5
2
2,5
3
3,5
Figure 1
Structural Change Results
Exchange Rate Relationship
1974:07
1978:08
1979:10
1984:08
1985:10
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 in
economic policy:
• October 1979; the US Federal Reserve de-emphasized the
federal funds rate in favor of monetary aggregates as its
primary 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 policy
changes.

Disconnect Puzzle as an Artifact of Determinate Models
Meese and Rogoff tested the predictive efﬁcacy of models that
we call determinate:
• such models rule out unanticipated structural change.
• the time-invariant models tested by Meese and Rogoff are
a particularly restrictive subclass of determinate models.
Allowing for such change shows that
• in each regime, many of the fundamentals implied by
economists’ exchange-rate models matter in ways that
are consistent with these models’ qualitative predictions.
• Different fundamentals with different inﬂuences drive
the exchange rate across the two regimes.


0
0,025
0,05
0,075
0,1
0,125
0,15
Figure 2
Pre- 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 the
structural break found in 1978:09. Model variables are in logs. Source: Frydman and
Goldberg (2007).

The disconnect puzzle stems from ruling out unanticipated
structural change.
• Messe and Rogoff average very different forecast errors
implied by the model prior to and after the break:
• the forecast error of the estimated model prior to the
break point deteriorates markedly once structural
change occurs.

Missing Fundamentals in Stock Prices
Ignoring unanticipated structural change has also led to a
widespread belief that
• equity prices are driven by psychological factors that are
largely unrelated to fundamental considerations.
Finance theorists often suppose that the equity price, Pt, is
determined by the following equilibrium relationship:
Pt =
Dt +F M
t (Pt+1|Zt)
1+r
(1)
• F M
t [Pt+1|Zt] represents an aggregate of market
participants’ (the market’s) forecast;
• Zt represents the union of information variables and
other factors that participants consider relevant.

Conditional Rationality
To turn this equilibrium condition into a theory of equity
prices,
• an economist must represent the market’s forecast.
Muth’s (1961) insight: the market’s forecast should be
consistent with that of an economist.
• Equilibrium condition in (1) formalizes an economist’s
and the market’s understanding of Pt.
Iterating this condition forward:
Pt =
∞
k=0
1
1+r
k+1
F M
t (Dt+k|Zt) (2)

Equity Prices in REH Models
Rational expectations hypothesis (REH): “expectations are
essentially the same as the predictions of the relevant
economic theory” (Muth, 1961, p. 315).
Relevant economic theory: determinate models
• the process driving the prospects of companies never
changes in unanticipated ways:
Dt = Dt−1(1+g)+εt (3)
Pt =
∞
k=0
1
1+r
k+1
Et (Dt+k|Zt) =
Dt
r −g
for all t (4)

Missing Financial Markets’ Essential Role
REH implies that there is only one right way to forecast
company prospects and market prices;
In his prescient critique of socialist planning, Friedrich Hayek
argued that
The economic problem of society is...a problem of the
utilization of knowledge which is not given to anyone
in 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 of
individuals’ knowledge and information
• in assessing the prospects of alternative uses of its
capital.

Efﬁcient Market Hypothesis
Because it relies on REH, efﬁcient market hypothesis portrays
markets as
• able to assess the actual (ex post) prospects of assets
nearly perfectly,
• setting prices nearly perfectly at ex post fundamental
value, except for a mean-zero error term, ηt:
P
f
t =
∞
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).

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 understanding
outcomes.
• on purely logical grounds, REH represents rational
forecasting.
• Failure of REH models points to market participants’
irrationality.
• their forecasts and outcomes are largely driven by
non-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 fully
foreseen in advance in probabilistic terms.
• REH models do not represent conditionally rational
forecasting in real-world markets.
• REH models represent decision-making by irrational
participants, who forego proﬁt opportunities.

Imperfect Knowledge Economics (IKE)
An approach to building models that are open to
unanticipated structural change. (Frydman and Goldberg,
2007).
• Jettisons determinate models;
• but it does presume that the process driving outcomes
exhibit qualitative and contingent regularities.
An IKE model is only partly open to unanticipated structural
change
• it hypothesizes that there are protracted intervals of time
during which
• such change can be characterized with qualitative
constraints.

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 basis
of (IKE) models that are partly open to unanticipated
structural change.
• characterize market participants’ understanding of
change with qualitative and contingent conditions.

Contingent Market Hypothesis
Like EMH,
• CMH represents an economist’s and the market’s
understanding of prospects of assets with the present
value model:
Pt =
∞
k=0
1
1+r
k+1
F M
t (Dt+k|Zt) for all t

In sharp contrast to EMH, CMH
• recognizes that no one can fully foresee when and how
the process underpinning company prospects might
change:
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 of
these parameters so that,
• for example, a rise in current earnings or national output
will lead to a subsequent rise in dividends.

Like EMH,
• CMH relies on internal coherence (CEH) to represent the
market’s forecast and equity prices at a point in time
F M
t (Dt+k|Zt) = βt,kZt for all t and k (7)
Pt =
∞
k=0
1
1+r
k+1
F M
t (Dt+k|Zt) = βtZt (8)
Zt, represents a broad set of factors that market participants
rely on to forecast companies’ proﬁtability and prospects.

Opening the Present Value Model to
Unanticipated 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’ revisions
of their forecasting strategies
• direct informational effects, βt∆Zt+1 represent the
impact of new information.

Unless structural change effects are constrained ex ante, the
model has no implications.
• for the time-series regularities (co-movements) between
stock prices, ∆Pt+1, and informational variables,∆Zt+1.
To illustrate, suppose that βt is positive and represents the
direct impact, of say, company earnings.
Movements in earnings and prices (between adjacent
periods) may or may not be (associated with movements of
prices) 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 fully
speciﬁed in advance in probabilistic terms
• predict quantitative regularities that are hypothesized to
last from t = 0 to inﬁnity.
Partly open:
• constrain unanticipated structural change with
qualitative and contingent conditions.
• predict that qualitative regularities characterize
time-series movements during intervals
• that begin and end at times that cannot be fully known in
advance, even in probabilistic terms.

Example:
∆βt+1Zt+1 < βt∆Zt+1 (10)
Suppose that there is only one variable, say earnings, and that
βt > 0 in every period.
• Whether the model implies that equity prices co-move
positively 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 one
direction
• 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 4
S&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 by
fundamentals.
• Because the process driving prices and fundamentals
changes in unanticipated ways,
• equity prices tend to depart for long stretches of time
from 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 of
fundaments, such as earnings.

Intermediate View of Markets
Essential:
• provide valuations of relative prospects of alternative
uses of capital
• that no single individual can arrive at on his own.
• enable society to take advantage of the diversity of
interpretations by and information of many individuals.
Figure 3, swings around ex post fundamental values
• suggesting that in terms of longer-term averages, market
prices reﬂect prospects fairly well.
• such averages cannot guide allocations ex ante; they can
only be assessed ex post;

Inherently imperfect:
• Beyond short horizons, prospects can, at best, be dimly
understood,
• equity prices tend to be driven by short-term movements
in 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 could
implement policies (Frydman and Goldberg, 2011)
• to dampen such swings
• to protect the banking system from their consequences.
CMH also provides a foundation for designing new
international exchange rate arrangements
• intermediate: between ﬂoating and ﬁxed exchange-rate
regimes

In order to improve the market’s role in valuing alternative
uses of capital, the state should
• reform corporate governance rules with an aim
• to provide incentives for corporate managers to consider
longer-term consequences of uses of company’s retained
earnings and other ﬁnancing.
• reform taxes (increase the wedge between longer and
shorter term capital gains)
• to shift investors’ focus toward evaluating companies
longer-term prospects,
• so the market prices better reﬂect such prospects.

Slides roman frydman oecd june 5 2014

Recommended

Recommended

More Related Content

Similar to Slides roman frydman oecd june 5 2014

Similar to Slides roman frydman oecd june 5 2014 (20)

More from OECD_NAEC

More from OECD_NAEC (20)

Recently uploaded

Recently uploaded (20)

Slides roman frydman oecd june 5 2014