Tuesday, October 06, 2009

2008 Re-Invigorates Macro?

Commenter 'Noah' posted on this blog:
At my university (University of Michigan, not a "top" school but no slouch either), macro - especially behavioral macro and financial macro - is the hot new thing for grad students, thanks to the crisis.

Nothing really sparks curiosity more than a big puzzle that is important and seemingly soluble. Many independent hypotheses have been offered for the 2008 crisis, and this has surely motivated many to make their case. Given the way this totally blindsided economists (and most everyone else), clearly this is appropriate.

Yet, I'm not sanguine that extrapolations from 2008 will give us broad, generalizable, useful macroeconomic models. The crisis, to me, seems a peculiar effect from a sector with a century of good results that was then overdone. I imagine any sector with such a run will be susceptible to such a problem, but I'm not sure what other sectors would be comparable (US debt?). It's like living your life as if you are about to be mugged: preventing this is important, expertise in this area can prevent an damage if attacked, but it is still irrelevant to most people because it is so rare.

Puzzles are fun for academics because merely explaining to the ignorant (eg, undergrads) how things work is hardly sufficient to sustain enthusiasm. There's a lot we don't know, and figuring these out is fun and important. Yet, many prominent puzzles are often highly misleading. For example, the equity premium puzzle was explaining why the equity risk premium was 8%, given what we know about utility functions and the volatility of the stock market. It turns out this equity premium puzzle was vastly overstated, now thought to be around only 3.5% (and as I have argued, effectively zero). Further, solutions to this problem just amplified the puzzle as to why there is no risk return relationship within most asset classes like equities in bonds; when you fix one problem by making others worse, it's not a good solution.

So, I'm all for puzzles, but it's important to fixate on problems that are truly important. Not important with hindsight, but important for the future. Many commentators talk about the past as if it was so obvious. But the fact that 99% of stock brokers can tell you how best to invest last year still generates a useless forward looking strategy, as demonstrated by their record.


Noah Smith said...


You're talking about the question(s) of why bubbles form, which is of course very important.

But I think there is another, related question for macroeconomists to answer: How do endogenous financial effects (like bubbles) affect the real economy? And can policy exert any degree of control over that transmission mechanism? That seem to me to be a question that economists, more than finance people, are in a position to tackle.

Anonymous said...


What of curiosity what do you think are the important questions that economists should be addressing?

Anonymous said...


not being into finance, there is though something about the equity premium puzzle that puzzles me. Looking at it from the point of view of a businessman, not an investor, if the equity premium were zero, why would I have my capital invested in a business? I would expect that the aggregate equity premium for all companies in US must be positive, otherwise there would be no incentives to have a business.

Even stronger, is it obvious that a zero-equity-premium is compatible with GDP growth? The 6% of GDP that corporate after-tax profits represent is suspiciously similar to the 6% average GDP growth in the past century. How correct is it to say no profits, not growth without premium?

Again, I may be missing something critical, but stocks are not pieces of paper, they represent pieces of a business. I would describe the premium as an ownership premium, if you wish. Didn't even Marx notice the importance of profits for capitalism? After all, the common statement that they yield more because they are risky does not apply to options. As you have said in the past, being even more risky, they should yield even more. But of course, there is such a thing, and options are not the claim to the ownership of anything.

Eric Falkenstein said...

I address this at more length in my book, finding Alpha, and discuss it more at http://www.defprob.com/video/chap6/chap6.html

But, fundamentally, I see profits as a return on equity capital, and this has been about the risk free rate when all the costs are added up. Marx thought profits were going to zero. Why take risk for the same return? The Search for Alpha, people looking for their comparative advantage.