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Rajiv Sethi
New York
Professor of Economics, Barnard College, Columbia University and External Professor, Santa Fe Institute
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Terrific post Nick. Among other things it explains very clearly that the rational expectations hypothesis is an equilibrium condition and not a behavioral assumption. Also reveals that when predictions based on rational expectations differ sharply from those based on adaptive expectations, it is the latter that are robust while the former are fragile. You can model agents as econometricians, using the most sophisticated forecasting methods available, and you still won't converge to the interior equilibrium if adaptive expectations would drive you away. This, of course, was Peter Howitt's point in his wonderful 1992 JPE paper. It seems like we keep having this debate every few months.
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Matt, the paper I linked to is just the first step in the following project: http://ineteconomics.org/press-release/grant-awarded-j-doyne-farmer-robert-axtell-john-geanakoplos-and-peter-howitt
Toggle Commented Aug 20, 2014 on The Agent-Based Method at Economist's View
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Well put. You're right of course that Fed profits need not constrain credits to individual accounts but under current practice this is what determines transfers to Treasury. I was trying to stay as close to current policy as possible, and I don't think that the constraint will be binding in the long run.
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Richard, since you posted this on my blog I have also replied there. You make an excellent point - the fiduciary duty of corporations ought to be to maximize shareholder utility not value, unless shareholders care about nothing other than value. Hard to implement with distributed ownership as you point out. Ironically, since voice is not an option, shareholders unhappy with a companies practice have only the option to exit. But this means that value maximizing firms will end up with value seeking shareholders.
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Mark, he gave this speech at the Minsky conference this morning (I was there). The audio of the speech is available here: http://www.levyinstitute.org/news/?event=45 The session after this one was great, with Cassidy, Blinder and Fazzari (Greenwald had to cancel). Fazzari's talk is especially worth a look - really thought provoking, and helpful in understanding both why the recovery has been so sluggish, and why conventional monetary policy has limited effectiveness under current conditions.
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Brad, by mid-2008 the size of the shadow banking sector exceeded 12 trillion. Much of this was short term financing (via repo, money market mutual funds, asset backed commercial paper, etc.) of long dated but highly rated asset backed securities. Once these securities started to look risky, they had to be funded in the capital market since they were no longer acceptable as collateral in the money market. Money market investors wanted cash or genuinely safe collateral, that is, Treasuries. There simply wasn't enough cash to satisfy the demand for redemptions, so the Fed intervened with cash injections (via the Primary Dealer Credit Facility) and exchanges of Treasuries for ABS (via the Term Securities Lending Facility). The newly issued Treasuries have just replaced the formerly highly rated ABS as collateral in the money market. From this perspective, one way to ask the debt capacity question is to ask how much long dated, highly rated debt the money markets were funding in mid-2008? The answer is about 12 trillion. So we may be reaching the limits of debt capacity.
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It cuts both ways, but the effect is not symmetric. Pessimism about one's candidate seems to depress turnout more than optimism. To explain why one needs a satisfactory theory of turnout, which we don't really have. I tried to sketch out some ideas in an earlier post that could give rise to this effect: http://rajivsethi.blogspot.com/2012/11/the-rationality-of-voting.html Asymmetric turnout effects could arise if the regret from not voting conditional on a loss falls off sharply with the margin of victory, while the satisfaction from having voted conditional on a win is relatively insensitive to the margin of victory.
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Nick, this is a very nice post. But I would add that we are always in the very short run. Financial crises and major asset revaluations are responses to the discovery that plans have been mutually inconsistent to a high degree for a long while. They cannot be understood (in my opinion) as equilibrium phenomena, or simply as responses to exogenous shocks. Nobody has yet found an exogenous shock large enough to account for the 1987 crash for instance. Mason's point above, that one can't take convergence for granted, especially global convergence, is spot on. One would have expected the learning literature to address this but most learning models themselves adopt a representative agent framework so we have a decision-theoretic approach to learning and all the interactions that can cause instability are assumed away. No surprise then that most learning models satisfy convergence to RE. I think these are all really interesting questions, and have tried to discuss them from time to time on my blog. It's nice to see you address them here. I always enjoy your posts.
Toggle Commented Aug 29, 2012 on The very short run at Worthwhile Canadian Initiative
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Prof Waldmann: If you read this post of mine from June 19, 2010, you'll see that I am very well aware of your JPE paper with DeLong et al. http://rajivsethi.blogspot.com/2010/06/on-tail-risk-and-winners-curse.html I have even cited it several times in my own work. I claim no originality for the idea that economics should adopt a more evolutionary approach; Veblen (1898) probably deserves credit for that. But if you think that your 1990 JPE paper is the last word on the subject, and there's nothing to be added by looking at heterogenous priors, we'll have to agree to disagree.
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Roger, thanks for posting this again, I had missed it on Mason's blog. I'm coming at this from a finance perspective where prices are generally flexible but heterogeneity is central: one needs to account for massive directional bets on both sides of the housing market, AIG betting on limited default and Paulson on a collapse for example. Hicks' notion of temporary equilibrium is very useful in understanding this because it allows for the clearing of spot markets (and any futures markets that exist) without requiring expectational consistency across individuals. In fact, temporary equilibrium is well-defined for any specification of expectations, including naive or adaptive expectations. The question is, what theory of expectations should we use to close the temporary equilibrium model. RE is one way to go but this would imply that both Paulson and AIG had the same beliefs about the housing market, which means that their ex-ante expected profits would be the same. From this perspective, Paulson just got lucky. Maybe so, but I think that allowing for heterogenous priors evolving under pressure of differential profitability is at the very least a promising direction for future research. I appreciate the enormous new insight that RE models with multiple equilibrium paths can bring to the understanding of the economy and am an admirer of your work as you know. But I don't think that models with mutually incompatible beliefs are an "irrelevant distraction" as your original post on Noah's blog seemed to suggest. Perhaps you were referring only to the non-market-clearing aspect of disequilibrium but a reader may have interpreted your remark to refer to all departures from RE as well.
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Maybe I'm missing something but this proposal sounds completely bizzarre. As Bill (above) said, the only way to implement it would be to hold the extra liability in escrow at the time of purchase, to be returned upon sale. Otherwise the transactions costs of collection would be enormous. But if the money is held in escrow, then as Anchard (above) says, the share price would fall to compensate, making the effective cost of ownership essentially the same. I don't get it.... what is Tyler thinking?
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George, you'll be interested in this: http://www.macroresilience.com/2010/10/18/the-resilience-stability-tradeoff-drawing-analogies-between-river-management-and-macroeconomic-management/ and this http://www.macroresilience.com/2009/12/06/minskys-financial-instability-hypothesis-and-hollings-conception-of-resilience-and-stability/ from Macroeconomic Resilience. I was opposed to the breaking of trades after the flash crash for the same reason: http://rajivsethi.blogspot.com/2010/05/algorithmic-trading-and-price.html
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Reason - follow the link to Solow's review and you'll see a nice discussion of Keynes on uncertainly. This just strengthens the point I was trying to make abut RE. Saving to leave one's options open is itself a kind of plan. Barkley and Greg - Thanks. The tweets by Mark Thoma and ModeledBehavior on Heilbroner were also nice to see.
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Here are readings from a related course of mine, but some require a bit of financial economics background: Carmen Reinhart and Kenneth Rogoff, This Time is Different: A Panoramic View of Eight Centuries of Financial Crises. NBER Working Paper W13882, 2008. Markus Brunnermeier, Deciphering the liquidity and credit crunch 2007-2008. Journal of Economic Perspectives, 2009. Hyun Shin, Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis. Journal of Economic Perspectives, 2009. Raghuram Rajan, Has Finance Made the World Riskier? European Financial Management, 2006. Ross Levine, An Autopsy of the U.S. Financial System. NBER Working Paper 15956, 2010. Joshua Coval, Jakub Jurek, and Erik Stafford, The Economics of Structured Finance. Journal of Economic Perspectives, 2009. Rene M. Stulz, Credit Default Swaps and the Credit Crisis. Journal of Economic Perspectives, 2010. CFTC and SEC, Preliminary Findings Regarding the Market Events of May 6, 2010. James Tobin, On the Efficiency of the Financial System. Lloyds Bank Review, 1984 Hyman Minsky, Finance and Profits: The Changing Nature of American Business Cycles. In The Business Cycle and Public Policy, 1980.
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I'm so terribly shocked and saddened by this. I knew her only from her writing here, and had come to appreciate her original, thoughtful, and always sensible perspective on things. I loved the way she managed to weave personal narratives into her economic arguments without ever seeming self-absorbed. My deepest condolences to her family and friends.
I cut cable two years ago because the quality of over-the-air broadcasts with a powered antenna was better than cable (even in Manhattan): http://rajivsethi.blogspot.com/2010/02/is-over-air-television-broadcasting.html
Toggle Commented Jan 7, 2011 on "Time to Cut the Cord" at Economist's View
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I cut cable two years ago because the quality of over-the-air broadcasts with a powered antenna was better than cable (even in Manhattan): http://rajivsethi.blogspot.com/2010/02/is-over-air-television-broadcasting.html
Toggle Commented Jan 7, 2011 on Time To Cut The Cord at Tim Duy's Fed Watch
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Mark, this is a very interesting post and I hope you'll follow up on these issues - especially regarding the learnability question. What is now called determinacy and learnability used to be called (in the context of general equilibrium theory) uniqueness and stability. Determinacy means that there is a single equilibrium profile of plans for any given history, which is nothing more than uniqueness of mutually consistent plans. Determinacy does not depend on any notion of disequilibrium (or learning) dynamics and can be examined by looking exclusively at equilibrium conditions. Learnability, on the other hand, requires the specification of some (necessarily ad hoc) disequlibrium adjustment process that describes how individuals respond to the realization that their intertemporal plans are mutually inconsistent. Not only can one have failures of learnability despite satisfying determinacy, one can have an equilibrium path that is learnable under one specification of disequilibrium dynamics but not another. There was a lot of attention to these issue in the 1950s and 60s, once the conditions for the existence of general equilibrium had been established. In a 1960 paper Herbert Scarf provided a robust example in which a unique equilibrium was also unstable, showing in the process that the conditions for stability can be much more demanding than those for uniqueness. The bottom line is that the link between determinacy and learnability is very tenuous.
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Frances, there's a good discussion of this in Boldin/Levine's book Against Intellectual Monopoly, where they argue that British authors in the 19th century who had no copyright protection in the US nevertheless made more money in the US market than the British one. Here's an extract: "How did it work? Then, as now, there is a great deal of impatience in the demand for books, especially good books. English authors would sell American publishers the manuscripts of their new books before their publication in Britain. The American publisher who bought the manuscript had every incentive to saturate the market for that particular novel as soon as possible, to avoid cheap imitators to come in soon after. This led to mass publication at fairly low prices. The amount of revenues British authors received up front from American publishers often exceeded the amount they were able to collect over a number of years from royalties in the UK." How could it work for music? Direct sale of songs/albums to an identified fan base bundled with autographs, concert tickets, etc. prior to broad redistribution. Not exactly the Radiohead model but still distribution at near-zero prices for copies that have negligible marginal cost of production. Similar to the sale by for-profit publishers of the 9/11 Commission Report which was not copyright protected and had massive distribution (combining sales and free downloads). Here's my post on Boldrin/Levine, which contains a huge number of other fascinating examples: http://rajivsethi.blogspot.com/2010/02/on-intellectual-property-and-guard.html
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"But the long-run feasibility of the strategy is better evidenced by Wikipedia - 400 million users and $14.5 million in annual donations, revealing an average willingness to pay of about 4 cents per year." Wikipedia is built on anonymous donations of highly skilled labor. Given a choice between "use Wikipedia and don't contribute to articles" and "use Wikipedia and contribute" the former costs a *lot* less but enough people choose the latter option to make the scheme viable. Same with Yahoo! Answers. This really is the worst example to use in making this point.
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Brad, you really ought to have linked here to your post on Bullard's paper: http://delong.typepad.com/sdj/2010/08/extremely-rough-a-note-on-bullards-interpretation-in-his-seven-faces-of-the-peril-paper-of-benhabib-et-al.html That is one of your most interesting posts in my opinion. It explains intuitively why the higher inflation steady state is locally but not globally stable under learning, and also completes George's analysis by asking what happens if one somehow ends up in the vicinity of the deflation trap.
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Nick, I think that the communication framework you have in mind is much richer than in the fairly narrow RE model that can be used to support Narayana's claim. In this RE model, there is only one way in which expectations can be self-fulfilling in response to a fall in the target nominal rate, and that is with a decline in inflation so great that the real rate temporarily rises even as the nominal rate falls. It's amazing to me how different this is from the old monetarism, but it's a coherent argument. I agree with you about stability and am therefore suspicious of it. Regarding your point about communication, the message space in the RE model is degenerate: the only "communication" that occurs is the change in the target rate, and the Taylor rule itself is the only exogenous aspect or policy instrument. With a richer message space I suspect that there could be different types of equilibrium paths of the kind you have in mind. This would take us in the direction of the sunspot literature.
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Just posted this on Brad's blog in response to Nick, but it's also relevant to this thread, especially Andy's comment: Nick, I'm with you on the merits of the argument (as you know) but what Jesus points out is that there are perfectly standard models (with RE) in which a lower target nominal rate causes an immediate decline in inflation that is large enough to cause a temporary *rise* in the real rate, this justifying the fall in inflation. With sticky prices it takes time to reach the new lower inflation steady state but the dynamics (under RE) are stable and in fact monotonic in nominal interest rates. In other words, Narayana's claim is coherent, and actually consistent with a very standard model. Now I don't believe that these dynamics are robust to small departures from RE in the direction of learning (though Jesus believes that they are). One interesting point - I originally thought that Jesus and Steve (Williamson) were on the same page on this, but I now think that they are not. Steve seems to think that Narayana's argument was just a restatement of the Fisher equation and not relevant to understanding the short-run effects of a higher nominal rate. Jesus on the other hand takes Narayana's statement at face value and defends it. I have to say, despite my disagreements with Jesus, I have really enjoyed going back and forth with him on this by email. I hope to write up a summary of the conversation in a blog post at some point.
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Nick, I'm with you on the merits of the argument (as you know) but what Jesus points out is that there are perfectly standard models (with RE) in which a lower target nominal rate causes an immediate decline in inflation that is large enough to cause a temporary *rise* in the real rate, this justifying the fall in inflation. With sticky prices it takes time to reach the new lower inflation steady state but the dynamics (under RE) are stable and in fact monotonic in nominal interest rates. In other words, Narayana's claim is coherent, and actually consistent with a very standard model. Now I don't believe that these dynamics are robust to small departures from RE in the direction of learning (though Jesus believes that they are). One interesting point - I originally thought that Jesus and Steve (Williamson) were on the same page on this, but I now think that they are not. Steve seems to think that Narayana's argument was just a restatement of the Fisher equation and not relevant to understanding the short-run effects of a higher nominal rate. Jesus on the other hand takes Narayana's statement at face value and defends it. I have to say, despite my disagreements with Jesus, I have really enjoyed going back and forth with him on this by email. I hope to write up a summary of the conversation in a blog post at some point.
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Andy, the thing is, in an RE model the extent to which expectations respond to changes in interest rates is not a behavioral parameter - it's determined endogenously in equilibrium. And one can set up very standard, currently mainstream models with or without sticky prices that give you an equilibrium response that is strong enough for Narayana's claim to be valid (Jesus Fernandez-Villaverde has convinced me of this in email correspondence over the past couple of days). The question, then, is whether the models themselves are robust to departures from RE, for instance with respect to learning. This is what Howitt's paper addresses so nicely.
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