Saturday, November 24, 2012

Scott Sumner: Damned if markets are efficient, damned if they're not

Last week I wrote a post that attempted to dehomogenize Scott Sumner from Krugman. I left a similar but more precise comment on Bob Murphy's blog. Sumner seemed to endorse it. But there's something that doesn't make sense.

Open market operations can really only have an effect if markets are not efficient. Yet Sumner is a great believer in efficient markets (as commenter Max notes on RM's blog). See Scott here and here. How can Sumner reconcile those two positions?

First, some definitions. I'll define efficiency as the idea that financial assets trade in the market at the discounted value of their future cash flows. Any deviation from this value will be fleeting as investors arbitrage it away. Another word for discounted value is fundamental value.

Here's the logic for why open-market operations need an inefficient market to work.* Say reserves are currently plentiful and yield 0%. Twenty-year 2% bonds are trading in the market at their fundamental value of $115 and an implied interest rate of about 1%. If the Fed announces it's going to buy a bunch of 20-year bonds, how can it increase their price above fundamental value? Any attempt to bid bond prices above $115 will cause rational traders to quickly sell every bond they own to the Fed so as to take advantage of the overvaluation. Bond prices don't change, nor does the 1% yield. Same goes for stocks and other assets. QE-style open market operations can't get a "bite" on asset prices.

But as market monetarists like to point out, even in today's environment of plentiful reserves, open market operations do seem to have an effect on asset prices. See Lars Christensen's chart, for instance. So if purchases have demonstratively pushed up asset prices, that means traders aren't selling those assets at their fundamental value, and therefore markets aren't efficient.

Ok, here's a way for Scott to have his cake and eat it to - he can be a believer in efficient markets and accept the relevance of open market operations. Let's redefine the efficient price of a some asset to be composed of not only its fundamental value (the discounted value of future cash flows), but also a liquidity premium. Assets have differing liquidity premiums depending on the expected ease of buying or selling them. Marketable assets have large liquidity premiums and, as a result, their efficient price is higher than if they were illiquid. It's worthwhile for rational traders to own liquid assets because in an uncertain world, the ability to sell or hypothecate some asset provides a set of options that an illiquid asset doesn't.

Having redefined efficient, when the Fed announces it will buy 20-year bonds, their fundamental value still doesn't change. Instead, the liquidity premium on 20-year bonds rises. After all, with the Fed wading into the pool, these bonds have become much more liquid. As a result, the efficient price of 20-year bonds will rise. In this way, prices can rationally diverge from their fundamental value without the assumption of efficiency being dropped. That's why open market operations can have bite, even in an environment like ours.

*I get this from Eggertson and Woodford, who get it from Neil Wallace, who got it from the efficient market crowd, Miller, Modigliani, and the rest.

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