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Financial markets and monetary economics.

Financial Markets and Monetary Economics

The October 1987 stock market crash, more than any other single event within recent years, has stimulated an extraordinary profusion of research on securities pricing by members of the NBER's Program in Financial Markets and Monetary Economics since the activities of this program were last summarized in the NBER Reporter.(1) To be sure, ever since the program's inception in the 1970s, many of its members had taken the pricing of securities and other speculative assets as a principal focus of their research. But in the same way that the Federal Reserve System's adoption of new monetary policy procedures in October 1979 became the practical impetus for much of the research done within the program during the early 1980s, the fact of the stock market crash and the need for greater understanding of its broader implications spurred a great deal of the program's research activity in the later years of the decade. At the same time, work has continued on other traditional areas of research interest, including (among others) the role of market imperfections in affecting how financial markets influence non-financial economic activity, implications of the special problems associated with debts issued by governments, and, of course, the conduct and effects of monetary policy.

Efficient Markets?

Perhaps the most immediate question posed by the stock market crash is whether the market is "efficient" in the conventional sense that securities prices, at any time, discount all information then available about subsequent cash flows that the owners of securities will receive. Because the market received no obvious new information in the days immediately preceding October 19, 1987, it is not surprising that several researchers have challenged the notion that the stock market is efficient in the usual sense. Robert Shiller, for example, in a series of papers using survey data to extend a line of research he had initiated some years earlier, has sought to establish the role of psychological "fads and fashions," rather than fundamentals of expected cash flows and discount rates, in affecting market prices. The results of a survey questionnaire that Shiller distributed immediately after the crash confirmed the absence of "news" as a major element in investors' decisions and pointed instead to factors related to a group psychology.(2) A similar survey that Shiller conducted in Japan suggested that the fall in Japanese stock prices primarily reflected the collapse of U.S. stock prices.(3) A further survey directed this time at the market for newly issued securities supported familiar claims of inefficiencies in the form of systematic underpricing of initial public offerings.(4)

Statistically based tests of market efficiency, including several based on novel statistic methods, have led to more mixed results. For example, Andrew Lo and Craig MacKinlay found that the variance of stock price data sampled at any specific observation interval does not correspond with the variance of prices sampled at different observational intervals in the way that market efficiency implies.(5) In further work, they showed that the fact that not all securities trade simultaneously can be an important part of this discrepancy, and they examined circumstances under which "contrarian" trading strategies (which many representations of inefficient markets suggest) can be profitable.(6)

In the same vein, Bruce Lehmann found a systematic tendency for stocks that had outperformed the overall market in one week to underperform in the subsequent week, and vice-versa. This phenomenon again indicated market inefficiency and the potential profitability of contrarian trading strategies.(7) John Campbell and Robert Shiller showed that the optimal predictor of future aggregate stock dividends is not just the current level of stock prices, as would be implied by standard notions of efficient markets, but a weighted average of the current price level and a moving average of earnings.(8) James Poterba and Lawrence Summers showed that high (or low) stock returns in one time period tend to be followed by high (or low) returns for a short time thereafter, but after a while returns change direction. This "mean reversion" in stock prices also contradicts conventional market efficiency.(9) Gregory Mankiw, David Romer, and Matthew Shapiro found similar evidence contradicting market efficiency, although less strongly than in the case of prior researchers' work.(10)

Explaining Observed Market Movements

Finding market inefficiency is one thing. Explaining it is something else. In a series of papers, Bradford De Long, Andrei Shleifer, and Lawrence Summers have suggested that observed deviations from market efficiency, including in particular the mean reversion phenomenon, are caused by the actions of "noise traders" who act on beliefs not grounded in securities fundamentals. In one paper, these authors showed that noise traders with erroneous beliefs not only can significantly affect market prices, but also can earn systematically higher returns than other investors.(11) In an extension of this work, they showed that such noise traders therefore not only can survive in the market but also can even come to dominate it eventually. Hence their research effectively rebuts the conventional efficient-markets presumption that such investors, if they existed, would decline in importance over time. These authors also found that the effects of noise traders' actions are not necessarily damped out by the contrary actions of "rational" investors. In a further paper, they also showed that the added market risk created by noise traders can reduce an economy's capital stock, and its consumption level--perhaps by large amounts--if the current empirical evidence on the extent of market inefficiency is correct.(12)

Not all explanations for observed market price movements are inconsistent with efficient markets, of course. For example, Fischer Black and Alan Marcus have each, independently, shown ways in which stock prices can exhibit mean reverting behavior even if markets are efficient.(13) Charles Nelson has argued that the empirical evidence supporting mean reversion in U.S. stock return data is weaker than other researchers have suggested.(14) Similarly, Kenneth Froot and Maurice Obstfeld have shown that some aspects of the observed behavior of stock prices that may appear to be evidence of irrationality among investors may actually be caused by a "bubble" phenomenon, which can arise even if all investors behave rationally.(15) Philippe Weil has shown that "bubbles" caused by the behavior of rational investors are not one-sided, but can either raise or lower a stock's price.(16) In other work, Weil and Alberto Giovannini have suggested that some apparent contradictions in the pricing of stocks and other securities may be attributed to economists' (artificially) assuming that investors' willingness to substitute returns received at one time for returns received at a later time is fundamentally determined by their willingness to bear risk at any specific point of time. In separate work, however, Weil showed that relaxing this assumption still does not explain observed pricing patterns.(17)

Among attempts to reconcile observed patterns of stock returns with standard notions of efficient markets, the line of research that has attracted the most attention within the program is one emphasizing that market risk changes systematically over time. In a series of papers, William Schwert has documented and analyzed the changes in the volatility of U.S. stock prices that have taken place over various time periods. In two papers, Schwert related changes in monthly stock price volatility since the early nineteenth century to such basic factors as business cycle developments, firms' leverage (which turned out not to matter much), profitability, default risk, and even occasional financial crises.(18) In another paper, he used daily data since 1885 to show that the dramatic jump in stock return volatility at the time of the October 1987 crash and the rapid subsequent decline in volatility were exceptional compared to prior U.S. history.(19) And in a paper that is likely to prove especially useful to other researchers in the field, Schwert also has provided monthly indexes of U.S. stock prices since 1802.(20)

Devising and estimating statistical representations of systematic changes over time in the volatility of returns on stocks and other assets is an important step in determining whether these changes can plausibly explain observed patterns of returns in markets dominated by risk-averse investors. Several researchers have modeled changing volatility using a statistical procedure originally designed by Robert Engle for describing time-varying variances and covariances. For example, Kenneth Froot and Jeffrey Frankel used Engle's procedure and an alternative to test the efficiency of the stock market. They found that their models do help to explain observed market returns.(21) Benjamin Friedman showed that both Engle's procedure and a simpler alternative implied large and rapid changes over time in the volatility of returns on both stocks and bonds.(22) William Schwert compared several different models of stock return volatility, and found that patterns of change over time exhibit important nonlinearities not captured by Engle's procedure.(23)

At the same time, other researchers have argued in favor of market efficiency on the grounds of volatility changes represented in other ways. Charles Nelson, for example, showed that if the volatility of stock returns depends on some specific variable known to investors, then the resulting price movements are consistent with equilibrium asset pricing theory.(24) Stephen Cecchetti showed that the degree of mean reversion observed in U.S. stock prices also could be consistent with equilibrium market outcomes.(25)

Financial Market Imperfections

Deviations from the perfect capital markets of the textbooks are interesting not just for what they imply about asset prices and returns but also because of their implications for nonfinancial economic activity. At the most fundamental level, Joseph Stiglitz has written a series of papers showing that financial market imperfections arising from asymmetries in the information available in the economy can, in principle, shape such prominent features of the economy as business cycles, productivity, real interest rates, and the role of money.(26) In closely related work, Stiglitz has elaborated the important role that banks play as a result of these imperfections.(27) In a similar vein, Ben Bernanke and Mark Gertler have examined ways in which information symmetries give rise to a relationship between an economy's financial structure (for example, how leveraged are firms?) and its nonfinancial performance. Their work raises the possibility that excessive financial fragility may impair--perhaps severely--the economy's ability to produce and distribute ordinary goods and services.(28)

In several studies, Glenn Hubbard has attempted to find evidence for, and to quantify, the effects of financial market imperfections on nonfinancial activity. In one paper, Hubbard showed that consumers' short-run willingness to adjust their spending in response to temporary tax changes is very sensitive to the importance of borrowing restrictions in the economy.(29) In another paper, he used panel data on individual U.S. manufacturing firms to show that investment spending is especially sensitive to cash flow among those firms that, on other grounds, are most likely to face financing constraints.(30) In further work, Hubbard and Mark Gertler found evidence supporting the familiar idea that financial imperfections have a greater effect on firms' investment spending during recessions than when times are prosperous. Their work also suggested that the usual inverse relationship between firms' size and the variability of their sales may be caused by financial constraints rather than by technological factors (as is often assumed).(31) In work examining the role of financial market imperfections in a comparative setting, Fumio Hayashi, Takatoshi Ito, and Joel Slemrod showed that the larger down payment requirement for home purchases in Japan than the United States not only leads Japanese families to save more than their U.S. counterparts at early ages but also explains part (though certainly not all) of the higher aggregate savings rate in Japan.(32)

Sovereign Debt

Several researchers in the program have devoted substantial effort to investigating the special implications of debts issued by government borrowers, which have the ability either to default unilaterally on their obligations or at least to erode the real value of those obligations by pursuing an inflationary monetary policy. In a series of papers, Herschel Grossman has examined the particular relationships connecting debt issues and inflation. In two papers, Grossman showed that under appropriate conditions reputation effects (by which a default would render future borrowing more costly) restrain a government from inflating away its debts. Grossman also indicated features likely to distinguish governments that will want to continue issuing nominal obligations from those that will not.(33) In related work, he showed that analogous reputational effects influence the willingness of a sovereign government to default on, or inflate away, debts it has issued abroad to finance its defense spending.(34) As a specific example, Grossman showed that the desire to maintain a trustworthy reputation for repaying war debts apparently was an important factor leading to deflationary postwar monetary policies in both the United States and the United Kingdom up until World War II, but not thereafter.(35)

In a further series of papers, Alberto Alesina and Guido Tabellini have examined the specific aspects of government debt problems that arise when governments are elected democratically. In two of their papers, they showed that because a government can use high debt levels to constrain the policies pursued by its successors, countries in which different political parties disagree sharply over spending priorities are likely to exhibit a bias toward government deficits.(36) In another paper, Alesina and Tabellini showed that political uncertainty in a setting of disagreement over distributional policies provides incentives for over-accumulation of external debt by government as well as incentives for external capital flight by private investors.(37) Alesina and Allan Drazen showed that when taxes raised to narrow a government's budget deficit have significant distributional implications (as is often the practical case), and when different parties have conflicting distributional goals, a "war of attrition" results, in which neither group concedes and the deficit remains large.(38) Kenneth Rogoff has analyzed the familiar tendency of governments to step up spending prior to elections, concluding that efforts to mitigate the resulting "political business cycle" may actually prove counterproductive in either or both of two ways.(39)

Monetary Policy

During the last three years, as always, problems of monetary policy have also been a principal focus of research by many memners of the program. The specific monetary policy issue that has attracted the greatest attention during this period has been the apparent breakdown of the relationships connecting growth of the familiar monetary aggregates (M1, M2, et cetera) to the growth of either income or prices, and the consequent need to devise ways of conducting policy capable of supplementing money growth targets, or even replacing them altogether. As is almost always the case in work on this particular subject, different researchers have reached disparate conclusions. James Stock and Mark Watson, using a new statistical test that they devised, showed that movements in the M1 stock did have predictive content for subsequent movements of real output in U.S. data through the mid-1980s.(40) Benjamin Friedman found the opposite result, either by extending the sample further into the 1980s or by allowing for the relationship between the commercial paper rate and the Treasury bill rate. He reached similar negative conclusions about the broader monetary aggregates, as well as a credit aggregate.(41) By contrast, Robert Rasche concluded that the demand for money (again M1) had behaved in a stable fashion throughout the post World War II period and, in a further paper, even during the Great Depression.(42) Michael Bordo, using data for Canada, Norway, Sweden, and the United Kingdom, found that changes in the money-income ratio are predictable on the basis of familiar macroeconomic variables, like income and interest rates, together with a number of institutional factors.

Loss of confidence in the reliability of money-income and money-price relationships, both within the Federal Reserve System and elsewhere, has prompted a widespread search for alternative indicators on which to base monetary policy actions. Frederic Mishkin, in a series of papers, has investigated the indicator properties of one specific set of variables sometimes suggested in this context by Federal Reserve officials: the term structure of interest rates. Using U.S. data, Mishkin showed that although relationships among the interest rates on short-term Treasury bills of different maturities do not contain information about subsequent price inflation, relationships between the interest rates on short-term bills and long-term bonds do contain such information.(43) In an extension of this work, Mishkin found that in France, Germany, and the United Kingdom, even the short end of the term structure contained inflation-predictive content, while other countries resembled the United States in this respect.(44) In a further paper, he found that movements in commodity futures prices (another potential indicator variable occasionally suggested by Federal Reserve officials) are not helpful in the effort to disentangle whatever separate information the observed term structure of interest rates may contain about likely future movements of inflation and real interest rates.(45)

Finally, the issue of general principles for the conduct of monetary policy once again prompted substantial research within the program. Bennett McCallum investigated the advantages of a flexible formula for setting the growth of the monetary base.(46) Robert Barro examined the implications of rules for targeting nominal interest rates.(47) Michael Bordo and Anna Schwartz drew on the U.K. experience to study the conduct of monetary policy under money growth targets. They concluded that by not allowing "base drift" (that is, by adjusting money growth in each period to offset any failure to achieve the prior period's target), the Bank of England could have halved the variability of U.K. inflation.(48) Carl Walsh, studying the U.S. experience under monetary targeting during 1976-84, concluded that induced policy responses to underlying shocks to aggregate demand and supply contributed to U.S. inflation during this period.(49) And on the potentially important question of what happens when the central bank changes from one way of conducting policy to another, Gregory Mankiw and Jeffrey Miron studied the much earlier U.S. experience, at the time the Federal Reserve System was established, and concluded from changes in interest rate behavior that (at least on that occasion) market participants quickly understood and adapted to the change in monetary policy regime.(50)

(1)B.M. Friedman, "Financial Markets and Monetary Economics," NBER Reporter, Winter 1986/87, pp. 1-9. (2)R. J. Shiller, "Investor Behavior in the October 1987 Stock Market Crash: Survey Evidence," NBER Working Paper No. 2446, November 1987. (3)R. J. Shiller, Y. Tsutusi, and F. Konya, "Investor Behavior in the 1987 Stock Market Crash: The Case of Japan," NBER Working Paper No. 2684, August 1988. (4)R. J. Shiller, "Initial Public Offerings: Investor Behavior and Underpricing," NBER Working Paper No. 2806, December 1988. (5)A. W. Lo and A. C. MacKinlay, "Stock Market Prices Do Not Follow Random Walks: Evidence from a Simple Specification Test," NBER Reprint No. 1180, May 1989. (6)A. W. Lo and A. C. MacKinlay, "An Econometric Analysis of Nonsynchronous Trading," NBER Working Paper No. 2960, May 1989, and "When Are Contrarian Profits Due to Stock Market Overreaction?" NBER Working Paper No. 2977, May 1989. (7)B. N. Lehmann, "Fads, Martingales, and Market Efficiency," NBER Working Paper No. 2533, March 1988. (8)J. Y. Campbell and R. J. Shiller, "Stock Prices, Earnings, and Expected Dividends," NBER Reprint No. 1170, April 1989. (9)J. M. Poterba and L. H. Summers, "Mean Reversion in Stock Prices: Evidence and Implications," NBER Reprint Paper No. 1233, July 1989. (10)N. G. Mankiw, D. H. Romer, and M. D. Shapiro, "Stock Market Forecastability and Volatility: A Statistical Appraisal," NBER Working Paper No. 3154, October 1989. (11)J. B. De Long, A. Shleifer, L. H. Summers, and R. J. Waldemann, "The Survival of Noise Traders in Financial Markets," NBER Working Paper No. 2715, September 1988, and "Positive Feedback Investment Strategies and Destabilizing Rational Speculation," NBER Reprint No. 1330, December 1989. (12)J. B. De Long, A. Shleifer, L. H. Summers, and R. J. Waldemann, "The Size and Incidence of the Losses from Noise Trading," NBER Working Paper No. 2875, March 1989. (13)F. Black, "Mean Reversion and Consumption Smoothing," NBER Working Paper No. 2946, April 1989; and A. J. Marcus, "An Equilibrium Theory of Excess Volatility and Mean Reversion in Stock Market Prices," NBER Working Paper No. 3106, September 1989. (14)M. J. Kim, C. R. Nelson, and R. Startz, "Mean Reversion in Stock Prices? A Reappraisal of the Empirical Evidence," NBER Working Paper No. 2795, December 1988. (15)K. A. Froot and M. Obstfeld, "Intrinsic Bubbles: The Case of Stock Prices," NBER Working Paper No. 3091, September 1989. (16)P. Weil, "On the Possibility of Price-Decreasing Bubbles," NBER Working Paper No. 2821, January 1989. (17)A. Giovannini and P. Weil, "Risk Aversion and Intertemporal Substitution in the Capital Asset Pricing Model," NBER Working Paper No. 2824, January 1989; and P. Weil, "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," NBER Working Paper No. 2829, January 1989. (18)G. W. Schwert, "Why Does Stock Market Volatility Change Over Time?" NBER Working Paper No. 2798, December 1988. (19)G. W. Schwert, "Stock Volatility and the Crash of '87," NBER Working Paper No. 2954, May 1989. (20)G. W. Schwert, "Index of U.S. Stock Prices from 1802 to 1987," NBER Working Paper No. 2985, May 1989. (21)C. M. Engel, J. A. Frankel, K. A. Froot, and A. Rodriguez, "Conditional Mean-Variance Efficiency of the U.S. Stock Market," NBER Working Paper No. 2890, March 1989. (22)B. M. Friedman and K. N. Kuttner, "Time-Varying Risk Perceptions and the Pricing of Risky Assets," NBER Working Paper No. 2694, August 1988. (23)A. R. Pagan and G. W. Schwert, "Alternative Models for Conditional Stock Volatility," NBER Working Paper No. 2955, May 1989. (24)C. R. Nelson, R. Startz, and C. M. Turner, "A Markov Model of Heteroskedasticity, Risk, and Learning in the Stock Market," NBER Working Paper No. 2818, January 1989. (25)S. G. Cecchetti, P. Lam, and N. C. Mark, "Mean Reversion in Equilibrium Asset Prices," NBER Working Paper No. 2762, November 1988. (26)B. C. Greenwald and J. E. Stiglitz, "Financial Market Imperfections and Business Cycles," NBER Working Paper No. 2494, January 1988, and "Financial Market Imperfections and Productivity Growth," NBER Working Paper No. 2945, April 1989; and J. E. Stiglitz, "Money, Credit, and Business Fluctuations," NBER Working Paper No. 2823, January 1989. (27)J. E. Stiglitz and A. Weiss, "Banks as Social Accountants and Screening Devices for the Allocation of Credit," NBER Working Paper No. 2710, October 1988. (28)B. S. Bernanke and M. Gertler, "Financial Fragility and Economic Performance," NBER Working Paper No. 2318, July 1987; and M. Gertler, "Financial Capacity, Reliquification, and Production in an Economy with Long-Term Financial Arrangements," NBER Working Paper No. 2763, November 1988. (29)R. G. Hubbard and K. L. Judd, "Finite Lifetimes, Borrowing Constraints, and Short-Run Fiscal Policy," NBER Working Paper No. 2158, February 1987. (30)S. Fazzari, R. G. Hubbard, and B. C. Petersen, "Financing Constraints and Corporate Investment," NBER Reprint No. 1069, November 1988, and NBER Reprint No. 1193, May 1989. (31)M. Gertler and R. G. Hubbard, "Financial Factors in Business Fluctuations," NBER Reprint No. 1251, August 1989. (32)F. Hayashi, T. Ito, and J. B. Slemrod, "Housing Finance Imperfections, Taxation, and Private Saving: A Comparative Simulation Analysis of the United States and Japan," NBER Reprint No. 1112, February 1989. (33)H. I. Grossman and J. B. Van Huyck, "Nominally Denominated Sovereign Debt, Risk Shifting, and Reputation," NBER Working Paper No. 2259, May 1987; and H. I. Grossman, "A Generic Model of Monetary Policy, Inflation, and Reputation," NBER Working Paper No. 2239, May 1987. (34)H. I. Grossman, "Lending to an Insecure Sovereign," NBER Working Paper No. 2443, November 1987. (35)H. I. Grossman, "The Political Economy of War Debts and Inflation," NBER Working Paper No. 2743, October 1988. (36)A. Alesina and G. Tabellini, "A Positive Theory of Fiscal Deficits and Government in a Democracy," NBER Working Paper No. 2308, July 1987, and "Voting on the Budget Deficit," NBER Working Paper No. 2759, November 1988. (37)A. Alesina and G. Tabellini, "External Debt, Capital Flight, and Political Risk," NBER Working Paper No. 2610, June 1988. (38)A. Alesina and A. Drazen, "Why Are Stabilizations Delayed?" NBER Working Paper No. 3053, August 1989. (39)K. Rogoff, "Equilibrium Political Budget Cycles," NBER Working Paper No. 2428, November 1987. (40)J. H. Stock and M. W. Watson, "Interpreting the Evidence on Money-Income Casuality," NBER Working Paper No. 2228, April 1987. (41)B. M. Friedman, "Monetary Policy without Quantity Variables," NBER Reprint No. 1182, May 1989; and B. M. Friedman and K. N. Kuttner, "Money, Income, and Prices after the 1980s," NBER Working Paper No. 2852, February 1989. (42)D. Hoffman and R. H. Rasche, "Long-Run Income and Interest Elasticities of Money Demand in the United States," NBER Working Paper No. 2949, April 1989, and "The Demand for Money in the United States during the Great Depression: Estimates and Comparison with the Postwar Experience," NBER Working Paper No. 3217, December 1989. (43)F. S. Mishkin, "What Does the Term Structure Tell Us about Future Inflation?" NBER Working Paper No. 2626, June 1988, and "The Information in the Longer Maturity Term Structure about Future Inflation," NBER Working Paper No. 3126, September 1989. (44)F. S. Mishkin, "A Multi-Country Study of the Information in the Term Structure about Future Inflation," NBER Working Paper No. 3125, September 1989. (45)F. S. Mishkin, "Can Futures Market Data Be Used to Understand the Behavior of Real Interest Rates?" NBER Working Paper No. 2400, October 1987. (46)B. T. McCallum, "Targets, Indicators, and Instruments of Monetary Policy," NBER Working Paper No. 3047, July 1989, and "Could a Monetary Base Rule Have Prevented the Great Depression?" NBER Working Paper No. 3162, November 1989. (47)R. J. Barro, "Interest Rate Targeting," NBER Reprint No. 1279, September 1989. (48)M. D. Bordo, E. U. Choudhri, and A. J. Schwartz, "Money Stock Targeting, Base Drift, and Price-Level Predictability: Lessons from the U.K. Experience," NBER Working Paper No. 2825, January 1989. (49)C. E. Walsh, "The Impact of Money Targeting in the United States, 1976-1984," NBER Working Paper No. 2384, September 1987. (50)N. G. Mankiw, J. A. Miron, and D. A. Weil, "The Adjustment of Expectations to a Change in Regime: A Study of the Founding of the Federal Reserve," NBER Reprint No. 915, October 1987.
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Author:Friedman, Benjamin M.
Publication:NBER Reporter
Date:Mar 22, 1990
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