Krugman and Summers Want to Keep Finance Fun
Here is an intriguing Federal Reserve discussion paper that finds that efficient markets are bad.1 Or, specifically, it argues -- based on a theoretical model that seems to fit a big data sample of actual stocks -- that equity misvaluation is good for companies, because it allows them to time the market in making financing decisions. So when a company knows its stock is overvalued, based on its own knowledge of its cash flows and prospects etc., it will issue stock and build up a cash reserve; when it is undervalued it will buy back stock.
Overall, the model predicts that these effects will cause companies to raise more cash, and invest more of it, more productively, than would a market with no equity misvaluation. So markets that sometimes get pricing wrong increase productive investment. They also increase shareholder value by about 8 percent.
That's sort of weird. In my former life I helped companies issue and buy back equity and let us say I did not notice any strong trend towards buying low and selling high.2 But I guess it's possible?
It's particularly interesting today after this weekend's economics-blogger brouhaha over Larry Summers's IMF speech.3 Summers argued that we might be in a new normal of negative real interest rates, rather than a temporary crisis, and that we need new ways of thinking about the zero lower bound as a long-term state of affairs.
Among other things, that might require revisiting the idea that financial prudence is, y'know, good. Paul Krugman's important post on the speech characterizes Summers's view as being that "we may be an economy that needs bubbles just to achieve something near full employment" and "that even improved financial regulation is not necessarily a good thing -- that it may discourage irresponsible lending and borrowing at a time when more spending of any kind is good for the economy."4
In 2006, one thing that I guess you could think, is that the American financial industry was big and rich and arrogant because it was really good at allocating capital, and because allocating capital is a really important business. In 2013, the importance of capital allocation is if anything even more obvious, but it's a lot harder to be confident that the financial industry is really good at it. Mistakes, you may recall, were made.
How do you respond to that? "We've learned our lesson and are much better now, nothing to see here, thanks for your concern," is not a particularly compelling thing to say, whether or not it is true. "Finance should be tightly regulated, boring, and utility-like, so it cannot blow us up again" has considerably more intuitive appeal, though it is troublesome to put into practice. It is also, well, boring, and drab, and bad for the old self-esteem.
It also might be wrong, is the thing. You might need bubbles. You might need equity misvaluation. Messing things up may be an important, useful function of the financial system.
Of course, this complex of arguments around the idea that finance has to be inefficient, irresponsible, bubbly, uncontrolled, in order to do its job -- that is an idea that I can get behind! It's fun. It doesn't consign finance to the role of boring utility; it encourages creativity and excitement and risk-taking and oh sure sometimes stupidity. It tears bankers down from their stature as Masters of the Universe, but it leaves them a glorious place as inspired vessels of inscrutable and wild powers beyond the ken of man. Under the circumstances that is not a bad trade.
1 "Equity Market Misvaluation, Financing, and Investment" by Missaka Warusawitharana and Toni M. Whited. Like all these things it's been floating around the Internet since at least like 2011 but the Fed issued it today so, tough, there's only so much Internet I can read, Fed discussion papers make the cut, SSRN does not.
2 In an even more former life I was a corporate lawyer and I don't think I would have advised a company to issue stock when it knew important things about its cash flows that the market didn't, but that is a tougher question with a fuzzier answer. Lawyer questions often are.
3 That link is to Miles Kimball's Quartz article, which embeds video of the speech. (I don't know of a transcript.) Krugman's post is very good and summarizes the main points. I am sympathetic to Ryan Avent's view. Here are Tyler Cowen, Izzy Kaminska (also), Brad DeLong, Matt Yglesias, and of course Matt Klein.
BY THE WAY, does anyone else read Summers's speech as saying "You're not gonna make me Fed chair? Fine. I'm gonna go around saying underminey things about macro policy and financial regulation to make Janet Yellen's job awkward"?
4 I cite this a lot, but an important source of my thinking about these matters is this interfluidity post about financial complexity. The intuition is that the financial system -- especially the banking system -- exists for the purpose of making risky investments in businesses, while providing safe investments to investors. In other words, for the purpose of transmuting risky assets into safe ones.
You'd expect that to be difficult and it is. Banks can do some of this transmutation themselves: Diversification and tranching and prudent management can actually make investing in banks safe while the banks fund risky activities. Some of it, though, requires government support: Deposit insurance, at least, and maybe too-big-to-fail backstops.
And some of it may be just a fiction. You take a pile of risky assets, wrap them in gauze, and call them safe. And just by doing that you encourage socially advantageous investment.
I find that a useful lens for considering the Summers speech on bubbles, and the Warusawitharana and Whited paper on equity misvaluation. In order to have socially optimal investment, you gotta get stuff wrong.