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Dr. Pangloss and Serial Correlation in Asset Values

Almost all of the time economists argue like this:

The value of an asset today depends on what its cash flow is going to be over the next year and on what its value is expected to be in a year, and its value in a year depends on what its cash flow is expected to be between one and two years from now and on what its value will be in two years, and its value in two years depends on what its cash flow is expected to be between two and three years from now and on what its value will be in three years, and so on. So the value of an asset today will be the present discounted value of future cash flows between now and infinity--which means that if the chance of anything unpleasant happening in the future, even the distant future, rises today, that rise shows itself in a fall in the price of the asset right now.

It disturbs Nick Rowe that this doesn't seem to work:

Worthwhile Canadian Initiative: Why does stuff take so long to happen?: For example, the Eurozone crisis. A couple of decades back, I noticed that things often seemed to happen the way economists thought they would happen, but that they always seemed to take about ten times longer to happen than you would have thought they would. We go from one equilibrium to another equilibrium in a few seconds on the chalkboard. It seems to take forever in the real world.

I just read the latest Europe Update on Calculated Risk. And again this morning on Eurointelligence. I then re-read all my old posts on the Eurozone.... Two years, or even one year ago, what I was writing about the Eurozone was an extreme view. Now it's fairly mainstream. There is little in those old posts I would want to change. I have nothing new to add. Things have been slowly getting worse over the last two years. I could feel vindicated. Events have been proving me right (so far). "Look at me! I'm a brilliant economic forecaster, and should be commanding megabucks in speaking fees and throwing wild parties". But maybe I just got lucky....

Some people believe the eurozone crisis is a liquidity crisis. Some people believe it is a solvency crisis. And some, like me, believe you can't really separate the two....

Take liquidity crises first.... [A] sunspot causes people to expect a run... everyone... [tries] to get their cash out... before everyone else gets to the bank.... One minute we are in the good equilibrium, with no run. Then bang!... A "slow motion bank run" is an oxymoron. And yet that seems to be just what has been happening.

Solvency crises don't depend on multiple equilibria, but on changing fundamentals... on expectations of those fundamentals -- whether people expect Greece will be able to pay.... [T]hose expectations should not change slowly and predictably.... Expectations of what will happen at some fixed future time ought to follow a random walk (a martingale, to be precise), where the next move is as likely to be up or down.

Instead, interest rates on Greek and Irish debt have been slowly trending up. Now sure, a martingale can trend up, or down, for a prolonged period, just as you can get 10 heads in a row from a fair coin. But it's unlikely. It's not what I would have expected....

I don't understand why it is taking so long.

But suppose the smart-money traders are risk-averse and credit-constrained. And suppose that there are some dumb-money traders who think the future will be like the past. And suppose there are other traders who believe that they are gambling with the government's money--that if their portfolios crash they will get bailed out, and their view of the chance of rescue-if-crash changes slowly over time. And suppose that there are other traders who used to be the smart nimble money and who think that they are still the smart nimble money--that they will hear the real news first when it arrives, and then trade at old false non-equilibrium prices just at the start of the crash. And suppose that there are other traders who really are the smart nimble money.

Then the law of iterated expectations is unlikely to hold. Instead, you are more likely to get a price pattern that looks more like Paul Krugman's Pangloss value--what is the best that things might possibly be--or a weighted average of iterated rational expectations and Pangloss values. And--if limits to arbitrage bind--is there any reason why the Pangloss value might not evolve over time in the way that puzzles Nick? I think not...

You could say something similar about the U.S. Ten-Year Treasury right now. Indeed, I have been told of two dinners and a lunch, both relatively recently, at which all at the table claimed to still be long Treasuries because they all expected to be the first to hear the news that the U.S. Treasury is going to move and to sell before the price dropped...

The minute the Federal Reserve Bank of New York unexpected raises the Fed Funds target rate by 25 basis points is going to be a very interesting minute indeed, whenever it comes...

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