Wednesday, October 30, 2013

Eugene Fama is right on QE

Eugene Fama of Chicago Booth School of Business is one of the three winners of the 2013 memorial Nobel prize in economics – and a rare winner of one of these softer prizes whom I consider extremely well-chosen (the efficient market hypothesis will be discussed later).

Yesterday, CNBC's Rick Santelli asked him about the quantitative easing.

The interview has sparked a controversy in a part of the economics blogosphere. Here is the video:

If you don't see any video above, find it on this page of Pragmatic Capitalist who liked Fama's fresh observations as much as I did. Note that in the mobile template, the rectangle only shows a part of the image because the whole video doesn't fit in; switch to the full green web template if it is a problem for you.

The exchange makes me think that the "economic science" journalists are equally deluded and suffer from the same kind of idiotic group think as most of the science journalists writing about the climate or high energy physics.

Well, Santelli's idea is that everyone agrees that the quantitative easing has been a wonderful thing with a miraculous curing effect on the economy and the only issue is that one must be careful while exiting it. Everyone has to agree with these theses, Santelli assumes, so the only thing that an economic Nobel prize winner may add are some irrelevant details, babbling that no one cares about and whose only point is to confirm the "consensus" of the journalists talking about the markets. Nobel prize winners are just decorative appendages on the journalists' neck.

However, Fama just doesn't agree. He looks at the thing analytically and classifies the whole operation as a simple example of "asset swapping". In effect, the American central bank is buying back some long-term debt and selling new short-term debt in order to have cash for the buybacks. This maneuver is expected – and arguably has the desired purpose – to lower the long-term interest rates but the price to pay is the increase of the short-term interest rates. The operation doesn't do much, Fama concludes.

Santelli obviously doesn't want to accept this insight so he acts as if he fails to understand plain English. For example, he's asking, if it's so inconsequential, why don't all the central banks do such a thing all the time? Fama is smiling because he has already provided the viewers with the answer. The central banks may do such things but they're pretty much inconsequential, neutral events, so it doesn't matter. The central bankers may also hug the trees every morning which still doesn't mean that the economy will triple every year.

It seems obvious to me that Fama's basic claim is right. There could be operations that dramatically change the inflation rate and other quantities – like dropping trillions in banknotes from the helicopters or stealing all treasuries from their owners in some way – but as long as such things are not being done, the Fed is just redistributing its assets and debts and moving piles across the room just isn't the most important maneuver for the economy.

If one reduces the long-term debt by issuing some other debt, it's clearly a neutral event. If the two debts have different maturity dates, such an operation will change the yields of the two kinds of debt in opposite ways. It will add a contribution that tries to lower the long-term interest rates but it will also add another contribution that raises the short-term interest rates.

However, there are also other contributions – other factors and pressures – that determine both interest rates (and the whole curve) so the final outcome may be different. It just happened that even the short-term rates were dropping for some other reasons and the Fed took credit for that trend. However, as Fama points out, the only rationally expectable consequence of the asset swapping for the short-term interest rates was their increase so it is preposterous for the Fed to take credit for these short term interest rates' decrease. The short-term interest rates dropped despite the Feds' efforts to the contrary, not because of them.

When Santelli mentions that some people are praising QE for their car loans, it's really preposterous because generic people with car loans can't have a clue about the actual causal relationships and mechanisms that operate in the economy.

Santelli asked Fama why central banks aren't doing such things all the time. Isn't it a great outcome to lower the long-term interest rates? Well, it wouldn't do much, Fama's arguments imply. If I elaborate on Fama's ideas how I understand them, the long-term debt isn't the only debt and those who buy treasuries may choose which kind of debt they decide to buy. If the short-term interest rates become high enough, the holders of treasuries will start to prefer the short-term debt which they may buy again and again. The nominally long-term debt will represent a lower percentage of the total debt than before. Much of the debt will be moved to nominally short-term debt that is "actually" a long-term debt because the bondholders are determined to buy it again and again. So the asset swapping will only change how often they have to renew some papers. It doesn't affect the essence much. The total debt is still the same number, it's just distributed differently, and the U.S. and others are pretty much paying the same average interest rates for the debt. Of course that you can't create miracles for the economy just by moving piles from one side of the room to another. The taxpayers own all the assets as well as liabilities as a whole, Sack und Pack or Sakum Prdum, as we say in Czech, so it doesn't matter if some terms in the balance sheet are canceled on the paper.

These are crystal clear arguments but some people – like Rick Santelli – just prefer their mindless group think over rational arguments. It's not just Rick Santelli who likes to turn their brains off. Economist Brad DeLong wrote a rant against Fama's explanation (via Pig). As far as I can see, DeLong's rant doesn't contain a tiny glimpse of an argument. It just claims that Fama is clueless.

Efficient market hypothesis

Well, in order to give DeLong the full credit and to praise every aspect of his knowledge and creativity, I must admit that the last word of his rant is "dumbass", too.

DeLong may say that Fama is a "dumbass" but I think that he realizes very well that when it comes to the brilliance in economics, he (DeLong) is just a tiny little wee wee if compared to well-known Chicago school economists, even third-wave Chicago school economists like Fama (the Chicago school was linked to Milton Friedman's monetarism through the 1970s which became replaced by "new classical economics" based on "rational expectations" but the thoughts kept on irritating leftists and Keynesians in the same way as monetarism because they are largely equivalent). In fact, Fama's main expertise is exactly the portfolio theory so questions whether some asset swapping matters are questions he has successfully (understatement) studied for 50 years.

The Chicago school of economics is a culture of economic thought that really makes sense, that puts the primary principles such as free markets to the center, and that's been repeatedly tested to be vastly superior in comparison with other general approaches (and yes, Chile has been a major example of that although some people find it politically incorrect to even talk about these successes).

Fama began to be influential in economics since his PhD thesis in the 1960s. He proposed nothing less than the efficient market theory. Well, we may sometimes talk about "market inefficiencies" but I surely think that the understanding why the markets are basically efficient and what it implies is as important for economics as the understanding of classical physics for a physicist.

Prices may fluctuate and resemble a random walk – well, the typical price may behave as \(\exp(R(ct))\) where \(c\) is a constant, \(t\) is time, and \(R(x)\) is a random walk function that tends to behave as \(\langle |R(x)|^2\rangle=\sqrt{x}\). The more they fluctuate, the greater profit the investor expects because he may get huge losses instead, too. In fact, even the expectation value of the profit should be higher for more volatile assets – the extra profit is a premium one gets for the risk.

But once the system exists, investors are spread over assets and none of them will really be a better investment than others – assuming that no one is an "inside trader" who has a "systematically better information" about the future behavior of the prices. A higher risk may bring you higher profits – or greater losses. Many people who claim special skills and knowledge that goes beyond the efficient market hypothesis are inside traders and charlatans who oversell their good luck or their morally questionable enhanced access to some tools of the markets and to the government as a talent.

The random-walk character of the prices was first modeled by Jules Regnault, a broker, in 1863, and Louis Bachelier, a French mathematician, in a 1900 thesis. But Fama went further. And in the 1990s, he constructed a more quantitative Fama-French three-factor model of portfolio's returns.

I don't want to go into details of Fama's work because this is not an economics blog. But if I return to the debate about quantitative easing, the main big-picture tension here seems to be the pro-government/anti-government intrinsically ideological debate. Keynesians like Brad DeLong want to attribute lots of miraculous powers to the government. If you move the piles of treasuries from one side of the room to another, you will make the economy prosper forever, and so on.

The reality is different and kind of simpler. There are no miraculous cures. The best thing that the government may do is to encourage sensible overall/average interest rates (e.g. by targeting inflation) which means to guarantee that the currency remains a good and predictable enough a unit of wealth and to avoid interventions into any of the relative prices which are optimally determined by the free markets.

Sometimes, a government may intervene into relative prices and it may distort these prices – and distort the market. It may help to create bubbles at particular places or to induce the opposite development, whatever is the right word for anti-bubbles. But in some cases, the distortion is pretty much inconsequential. In the case of quantitative easing as interpreted by Fama, the distortion just involves the increase of prices of treasuries using one color on the paper and the decrease of treasuries with another color. The bondholders owning the first color will be a bit lucky while the bondholders with the second color will be a bit unlucky because the central bank has effectively moved a part of their wealth to the pockets of the first group (which is something that shouldn't be done by the government) but the overall impact on the whole economy is pretty much zero. All of them still hold treasuries or debt of some sort. Its overall magnitude hasn't changed. And the overall magnitude of the debt determines the risk that America will default – and it determines the effective, average interest rates as a consequence.

The tense exchange between Santelli and Fama shows how much the actual top experts are being avoided by the media and how shocked the media folks inevitably are when one of them gets on the TV screen. The media are largely controlled by mediocre pseudoexperts such as Brad DeLong who have been trained to think that a few insults and the repetition of not quite coherent clichés (and flawed arguments that almost always overlook one side of the equation among two) may replace or beat evidence or a sensible argument that just works.


  1. Saw the title, was curious about Fama's views on quantum entanglement. Disappointed :(

  2. LOL, has QE ever been used as an acronym for quantum entanglement?

  3. I smiled when Fama said to Santelli: "There is so much confusion in what you said, it's difficult to answer."
    Do you happen to know that feeling, Lubos?! ;-)

  4. Fama is at the University of Chicago's School of Business (business economics) - "Booth" above - not the department of economics that Milton Friedman helped to make famous. Just a detail, Dr. Motl.

  5. Hi, I've never claimed that they were from the same department. However, what I did claim and do claim is that both of them are counted into the Chicago school of economics

  6. Wasn't that the reason for QE? To keep nominal rates from falling below zero and preventing capital flight to the world's mattresses?

  7. If QE is mere asset-swapping, I don't understand why we keep hearing that the Fed has been buying bonds directly from the Treasury.

  8. Dear Smoking Frog, QE means that the central bank is buying financial assets from commercial banks

    but if one considers the operation that you describe, it would be even more immaterial because both the Fed and the Treasury are just two pockets of the same U.S. taxpayers' funds, so why should it matter if one of them buys something from the other? The U.S. taxpayer owns both; the U.S. government is responsible for both.

  9. Well, one must distinguish short-term and long-term interest rates. None of them will really drop below zero exactly for the reason you mention - one could use mattresses as a better solution.

    QE is meant to increase the money supply and because the normal monetary policy trying to lower short-term interest rates is already depleted, QE means that they start to buy longer-term bonds, too. This has the effect of lowering the lower-term interest rates as well but the flip side of the same coin is that it adds positive pressure on the short-term bonds because they're being issued to get the cash needed to buy the long-term ones.

    Makes sense?

  10. Hi Olena, LOL, way too often. ;-)

  11. QE has had an effect on the behavior of a few of my relatives. They're convinced that it's equivalent to the goverment printing huge piles of money and that hyperinflation is just around the corner. Supposedly the only reason the US hasn't yet collapsed into anarchy is because of some unclear left-wing conspiracy. They've stocked up on gold, guns, and MREs.

  12. Exactly, I too thought this is about something Quantum Enything ?... :-D

    ... goint to finish readint the List of superpartmers now :-)

  13. These views are quite close to those of some conservative TRF readers, especially those who worship the gold standard. All such folks are confident that it's extremely important what the payment units look like and how one redistributes them.

    In reality, none of these things really matters. America could switch to the Iranian currency and use bones from chickens as coins or banknotes and if there were comparable expectations about the inflation rate and if the swapping were done fairly at the beginning, nothing would really change.

  14. Hahaha, when you look at the list of recent TRF articles in the right side bar, and intentionally misread the two newest ones at the top together, you get

    Eugen Fama is right on QE Gravity (2013)

    Quantum Entanglement Gravity ... :-P :-D ;-)!

  15. Whatever the Fed is doing, the economy is not responding. Unemployment is very high, and the only drops occurred because people left the labor force. Despite very low interest rates, inflation is low, but so is growth. And the low interest rates are raising havoc among individual savers, retirees and pension funds.

    QE amount to 6% of the American GDP. The fact that it doesn't seem to be doing anything suggests that the economy would be in free-fall without it. Vox Day's opinion that we are in debt deflation and poised for depression seems relevant here. Let's hope he's wrong.

  16. Funny, after seeing this comment, I scrolled to see the part of the sidebar where there are the recent TRF Articles, and thought that I had actually found an article saying "Eugen Fama is right on QE gravity (2013)", and thought that the "2013" was the time stamp or something.

  17. I'm going to read this closely as it concerns topics that I've been reading about lately. Looking forward to reading a future article on "efficient markets". What I find curious is that Fama and Robert "Irrational Exuberance" Shiller do not profess some sort of gentleman's agreement where each concedes that the other's hypothesis is perfectly valid in one domain or set of scenarios, while claiming that his own applies the rest of the time. No, they actually tear into each other like WWE wrestlers hopped up on caffeine!

    What irks me, even though I should be used to it by now, is that I have been reading and thinking about this QE (and "tapering") thing for weeks and still I could not write such a long article, at least not without yet more study and reflection. And Luboš does this as a mere afterthought, something squeezed in when he has an hour's free time. More and more he reminds me of Leviathan in the Hellraiser movie, a beam of penetrating blackness that sweeps across the land like the hands of a clock across its face, before which no shelter is possible, no secrets remain concealed, no skeletons unseen. It's ... uncanny.

  18. Dear Eugene, you *could* write such a thing, too!

    The Nobel committee was surely trying to achieve some kind of a balance by naming both (and the third one whom I know next to nothing about). Fama has been making fun of Shiller's ability to predict the crises - with his pessimism on prices, Fama said, he could have claimed to predict any crisis given a long enough horizon. ;-)

    Shiller's predictions are fun but it's sort of an ad hoc guessing - I don't quite understand the theory behind his proclamations and if he claims one to exist.

  19. Santelli hates QE and has consistently and vociferously railed against if from the beginning. You seem to be very confused about your facts.

  20. OK, I don't know which way he cares - I didn't have a clue who Santelli was a few hours ago and I will forget about him in a few hours again - but he's just wrong to care.

  21. Wow. Were you watching the same clip that I was? Fama claims that the Fed purchasing debt is not a big deal. In his words, buying long term debt to reduce rates is a 'nothing activity.' No wonder the Swedish central bank gave this idiot the prize in memory of Alfred Nobel.

    The problem is that Fama is an absolute fool. Any trader or long term fundamentals based investor will tell you that Fama's Fama efficient-market hypothesis theory is useless and obviously wrong. Fama concludes that people like Buffet could not exist because their returns will be random and match that of a general large cap index. But that is clearly not the case. There are many long term investors that have done very well by taking advantage of the fact that the market is not efficient.

    Note the obvious problem with Fama's EMH; Fama assumes that successive price changes are independent of changes that took place in the previous period and that the price changes have some probability distribution that is known.

    For EMH to be true, all actors in the markets have to interpret information the same way. They also have to be impacted by the knowledge in the same way only must all knowledge be interpreted in the same way and have the same time preferences. As the Fama builds his theory on objectivity. For him all investors are essentially the same. They have the same goals and the same time preferences.

    But the assumptions are invalid. We know that people jump on board 'hot' markets precisely because they have gone up in previous periods. We also know that the price changes tend to be greater as one gets to the latter stages of a secular bull or bear market run and that increases tend to be not as great per unit of time as collapses. Spend two hours on CNBC and you see a vast difference in time preferences. Some players are interested in high frequency trading and consider a single day too long a holding period. Others look at the very long term and are quite happy when their favourite stocks are falling in price because they look to acquire as many shares as possible for as little as possible. Some want cash flows. Others want growth and capital gains.

    If anything, the clip shows that Santelli's grasp of economics is far better than Fama's. Santelli has spent a lot of time in the trading pits and knows that reality is very different from Eugene Fama's model. Santelli also understands that Fama has little clue about monetary theory. Unlike Fama, he knows that the Fed cannot start to unload long term treasuries without causing a huge rupture. In the trading pits that he covers any sell-off of long term treasuries will destroy the currency. In effect Fama is cheering the path that Gideon Gono made popular in Zimbabwe. That did not work out very well. Sadly, I think that giving the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel to Fama will have one positive effect. It will make people forget that Al Gore, the IPCC, and Obama were awarded the Nobel Peace Prize.

  22. The efficient market hypothesis is the zeroth approximation that is totally critical for the understanding of the markets anywhere.

    People like Buffett are bound to exist by chance - much like pieces of a random walk that go up for a while - and aside from Buffett, there are many very similar folks who lost their money and who are not famous although they don't differ too much. I don't claim that one can never find some patterns that seem to go beyond chance. But relying on all these patterns always carries risks so soon or later, the data restore the idea that the profits are random.

  23. You might want to look into what hyperinflation will look like. For a long time you will not see much but general price increases, often hidden by new packaging and changes in portion sizes for processed foods. You will see Dollar stores increase their prices to $1.50 or $2 for many of their goods. In January of this year Wendy's dumped its 99-Cent Menu. McDonald's just announced that it is ending its Dollar Menu. The changes had to be made because the companies had seen a substantial increase in the cost of their inputs as the price of buns, vegetables, meat, condiments, etc., kept going up. A dollar of input cost in 2007 was $1.20 five years later even though billions had been spent on eliminating non-value-added steps from the production, transportation, storage, and distribution processes for all goods.

    Some of your relatives probably know a few things that you do not. While you will not see hyperinflation until it is too late the pattern will be pretty clear. Things will seem acceptable until faith is lost and within a few months the currency will die.

    They also probably know that because the USD is the reserve currency there will be a big fight by all central banks to keep it afloat. Other central banks will print money and buy debt just as the Fed does. To provide cover for their activities they might print money and buy debt from each other. The reporting agencies will 'adjust' price gains for 'quality' or manage to ignore categories that used to be counted as a part of the same cost. For example, they can show that the price of flying went down by not counting the fees paid for meals, drinks, or luggage even though they all used to be rolled up into costs from previous comparison periods. But in the end bad accounting and finance cannot save the day and reality will intervene. At that point we will find if the interventionists were right about the Fed's injections of liquidity being benign or if the anti-Fed, hard money types were correct.

  24. There is no central planning in anything I wrote.

  25. In the long run, the preppers will be proven right. Anarchy will descend, neighbor turn against neighbor, cannibalism will make a return. But it could be a couple of centuries before that happens. In the meantime, why not enjoy life to the fullest. It is extremely unlikely that some nightmarish breakdown of social order will occur within the next couple of decades. Converting significant amounts of cash into an illiquid and highly volatile asset such as gold could be a bad choice. A diet of canned food for months is not very healthful nor tasty. But if you like the survivalist lifestyle, then go for it. Whatever floats your boat.

  26. Here I would not entirely agree. Perhaps Buffett was lucky initially. But not in the second half of his career. It's not like there is an army of footsoldier-investors who are indistinguishable from one another and at every mile that they advance, a few hit on a cache of weapons and gold by accident while the majority succumb to artillery fire and then everyone's chances are reset to zero at the next iteration. Buffett is doing something right and it probably involves little sophisticated quantitative analysis. His "value investing" principles can be emulated, but the "social capital" he has built up cannot. Powerful people approach him first to offer lucrative investment opportunities, they do not approach his competitors. This isn't illegal, it's not insider trading. It's an example of "network effect" where strength builds upon strength.

    To cultivate this appeal, he has built a public persona apart from the hustle of Wall Street. Staying in Omaha, Nebraska, is an essential part of this persona. The world of finance is a cut-throat environment, but CEOs of major corporations see themselves as industrialists not financial people and being popular and well-liked by them is Buffett's recipe for success, I think.

  27. "The efficient market hypothesis is the zeroth approximation that is totally critical for the understanding of the markets anywhere."

    Sorry but the simplifying assumptions make understanding of how markets work by using EMH impossible. (Which is why Santelli, who has decades of experience in the trading pits knows that Fama is just an empty suit who does not know that his understanding is insufficient.)

    For EMH to be true knowledge has to be interpreted in the same way by all investors. All those investors have to have the same goals and the same time preferences. The impact of that that knowledge has to be identical among all actors.

    Since we have the requirement that all individuals have to interpret knowledge in the same way there is no subjective subjective element from knowledge formation. News would have the same impact on a Keynesian that it would on a Marxist, Austrian, or Monetarist. Is that realistic?

    Since the impact has to be the same, that means that all market actors have the same goals, the same time preferences and must interpret the news in an identical way. That certainly is not realistic.

    As David Howden shows, (see, LvMises used a similar model to examine the source of entrepreneurial profit and loss a few years before Fama created EFH. Like Fama, Mises did away with the Bergsonian time elements. He did this by making three assumptions; there was no connection between time periods and price changes, the distributions were known, and expectations were homogeneous. To remove friction from the system he assumed that there were no transaction costs. That gives you a static tool with which you can study price formation.

    The trouble is that this tool is not realistic. There is no place for an entrepreneur in Fama's markets and there is no way for the factors of production to be coordinated effectively. And since EMH removes future uncertainty there is no room for real information.

    If you are interested Howden does a good job explaining the problems with Fama. If you want more I suggest looking at someone like Nassim Taleb, who attacks the use of Gaussian mathematics as the basis of modern finance. As Santelli points out academics like Fama are clueless about how the real markets operate. Their models may work under some circumstances at some times but when something unexpected happens they crash and burn and require that those that used them get bailed out.

    If you were objective and cared about the real world you might want to do some reading. If you did you would find that Santelli is a far better economist than Fama.

  28. For a really smart guy you can certainly be clueless at times. What do you think that QE is? It is not the free market. It is central planning by an institution that is given a monopoly over the creation of money in the United States.

    The debate is between those that favour central planning and want to Fed to keep intervening in the market and those like Santelli, that want the markets to punish incompetence and lousy judgment so that the economy can finally begin to recover.

  29. Vangel - once again you are doing yeoman's work. Well done! Keep it up! And Good Luck!