Trash Talking

In a recent post I made fun of some guy in the Senate whose objection to Janet Yellen being Fed Chairperson is that she believes monetary policy is effective. Since winning this years Nobel Prize in Economics for the Efficient Market Hypothesis (EMH), Eugene Fama said of Quantitative Easing (QE): "They're basically neutral events. I don't think they do very much."

In response, another economist called him a "dumbass".

Fama's logic was that the Fed is "issuing a lot of short-term debt — $85 billion a month — and using it to buyback long-term debt with the goal of lowering the interest on long-term debt." And that it will net out and not have much effect on the economy. By short term debt he means the reserves at the Fed banks are given for their bonds.

Fama seems trapped in the mind set that QE is only about interest rates; it's not, it's about the level of nominal spending (as in not adjusted to inflation), which affects aggregate demand, which affects inflation, which affects real interest rates, wages, and plenty of other things that do have a real effect. As Ben Bernanke put it:

"...if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero."

For example, at the extreme, if the Fed were to print new money to buy all the gold in the world, it's impossible that sellers would not increase prices as the demand for gold, and supply of money available to buy it skyrocketed.

Maybe Fama was just referring to effects on interest rates? But what really confuses me is what he thinks is going on when the markets fall on expectations of tapering, and shoot up at the prospect of more monetary stimulus. According to the EMH, prices of assets reflect all available information about future earnings. Therefore their future path is unpredictable, because only new information that no one had before can change prices. 

Now, no one, not even Fama, believes this is 100% rigidly true, at least not in the short run. But how would he explain market movements to new Fed announcements? It's completely consistent with the EMH, if the Fed can affect earnings, that new information about Fed actions get incorporated into prices and changes them. 

The only alternative is that on the exact same day as Fed announcements, by sheer coincidence, and for no recorded reason, the market became more risk averse when less stimulus was expected, and more risk taking when more stimulus was expected.[1] But not because of the news about monetary policy. 

What? That's kinda dumb. 






1. This is consistent with EMH because a person's risk aversion is a psychological trait, and not driven by earnings expectations. Some investors take more risk than others even at the same expected rate of return.