Saturday, June 25, 2011

Asset Prices, the Business Cycle, and Unemployment

A few months ago, I blogged about research done by Roger Farmer and Naryana Kocherlakota on understanding unemployment; and in particular relating trends in unemployment to asset markets and investor confidence.

The key issue is that it's difficult to understand why unemployment remains so high so far after the financial crisis. A real business cycle approach would look for real shocks to production; in particular idiosyncratic shocks to technology. Yet it appears that this recession involves a number of nominal and financial-sector related frictions difficult to rationalize using that model.

Another approach relies on New Keynesian thinking. In this view, prices are “sticky” as it is costly to adjust prices in the short-run in response to a moderate shock. This induces a friction in in economic activity, especially in the market for labor, that can be fixed through macroeconomic stabilization in the form of monetary or fiscal stimulus. However, if you look at scanner data, retail prices are actually fairly flexible. On top of that, the economy faced such a substantial shock, and we are sufficiently far out in the future, that surely price-setters have had the chance to adjust prices by now.

In short: the particular frictions and shocks underlying traditional macroeconomic models seem to be of limited relevance in explaining this recession. As a result, I’ve been trying to read up on alternate models — relying, for instance, on financial market frictions, household balance sheets, etc. Roger Farmer, in a new paper, offers up another such model that relies on old-style Keynesian thinking.

The basic logic comes out in this graph:

This shows asset prices and unemployment being closely linked throughout the business cycle; which isn’t a trivial fact. The logic is that asset prices follow bubbles and crashes due to self-fulfilling optimism and pessimism from investors. These booms and crashes result in larger social consequences in the form of higher unemployment through search frictions in the labor market.

In this model — as in some sense as in Keynes original work — investors do have rational expectations. They expect a bubble; and a bubble happens. They expect an economy that performs poorly over an extended period of time; and that too materializes.

Nevertheless, the paper still relies heavily on psychological assumptions about investor behavior. Investor confidence drives both asset prices, as well as willingness to hire. This response is, as I suggested in my last post, asymmetrical, as it is harder to hire than it is to fire.

I find this paper interesting as it brings the problem of unemployment into the domain of asset pricing. While Farmer emphasizes the psychological basis of bubbles and busts, someone like John Cochrane would emphasize how ultimately discount rates — the rates at which we value future income relative to current income — determine the values of current financial assets (which are just claims to future cash flows).

In Cochrane’s world — asset prices fluctuate in conjunction with macroeconomic outcomes. Is the economy looking bad? Do you anticipate losing your job, your business, or other such negative shock? If so, you wish to hold less risky assets. Yet we can’t all rebalance away from risk, as there are only so many stocks and bonds and so forth. Instead, the price of stocks and bonds fall in order to compensate us for bearing this sort of risk in a time of economic uncertainty.

Yet Farmer would point out that the process also works in reverse. High discount rates — equivalently, “pessimism” — felt by the owners of capital manifest themselves in an unwillingness to hire, particularly if there are frictions in the labor search process.

I suspect that tying Farmer’s model into a more "rational" model of asset prices that emphasizes the links between financial markets and real markets would amplify the multiple equilibrium nature of unemployment. This was the key feature of Keynes of course, and it’s interesting to see Farmer resuscitate this idea. And with unemployment at 9% or what have you it doesn’t seem implausible to think that numerous economic possibilities are open to us, depending on the nature of economic equilibria we end up at.

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