Risk - a few old thoughts

Cowen (1997) offers a version of the traditional Austrian theory that focuses on “risk” as distinct from “roundaboutness”. However this poses several problems. Firstly it runs the risk of misstating the original Austrian position – “roundaboutness” can not be easily summised as “chronological time”, and is really best thought of as whether a capital structure is more or less “elaborate”[1]. Cowen defines riskiness as “long-term, costly to reverse, high-yielding, and having returns highly sensitive to the arrival of new information” (Cowen 1997) and this also poses problems. It might seem reasonable to use basic finance theory to define risk as the inverse of returns, but when Cowen talks about “aggregate macroeconomic risk” the concept becomes highly dubious. Surely risk cannot be aggregated? Indeed instead of deciding upon the extent of their exposure to risk, entrepreneurs can only determine their exposure to different types of risk[2]. This begs the question: What sorts of risk do entrepreneurs engage in when credit conditions are loose? My suggestion is those that involve a more elaborate capital structure.

Moreover, we want to move away from characteristics of individual agents (such as risk preference) when trying to explain the so-called “cluster of errors” that arise during a cycle. Evans & Baxendale (2008a) highlights the heterogeneity of entrepreneurship, and we draw attention to the fact that an array of entrepreneurial plans will always exist[3]. If we assume reasonably efficient financial markets it is sensible to expect that the most profitable plans have a propensity to receive funding. Consequently during an inflationary boom there will be a systematic tendency for less profitable plans to find funding, and to come into fruition. Evans and Baxendale (2008a) therefore move away from representative agents to focus on marginal plans. Rather than deal with psychological explanations there are institutional reasons why the marginal plans will be prone to error.[4]


[1] Robert Miller has made an important discussion of buffer stocks. These might be defined as “resilience”. Indeed if we also label capital consumption as “extravagance” we have a three dimensional model to observe the Austrian cycle – resilience, elaborateness, and extravagance.

See Miller, R.C.B., 2010, “The role of ‘buffer stocks’ and commodities in an Austrian interpretation of the crisis” Paper presented at the Austrian Scholars Conference

[2] As a corollary an economic agent cannot be “risk averse”, they can only be “averse” to certain kinds of risk, but must also by definition have a corresponding penchant for other kinds of risk.

[3] This point is later echoed by Callahan & Horwitz (2010) “the ABC can be understood as assuming that actors have expectations that are to some degree heterogeneous”.

[4] Note that our knowledge assumptions here occupy a middle ground between omniscience and stupidity (see Evans 2014). This may seem sensible, but many economic studies imply that any deviations from the former leads to the latter.


NGDP growth falls to 1.9%, previous estimates downgraded

Today sees the release of the Second Estimate of the UK National Accounts, and thus the first chance to see NGDP data for the final quarter of 2015. Not only does it come in below 2% (using the quarter on same quarter of previous year measure) but previous estimates have been downgraded. The chart below shows NGDP growth from mid 2014 to now, with today's figures (in dark blue) relative to the estimates from Noovember 2015.

Coincidently, I have recently called for a ~2% NGDP growth target, and so I do not think this is bad per se. The problem is that the Bank of England had done a fairly effective job at returning NGDP to it's historic 4% rate (albeit without catching up on contractions in nominal income that ocurred during the great recession), and seemed committed to maintaining that. What we are seeing is NGDP falling below expectations, and this is highly concerning.


Update to The Kaleidic Guide to UK Monetary Policy

I've recently updated The Kaleidic Guide to UK Monetary Policy. The aim is to summarise some of the most important recent analysis and commentary on the economy, and weigh in on some important controversies. It is still very much a work in progress, and whilst I've attempted to provide a narrative structure some aspects may appear a little disjointed. You can download a PDF version, buy a hard copy, or even invite me to present it in person. But it's almost reached 300 pages!


2015 Q3 NGDP prediction market


Up until now we've used Inkling Markets as our prediction market provider, but they've recently been bought by Cultivate and will be offline from December. The finance questions for Cultivate will be run through a new website called Alphacast.

At the moment, members are unable to post their own questions. However, I've received some really helpful input from their technicians and one of their early trials will be a prediction market for UK NGDP. How cool is that! This is good timing because the Office for National Statistics release the second estimate of the National Accounts on Friday November 27th, and this will contain the first look at NGDP for Q3.

The question is: What will be the quarterly growth rate of NGDP for the UK economy for Q3 2015?

The market will only be running for a week, and as ever there's (relatively) large arbitrage opportunities early doors. So get trading!

Update: (27/11/15):

The correct answer is 3.4%.

Here's the Alphacast chart:



The Transmission Mechanism

I am yet to find the difinitive survey article that explains the transmission mechanism of monetary policy. I think there's 3 main reasons why it's proving elusive:

  1. There is no single transmission mechanism - hence it's always going to be complicated to present.
  2. There are big differences between US and UK monetarists.
  3. We've learnt new things about the transmission mechanism since 2008 but there's a pedagogical inertia that retains existing work.

A classic US textbook on monetary economics is Frederic Mishkin's "Economics of Money, Banking and Financial Markets". But look at the diagram below:

On first glance this is exactly the type of way to present such a tricky topic. It lays out several alternative channels, clarifies their background (i.e. presents credit view as slightly separate), and shows how they impact output. But it's not coherent. The key distinction between "interest rate" and "asset price" effects is flawed on the grounds that the interest rate matters because it's the price of bonds (i.e. an asset), whilst each of those asset price effects - whether it's the exchange rate, equity prices or credit markets - rely on interest rate changes (albeit the "cash flow" channel relies on nominal rather than real interest rate changes). This is why I struggled as an undergraduate - it's aint MECE.

I prefer this Mishkin article but it suffers from the same problem. Here's my attempt to summarise the transmission mechanism in terms of alternative schools of thought:

Not very helpful. One can also look at the Bank of England, and the ECB, but they leave out lots of important present-day channels. So help me out - where's the difinitive explanation of the transmission mechanism?