Pompeo Pontone

In order to explain fairly simply how expectations are formed, the Theory of Price Movements based on Rational Expectation Framework (John F. Muth, 1961) advance the hypothesis that they (the expectations) are essentially the same as the predictions of the relevant economic theory. In particular, the hypothesis asserts that the economy generally does not waste information, and that expectations depend specifically on the structure of the entire system. In particular, averages of expectations in an industry are more accurate than naive models and as accurate as elaborate equation systems, although there are considerable cross-sectional differences of opinion. Also reported expectations generally underestimate the extent of changes that actually take place. In essence, expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory. We can call therefore call such expectations “rational”. In other words, expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the “objective” probability distributions of outcomes). This is the case because: (i) Information is scarce and not wasted by the economic system; (ii) The way expectations are formed depends specifically on the structure of the relevant system describing the economy; (iii) A “public prediction” will have no substantial effect on the operation of the economic system (unless it is based on inside information). Without getting too technical and, for the sake of clarity, debating the adopted hypothesis of normally distributed random disturbances or the linearity of the equations of the system, from a purely theoretical standpoint, there are good reasons for assuming rationality. First, it is a principle applicable to all dynamic problems (if true). Expectations in different markets and systems would not have to be treated in completely different ways. Second, if expectations were not moderately rational there would be opportunities for economists to make profits in commodity speculation, running a firm, or selling the information to present owners. Third, rationality is an assumption that can be modified. Systematic biases, incomplete or incorrect information, poor memory, etc., can be examined with analytical methods based on rationality. The literature shows many comparisons between some of the empirical implications of the rational expectations hypothesis with those of the cobweb “theorem”. Although reported expectations often underestimate the extent of changes that actually take place, several studies have clearly shown that the empirical findings are clearly inconsistent with the cobweb theory and they are generally consistent with the rational expectations hypothesis. Switching from academic debate to the “real” world, Ben Bernanke in 2014 stated that “the problem with quantitative easing is that it works in practice, but it doesn’t work in theory”. Bernanke was referring to the Wallace Neutrality, a famous result from monetary theory that asserts that the size and composition of the central bank balance sheet has no effect on inflation or employment (Cohen-Setton and Monnet 2012). In a new paper (2016) Farmer and Zabczyk bridge the gap between practice and theory, and show how a central bank can influence both by intervening in asset markets and by using open market operations and trades in risky assets to insure those unable to insure themselves. But how can we try to capture the real effect of Quantitative Easing? In a 2018 Banque De France working paper (Penalver, Hanaki, Akiyama, Funaki, Ishikawa), the authors conduct a repeated experiment in which a central bank buys bonds for cash in a quantitative easing (QE) operation in an otherwise standard asset market setting. The experiment is designed so that bonds have a constant fundamental value which is not affected by QE under rational expectations and to ascertain whether the key result – QE raises bond prices when in the rational expectations equilibrium it shouldn’t – holds when participants are exposed to the same treatment three times. It is clear from the repeated benchmark treatment (without QE) that participants can learn that prices should not deviate from the fundamental price in this setting. In the Buy&Hold treatment in which the central bank permanently removes some bonds from the market, prices rise statistically significantly well above the fundamental price and stay there, even after the central bank has stopped buying. In most markets, repeated exposure only strengthens the belief that prices should rise. An interesting finding is that the central bank considerably overpays relative to the fundamental price and the most recent market price in round 1. Rather than compete this effect away (as rational expectations would imply), participants come to expect it. Indeed, by round 3 the price path in the earlier rounds significantly conditioned their price expectations. It was noticeable also that the peak price effect occurs earlier in the later rounds as participants start to anticipate higher prices from the beginning. Price dynamics in the Buy&Sell treatment is remarkably similar to that in the Buy&Hold treatment, particularly over the periods 1 to 7. The main difference occurs thereafter, as prices tend to drop to the fundamental price as the central bank sells. Overall, the central bank makes considerable losses. The ECB has flooded the markets with trillions of euros in liquidity (money base) since 2015. Since 2015 when the ECB initiated its quantitative easing (QE) programme, the money base increased by 166 percent (from 1.2 trillion euro to 3.2 trillion euro), while at the same time the money stock increased by a mere 20 percent. This leads to the conclusion that most of the two trillion-euro money base created by the ECB failed to filter through to the real economy. The burden of business cycle stabilisation in the eurozone will have to come from the fiscal authorities. The question then becomes how much leeway the fiscal authorities have to perform their stabilisation responsibilities considering that these authorities have significant levels of outstanding debt which can quickly become unsustainable.

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