The Stock Market and Acute Instability

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I just finished reading Marcelle Chauvet’s “Stock Market Fluctuations and the Business Cycle”. Available on SSRN, the paper “explores the possibility of predicting business cycle turning points using promptly available financial variables…. The proposed model generates predictions of business cycle turning points using the business cycle factor, and anticipation of these predicted turns using the stock market factor.” Her basic model is familiar: “The profit motive induces participants in financial markets to use every piece of readily available data to infer the current state of the economy. As new economic data are released, information is rapidly incorporated in market participants’ assessments of the strength of the economy.”

It is a good paper on an underappreciated subject. It would have been better if it modeled, more in depth, the rational behavior that motivates the link between the stock market and periodic extreme instability of highly specialized economies. The GEM Project’s micro-coherent analysis of nonstationary demand disturbances (NDD) is helpful here.

The Project substantially advances our understanding of the role of equity markets in the class of extreme instability manifested in the 2007-09 Great Recession. Its demand-side modeling is motivated by three interrelated ideas. The first is rooted in recent work by Nancy Stokey (2009). Once investors/lenders become uncertain about future macro trends, especially the adequacy of total demand, they become more inactive, postponing acquisition of assets until the uncertainty dissipates. Second is the bedrock GEM microfounded nominal-to-real causality that powerfully propagates macro shocks. The third, building on the foundation provided by Roger Farmer (2010a, 2010b), roots investor/lender macro uncertainty in the loss of creditability of stabilization authorities’ trend real-side objective. Such credibility, denoted by Ƈ throughout the GEM Project, is increasing in the degree to which the future state of the macroeconomy is believed to be consistent with stabilization authorities’ objectives. (Chapter 6)

Extreme-Instability Macrodynamics

Demand disturbances. GEM theorists bimodally separate total-spending disturbances. Stationary demand disturbances (SDD) reflect the contained, temporary weakening of nominal spending associated with garden-variety recessions. Nonstationary demand disturbances (NND) are much more consequential, reflecting unchecked spending collapses associated with acute instability that overwhelms automatic stabilizers and Fed purchase of short-term Treasury debt. (Chapter 10) As modeled in the Project, NDD critically differs from SDD by introducing uncertainty into investor/ lender perceptions of the credibility of stabilization-authorities’ trend real-side objective. Damaged Ƈ induces investors and lenders to become rationally inactive, awaiting a credible reversal in collapsing total demand. Among the consequences, the economy experiences a breakdown in its capacity to recycle saving into spending, the market failure that Bernanke (1984) identified as central to the macrodynamics that governed the 1930s depression.

Stock market. Mainstream modeling of equity pricing is simple and intuitive:


where Y denotes the broad equity-market average price and И represents relevant expectations of discounted inflation-adjusted future profits. The inability of textbook economics to accommodate stock-market behavior in NDD circumstances results from its rooting of И wholly in economic fundamentals and, ultimately, in micro-coherent, market-centric general-equilibrium theory. That description, inadequate for  highly specialized economies, prevents mainstream thinking from capturing the departures from economic fundamentals that characterize extreme instability.

Investor perceptions of the trend real-side credibility of stabilization authorities (Ƈ) critically mediates the relative influence of economic fundamentals and self-referential confidence (Keynes’s animal spirits) in stock-market behavior. When credibility is high, investors’ macro expectations are governed by generally agreed-upon probabilities, and the equity index is driven by profit fundamentals. As credibility erodes, however, the average investor becomes more uncertain, inducing rational inaction that forces stock-market outcomes (and investment outlays) to be increasingly driven by faltering confidence. (Chapter 6.)

In the second half of 2008 and the first half of 2009, Ƈ played a central role in the brewing NDD spending collapse. After the Lehman bankruptcy, investors clearly had become uncertain about trend real-side stabilization goals, becoming rationally inactive. Asset prices and total demand were pushed into downward spirals. The central macro issue quickly became the authorities’ capacity and will to reverse rapidly contracting total spending and hemorrhaging job loss.

Consider the counter-factual case. If equity investors in 2008-09 had been confident with respect to the Fed’s capacity and will to sustain trend aggregate demand in the face of the financial disruption associated with subprime and exotic residential-mortgage default, private-sector decisionmaking would have continued to be rooted in profit-seeking guided by economic fundamentals. The S&P 500 index would not have collapsed 50 percent..

Damaged Mainstream Thinking

If Ƈ is important, why do modern theorists relegate central banks’ trend full-employment objective to playing a distant second fiddle to the low, stable inflation goal? Here is the tough-love answer. Given that consensus general-market-equilibrium modeling cannot coherently accommodate MWR or otherwise rationally suppress wage recontracting, Mainstream theorists avoid model incoherence by downplaying nominal-to-real causality in their cyclical narrative. Aggregate demand and involuntary job loss are pushed into the shadows in modern business-cycle research. By default, search-match-bargaining analysis and its voluntary unemployment today unhappily occupy center stage; and by default inflation becomes the star of the stabilization show.

It is deeply embarrassing that mainstream macroeconomists have long advised central banks to emphasize nominal, not real, targeting. Woodford’s 2003 New Keynesian bible stands out: “… because of the difficulty involved in measuring the efficient level of economic activity in real time – depending as this does on variations in production costs, consumption needs, and investment opportunities – it may well be more convenient for a central bank to concern itself with monitoring the stability of prices.” (p.13) Elsewhere in Interest and Prices, inflation primacy is asserted more forcefully, notably when Woodford argues that Phillips-curve relations have mistakenly been thought to imply that “monetary policy should be used to achieve output or employment goals, rather than giving priority to price stability. The present study argues instead for a different view of the proper goals of monetary policy. Its use to stabilize an appropriately defined price index is in fact an important end toward which efforts should be directed – at least to a first approximation, it should be the primary aim of monetary policy.” (p.4)

Final Word

Professor Chauvet has a 2009 You-Tube post in which she describes her stock-market paper as an example of economic research that is useful in helping people understand the economy. Once her empirical analysis is combined with the behavioral modeling featured in the GEM Project, her goal becomes especially true. She is encouraged to join the Project.

Blog Type: Policy/Topical Saint Joseph, Michigan


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