Saturday, January 12, 2013

Farmerville

Wolfgang has sent me to the work of Roger Farmer, a self-described Keynesian economist who believes in what he calls qualitative easing - which consists of governments buying risky assets, in effect exchanging them for government bonds. I read one of his papers (I don't know of an ungated version). From the abstract:

This paper is about the effectiveness of qualitative easing; a government policy that is designed to mitigate risk through central bank purchases of privately held risky assets and their replacement by government debt, with a return that is guaranteed by the taxpayer. Policies of this kind have recently been carried out by national central banks, backed by implicit guarantees from national treasuries. I construct a general equilibrium model where agents have rational expectations and there is a complete set of financial securities, but where agents are unable to participate in financial markets that open before they are born. I show that a change in the asset composition of the central bank’s balance sheet will change equilibrium asset prices. Further, I prove that a policy in which the central bank stabilizes fluctuations in the stock market is Pareto improving and is costless to implement.

I didn't work through all the gory details, but I think I understand the basics. He makes some assumptions which produce a constrained optimization and derives some "theorems" from them. It didn't take me long to decide I despised this type of "science." While he dropped one kind of unrealism from his markets - a certain flavor of time traveler was excluded - he kept enough more to make an elephant, to borrow a phrase from Poincare.

Nowhere in his paper did I find any critique of the assumptions, any analysis of the implications of their failure, or any detailed comparison with experience. He did mention in one sentence that his results applied to his model, not the real world, though that disclaimer seems to get lost when he's pushing his theories elsewhere.

His theories have gotten a few real world tests. Something like his approach is being tried in Greece, Spain, Portugal, and Ireland. Ask the locals about its bang up success. So why does his theory produce nonsense? I'm not sure, but I think it can be traced to the assumptions he makes about uncertainty and perfect information - which coincidentally are exactly where we had massive market failures in the panic of 2007.