Business Cycles and Equilibrium

226 Pages·2010·1.101 MB·English

by  Fischer Black, Perry Mehrling

( continued from front flap ) $49$.4995.9 U5 SUASA/$/$5599.9.955 CCAANN
Black
Praise for
F i s c h e r B l a c k
• Includes discussions dedicated to “the effects B U S I N E S S
of uncontrolled banking,” “the trouble with B
econometric models,” and “the effects of
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noise on investing” C Y C L E S and
Throughout his career, Fischer Black described
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• Provides enlightening commentary on Black’s
I a view of business fl uctuations based on
life and work at the time Business Cycles and
EQUILIBRIUM N
Equilibrium was written the idea that a well-developed economy
will be continually in equilibrium. In the essays that
E
Updated Edition
constitute this book, which is one of only two books
Engaging and informative, the Updated Edition of
S
Black ever wrote, he explores this idea thoroughly
Business Cycles and Equilibrium will give you a S
and reaches some surprising conclusions.
better understanding of what’s really going on during “This book and the articles that preceded it electrifi ed the fi rst generation of
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these uncertain and volatile fi nancial times. Wall Street quants with Fischer’s famous rallying cry, ‘In my model, markets work,’ B U S I N E S S
With the newfound popularity of quantitative fi nance
and challenged them to ‘imagine a world without money.’ He gave us clear, logically Y
and risk management, the work of Fischer Black
FISCHER BLACK is regarded as one of the great consistent macroeconomics, without jargon or unnecessary math, which C
has garnered much attention. Even today, Black’s
innovators of modern fi nance theory. He is most was directly useful for making money. The material is as fresh and as relevant
L Business Cycles and Equilibrium—which lays out his
famous for cofounding the legendary Black-Scholes to profi t as when it was written.”
E theory that economic and fi nancial markets are in a
equation, although he contributed much more to —Aaron Brown, AQR Capital Management, author of
The Poker Face of Wall Street and A World of Chance S continual equilibrium—still challenges our thinking,
fi nance in the areas of portfolio insurance, commodity
C Y C L E S and
especially during our current economic crisis.
futures pricing, bond swaps, interest rate futures, and a
“Fischer Black has long been known as a genius in fi nance. He was also a genius
global asset allocation models. Black worked at the n
This Updated Edition clearly presents Black’s
on business cycles and monetary theory, and this book is the proof.”
University of Chicago and the MIT Sloan School of d
—Tyler Cowen, Professor of Economics, George Mason University classic theory on business cycles and the concept
Management, as well as Goldman Sachs. He received
E of equilibrium, and contains a new Foreword by
his PhD in applied mathematics from Harvard
“Fischer Black is a household name on Wall Street. Had he lived, Fischer Q the person who knows Black best: Perry Mehrling,
University. Black died in 1995, two years before the EQUILIBRIUM author of Fischer Black and the Revolutionary
would have shared (with Robert Merton and Myron Scholes) the Nobel Prize for
Nobel Prize was awarded to Myron Scholes and U
Idea of Finance. Mehrling places Black’s book in
their work in fi nancial economics. But Fischer also made extraordinarily deep
Robert C. Merton for their work on option pricing.
contributions to macroeconomics. This collection of Fischer’s key macro I the context of his own intellectual trajectory, shows
Since the Nobel Prize is not given posthumously, L
analyses is a feast for the intellect, but one that is very easily digested thanks to how to read it as a challenge to the macroeconomic
Black was given a prominent mention for the key I
Perry Mehrling’s marvelous introduction, historical perspective, and unique orthodoxy of his day, and suggests how Black
B
role he played in developing the equation.
ability to connect Fischer’s many dots. The book is of special relevance to anyone might have used his theory to make sense of today’s
R updated edition with a new foreword by
hoping to understand today’s fi nancial crisis and its macroeconomic fi nancial and economic meltdown.
and policy ramifi cations. I recommend it most highly.” I
U
—Laurence Kotlikoff, Professor of Economics, Boston University perry mehrling Filled with the practical perspectives of one of the
M most innovative minds in fi nance, the Updated
Edition of Business Cycles and Equilibrium:
• Contains Fischer’s original essays, which reach
some interesting conclusions concerning the
Updated
role of equilibrium in a developed economy
Edition
• Warns about the use and abuse of modeling
• Explains the risky business of risk in a
straightforward and accessible style
( continued on back flap )
ISBN: 978-0-470-49917-7
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Business Cycles
and Equilibrium
Updated Edition
Fischer Black
John Wiley & Sons, Inc.
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Copyright © Fischer Black 1987, 2010.
Foreword © John Wiley & Sons, Inc. 2010.
All rights reserved. First published 1987 by Basil Blackwell, Inc.
First published in paperback 1990.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted
in any form or by any means, electronic, mechanical, photocopying, recording, scanning,
or otherwise, except as permitted under Section 107 or 108 of the 1976 United States
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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their
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to the accuracy or completeness of the contents of this book and specifi cally disclaim any
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Library of Congress Cataloging-in-Publication Data:
Black, Fischer, 1938-
Business cycles and equilibrium/Fischer Black. – Updated ed.
p. cm.
Includes index.
ISBN 978-0-470-49917-7 (cloth)
1. Business cycles. 2. Equilibrium (Economics) 3. Title.
HB3711.B497 2010
338.5'42—dc22
2009025218
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
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Contents
Foreword v
Introduction xxi
Chapter 1: Banking and Interest Rates in a World Without
Money: The Effects of Uncontrolled Banking 1
Chapter 2: Active and Passive Monetary Policy in a
Neoclassical Model 23
Chapter 3: Rational Economic Behavior and the Balance
of Payments 43
Chapter 4: Uniqueness of the Price Level in Monetary Growth
Models with Rational Expectations 65
Chapter 5: Purchasing Power Parity in an
Equilibrium Model 81
Chapter 6: Ups and Downs in Human Capital and Business 85
Chapter 7: How Passive Monetary Policy Might Work 91
Chapter 8: What a Non-Monetarist Thinks 99
Chapter 9: Global Monetarism in a World of
National Currencies 107
Chapter 10: The ABCs of Business Cycles 117
iii
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iv contents
Chapter 11: A Gold Standard with Double Feedback
and Near Zero Reserves 129
Chapter 12: The Trouble with Econometric Models 135
Chapter 13: General Equilibrium and Business Cycles 153
Chapter 14: Noise 169
Index 191
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Foreword
P erry M ehrling
F
ischer Black (1938–1995) is best known for his fundamental con-
tributions to fi nance, most famously the Black-Scholes option
pricing formula that bears his name. He also aspired to contrib-
ute to macroeconomics. Indeed, he viewed his contributions to macro-
economics as more important than his contributions to fi nance, because
they were potentially more consequential for general social welfare. This
book records the development of his thinking in that fi eld from 1968,
when he wrote the fi rst draft of the paper that he includes as the fi rst
chapter, to 1986, when he revised his presidential address to the A merican
Finance Association to produce the paper that he includes as the last
chapter. In between, the papers are organized chronologically, rather
than thematically, more or less in the order in which Black brought
them to fruition (see the Appendix at the end of the Foreword). He
added some few notes, but otherwise there were no retrospective addi-
tions or omissions.
In Black ’s own professional life, the temporal span of this book
took him from his fi rst job at the management consultancy fi rm Arthur
D. Little, Inc., to what would be his last job at the investment banking
fi rm Goldman, Sachs & Co. In between, he spent 13 years in academia,
v
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vi foreword
fi rst at the University of Chicago ’ s Graduate School of Business
(1971–1975), then at MIT’ s Sloan School of Management (1975–1984).
This professional trajectory suggests that we can read the present book
as the record of a nonacademic outsider ’ s attempt to insert a new idea
into the insiders’ debate then raging between the Keynesians (at MIT)
and the monetarists (at Chicago).
The outsider’ s idea is present in the very fi rst chapter. Fischer Black
invites us to imagine a world without money and to think about how
such a world might work, then holds up that picture against both the
existing fi nancial system and against existing economic theories about
how that system works. For Black, this comparison suggests that there
are powerful forces at work tending to move us away from the existing
system in the direction of a world without money. That tendency, once
we recognize it, can be expected to produce a similar tendency in the
world of ideas, a tendency to move beyond our existing understanding—
based on the quantity theory of money (embraced by monetarists) and
its revision into the liquidity preference theory of money (embraced by
Keynesians)— in the direction of something new.
In this fi rst chapter, Black ’ s methodological focus is not yet on
equilibrium, not even fi nancial market equilibrium. We can see the
infl uence of Treynor’ s capital asset pricing model (CAPM) in the argu-
ment that “ a principal reason for introducing borrowing and lend-
ing is for the transfer of risk” (p. 12), but the price of risk plays no
role and the focus is instead on the rate of interest. Even more, Black ’ s
world without money is largely a world of banking institutions, not of
fi nancial markets. He imagines a world in which essentially all fi xed-
income securities, government and corporate bonds alike, are replaced
by bank lending and funded by bank deposits of one kind or another.
It is recognizably the CAPM world of equity and short-term debt, but
the debt part involves “ indirect fi nance ” not “ direct fi nance ” (to use the
phraseology of Gurley and Shaw in their 1960 M oney in a Theory of
Finance ).
Black says that “ equilibrium was the concept that attracted me to
fi nance and economics ” (p. xxi). In the fi rst chapter, we can see what
he means. Conceptualizing banks as fi nancial intermediaries that hold
loans to business and government as assets, and deposits from house-
holds as liabilities, Black was led naturally to conceptualize the larger
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Foreword vii
economy as a set of interlocking balance sheets. One person’ s asset is
another person ’ s liability. Balance-sheet thinking of this sort is a kind of
natural general equilibrium (or macroeconomic) thinking. Add to this
thinking the simple idea of profi t-seeking and competition between
intermediaries, and you have the abstract equilibrium concept with
which Fischer Black started his intellectual journey. For him, equilib-
rium is not at all a position of rest, much less the endpoint of a process
of dynamic adjustment. It is, as he says, only a position in which “ there
are no opportunities to make abnormal profi ts. ”
One consequence of his balance-sheet starting point was an instinc-
tual antipathy for the quantity theory of money, in both its domestic
and international incarnations (Milton Friedman and Harry Johnson,
respectively). “ Those who believe in the quantity theory are forced to
argue in terms of a world with commodity money or a world where the
government hands out massive amounts of currency or bonds, and then
transfer their conclusions to an entirely different kind of world” (p. 20).
Currency, in Black’ s world, is not paper gold (outside money), but
rather a bank deposit (inside money), not the exogenous imposition
of government policy, but rather the endogenous outcome of private
profi t maximization. As such, the law of refl ux applies — the supply
of money adjusts to the demand for money. “ When a bank creates a
deposit larger than the individual wants to hold, he can always use it to
pay off some of his loan ” (p. 16). “ If a bank issues money to make a loan
to one person, and that money is more than the public wants to hold at
equilibrium interest rates, then it will simply be used to pay off another
loan, at the same bank or at another bank ” (p. 38). In this way, any
incipient excess supply of money has no chance to affect the price level
(or the rate of interest), since it is immediately cancelled.
Because of his antipathy toward the quantity theory, Black rec-
ognized that monetarists would resist his ideas, but he seems to have
thought that Keynesians would be more sympathetic. Thus, we see him
positioning his ideas in explicit opposition to Friedman and Johnson,
but as an extension of the work of Keynesian economists such as
Vickrey, Tobin, Gurley and Shaw, and Patinkin (pp. 2–4). Indeed, it was
to the Keynesians that he fi rst offered these ideas, on March 12, 1970, in
Franco Modigliani’ s Monetary Theory Seminar at MIT. His fi rst formal
academic presentation was a success, but Modigliani was not convinced.
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viii foreword
As leader of the research team that had recently produced the mon-
etary sector of the Federal Reserve’ s econometric model of the United
States, Franco Modigliani was a central fi gure of Keynesian monetary
economics. By contrast to Milton Friedman, he urged an activist coun-
tercyclical monetary policy, but his opposition to Friedman’ s monetar-
ism did not extend to the quantity theory of money more generally.
Rather, following in the footsteps of the so-called American Keynes,
Irving Fisher, Modigliani accepted the quantity theory of money as a
theory of the long run, and understood short-run business fl uctuations
as disequilibrium deviations from the long-run equilibrium path.
From this perspective, we can understand Black’ s second c hapter
as an attempt to engage economists like Modigliani on their own turf.
Instead of trying to tempt the reader with his own vision of a world
without money, in this second paper he is trying to demonstrate that the
reader’ s own vision of a world with money simply does not make logi-
cal sense. He does this by taking the Solow growth model as a widely
accepted model of long-run equilibrium, and then showing how
attempts to bring money into the picture as an active force control-
led by policymakers lead inevitably to logical contradiction. (Chapter 4
plays a similar game with a paper of Sargent and Wallace.) The only
way these models make sense, he argues, is if policymakers passively
supply whatever quantity of money is demanded by h ouseholds (thus
reproducing in the public money supply exactly the behavior that Black
expects from private banks in his world without money). Apparently,
Black viewed this second paper as foundational for everything else in
his subsequent engagement with the academic economists, as evidenced
by his frequent references to it (p. 60, 61, 79, 151, 165, 187). Why?
As a student of the mathematical logician W. V. O. Quine, Black
considered the demonstration of logical error to be suffi cient for
rejection of a theory. This Quine infl uence is also likely the source of
Black ’ s otherwise puzzling argument that “ the quantity of money can
have no effect on output, employment, or prices, because the quantity
of money does not exist” (p. 10). See also his puzzling idea that logi-
cal contradiction qualifi es as “ evidence that a government cannot con-
trol its country’ s money stock ” (p. 60). “ A plausible theory is one that
does not imply consistent, easy to exploit profi t opportunities ” (p. 142).
Equilibrium modeling is, for Black, fundamentally a test of the l ogical
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