Category: Books

That is the title of Robert H. Frank's latest book, published by Basic Books and due out later this month.  The subtitle is Common Sense Principles for Troubled Times.  I received my copy today and of course it goes to a prominent spot in my "to read" pile.

Geoffrey Miller, in his new book Spent, suggests an intriguing but I think absurd idea:

For example, companies could sell certain products only to consumers who have a certain minimum or maximum score on one or more of the certain Central Six [personality] traits.  Hummer dealers could advertise that the "Party Animal Red Pearl" paint color is available only to customers who score in the top 5 percent for extraversion.  Customers who want to display their unusually high extraversion through that bright red color would have to electronically validate their extraversion score at the dealership before they could sign the purchase agreement.  In this way, Hummer could guarantee that Party Animal Red Pearl becomes a reliable signal of friendliness, self-confidence, and ambition.  Or Lexus could sell the "Mensa Quartz Medallic" color of the LS 460 only to customers whose validated intelligence scores are high enough for them to join Mensa International (IQ 130+ or the top one in fifty).  The more exclusive "Prometheus Glacier Pearl" color could indicate an IQ above 160 (the top one in thirty thousand) — the qualification for joining the Prometheus Society.

But why those proposals are so absurd — that is harder to answer.  What are your thoughts?  Can it be that people ought not to be seen as signaling too purposively?  Maybe, but if so, that would seem to rule out so much — too much — of the marketplace signaling which we in fact observe.

In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The
essence of this convention — though it does not, of course, work out
quite so simply — lies in assuming that the existing state of affairs
will continue indefinitely, except in so far as we have specific
reasons to expect a change. This does not mean that we really believe
that the existing state of affairs will continue indefinitely. We know
from extensive experience that this is most unlikely. The actual
results of an investment over a long term of years very seldom agree
with the initial expectation. Nor can we rationalise our behaviour by
arguing that to a man in a state of ignorance errors in either
direction are equally probable, so that there remains a mean actuarial
expectation based on equi-probabilities. For it can easily be shown
that the assumption of arithmetically equal probabilities based on a
state of ignorance leads to absurdities. We are assuming, in effect,
that the existing market valuation, however arrived at, is uniquely correct in
relation to our existing knowledge of the facts which will influence
the yield of the investment, and that it will only change in proportion
to changes in this knowledge; though, philosophically speaking it
cannot be uniquely correct, since our existing knowledge does not
provide a sufficient basis for a calculated mathematical expectation.
In point of fact, all sorts of considerations enter into the market
valuation which are in no way relevant to the prospective yield.

Nevertheless the above conventional method of calculation will be
compatible with a considerable measure of continuity and stability in
our affairs, so long as we can rely on the maintenance of the convention.

For if there exist organised investment markets and if we can rely
on the maintenance of the convention, an investor can legitimately
encourage himself with the idea that the only risk he runs is that of a
genuine change in the news over the near future, as to the
likelihood of which he can attempt to form his own judgment, and which
is unlikely to be very large. For, assuming that the convention holds
good, it is only these changes which can affect the value of his
investment, and he need not lose his sleep merely because he has not
any notion what his investment will be worth ten years hence. Thus
investment becomes reasonably “safe” for the individual investor over
short periods, and hence over a succession of short periods however
many, if he can fairly rely on there being no breakdown in the
convention and on his therefore having an opportunity to revise his
judgment and change his investment, before there has been time for much
to happen. Investments which are “fixed” for the community are thus
made “liquid” for the individual.

It has been, I am sure, on the basis of some such procedure as this
that our leading investment markets have been developed. But it is not
surprising that a convention, in an absolute view of things so
arbitrary, should have its weak points. It is its precariousness which
creates no small part of our contemporary problem of securing
sufficient investment.

The insights here have yet to be fully mined.

This chapter is a wild ride, often verging on incoherence but sometimes falling into brilliance.  In any case it is hard to follow.

The first page or two of this chapter presages Tobin's "q theory" and the notion that differential rates of return determine additions to the capital stock (or lack thereof).  The theory of irreversible investment, and the corresponding notion of option value, has made q theory obsolete although not in a way which damaged Keynesian theory.  Quite the contrary.

The end of section i notes that the rate of interest, as used to evaluate capitalized streams of future income, has to come in part from outside the market for capital goods themselves.  This whole section will make more sense once you've read the notorious chapter 17.  Maybe the claims are true as stated in this chapter (all relations are those of general equilibrium in the final analysis), but what Keynes actually meant here is not so obviously true.  He is hinting at the notion that a liquidity trap can halt new investment and that the rate of return on money can "rule the roost."  When and whether this can be true is a central question for contemporary macro and we will return to it.

Parts of section ii hint at the later "reswitching" debates in capital theory and in this section Keynes is drawing upon Irving Fisher's notes on the problem.  He's again getting at the claim that a purely "real" (non-monetary), partial equilibrium theory of interest won't carry much explanatory power.  I don't think he is wielding the right weapon here.

Section iii pokes a hole in the Fisher Effect.  Keynes points out that if expectations of inflation induce a higher nominal interest rate, why don't those same expectations cause prices to go up now?  This adjustment, by the way, would eliminate the nominal premium on the rate of interest.  This simple yet powerful point doesn't get the attention it ought to.  Storage costs for goods and services may eliminate this paradox but perhaps not completely.  It is striking how few economists have thought this problem through.

The chapter ends with a blizzard of arguments about the importance of expectations.

Whew!  Overall this chapter supports my view that Keynes was obsessed with capital theory and had deep ideas on the topic.  But in terms of understanding the overall argument of the GT, if you can follow chapter 17 (ha), you needn't worry too much about all the difficult arguments and passages here.