Thursday, August 21, 2008

Merging Macroeconomics and Finance (fg)

Asset Prices and the Economy from John Cochrane:

Understanding the marginal value of wealth that drives asset markets is most obviously important for macroeconomics. The centerpieces of dynamic macroeconomics are the equation of savings to investment, the equation of marginal rates of substitution to marginal rates of transformation, and the allocation of consumption and investment across time and states of nature. Asset markets are the mechanism that does all this equating. If we can learn the marginal value of wealth from asset markets, we have a powerful measurement of the key ingredient of all modern, dynamic, intertemporal macroeconomics.

In fact, the first stab at this piece of economics is a disaster, in a way first made precise by the “equity premium” puzzle. The marginal value of wealth needed to make sense of the most basic stock market facts is orders of magnitude more volatile than that specified in almost all macroeconomic models. Clearly, finance has a lot to say about macroeconomics, and it says that something is desperately wrong with most macroeconomic models. In response to this challenge, many macroeconomists simply dismiss asset market data. “Something’s wacky with stocks,” they say, or perhaps “stocks are driven by fads and fashions disconnected from the real economy.” That might be true, but if so, by what magic are marginal rates of substitution and transformation equated? It makes no sense to say “markets are crazy” and then go right back to market-clearing models with wildly counterfactual asset pricing implications. If asset markets are screwed up, so is the equation of marginal rates of substitution and transformation in every macroeconomic model, so are those models’ predictions for quantities, and so are their policy
and welfare implications.

Many financial economists return the compliment, and dismiss macroeconomic approaches to asset pricing because portfolio-based models “work better”—they provide smaller pricing errors. This dismissal of macroeconomics by financial economists is just as misguided as the dismissal of finance by macroeconomists.

In sum, the program of understanding the real, macroeconomic risks that drive asset prices (or the proof that they do not do so at all) is not some weird branch of finance; it is the trunk of the tree. As frustratingly slow as progress is, this is the only way to answer the central questions of financial economics, and a crucial and unavoidable set of uncomfortable measurements and predictions for macroeconomics.