BUSINESS C Y C L E S and EQUILIBRIUM

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( continued from front flap ) Black $49.95$49.95 USA/$59.95 USA/$59.95 CANCAN Praise for • Includes discussions dedicated to “the effects BUSINESS CYCLES and CYCLES EQUILIBRIUM BUSINESS of uncontrolled banking,” “the trouble with Fischer Black econometric models,” and “the effects of BUSINESS noise on investing” hroughout his career, Fischer Black described • Provides enlightening commentary on Black’s CYCLESand a view of business fl uctuations based on life and work at the time Business Cycles and Equilibrium was written Tthe idea that a well-developed economy EQUILIBRIUM will be continually in equilibrium. In the essays that Updated Edition Engaging and informative, the Updated Edition of constitute this book, which is one of only two books Business Cycles and Equilibrium will give you a Black ever wrote, he explores this idea thoroughly 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 these uncertain and volatile fi nancial times. Wall Street quants with Fischer’s famous rallying cry, ‘In my model, markets work,’ With the newfound popularity of quantitative fi nance and challenged them to ‘imagine a world without money.’ He gave us clear, logically 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 has garnered much attention. Even today, Black’s was directly useful for making money. The material is as fresh and as relevant BUSINESS innovators of modern fi nance theory. He is most Business Cycles and Equilibrium—which lays out his famous for cofounding the legendary Black-Scholes to profi t as when it was written.” theory that economic and fi nancial markets are in a equation, although he contributed much more to —Aaron Brown, AQR Capital Management, author of continual equilibrium—still challenges our thinking, fi nance in the areas of portfolio insurance, commodity The Poker Face of Wall Street and A World of Chance especially during our current economic crisis. futures pricing, bond swaps, interest rate futures, and “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 on business cycles and monetary theory, and this book is the proof.” CYCLESand This Updated Edition clearly presents Black’s University of Chicago and the MIT Sloan School of —Tyler Cowen, Professor of Economics, George Mason University classic theory on business cycles and the concept Management, as well as Goldman Sachs. He received of equilibrium, and contains a new Foreword by his PhD in applied mathematics from Harvard the person who knows Black best: Perry Mehrling, University. Black died in 1995, two years before the “Fischer Black is a household name on Wall Street. Had he lived, Fischer would have shared (with Robert Merton and Myron Scholes) the Nobel Prize for author of Fischer Black and the Revolutionary Nobel Prize was awarded to Myron Scholes and their work in fi nancial economics. But Fischer also made extraordinarily deep Idea of Finance. Mehrling places Black’s book in Robert C. Merton for their work on option pricing. contributions to macroeconomics. This collection of Fischer’s key macro EQUILIBRIUM the context of his own intellectual trajectory, shows Since the Nobel Prize is not given posthumously, 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 Perry Mehrling’s marvelous introduction, historical perspective, and unique orthodoxy of his day, and suggests how Black 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 hoping to understand today’s fi nancial crisis and its macroeconomic updated edition with a new foreword by fi nancial and economic meltdown. and policy ramifi cations. I recommend it most highly.” —Laurence Kotlikoff, Professor of Economics, Boston University Filled with the practical perspectives of one of the perry mehrling most innovative minds in fi nance, the Updated Edition of Business Cycles and Equilibrium: • Contains Fischer’s original essays, which reach Updated some interesting conclusions concerning the Edition role of equilibrium in a developed economy • Warns about the use and abuse of modeling • Explains the risky business of risk in a straightforward and accessible style

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ISBN: 978-0-470-49917-7 bindex.indd 198 8/24/09 9:40:43 AM Business Cycles and Equilibrium Updated Edition

Fischer Black

John Wiley & Sons, Inc.

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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

ffirs.indd ii 8/27/09 11:20:38 AM 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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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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P erry M ehrling

ischer Black (1938–1995) is best known for his fundamental contributions to fi nance, most famously the Black-Scholes option Fpricing formula that bears his name. He also aspired to contrib- ute to macroeconomics. Indeed, he viewed his contributions to macroeconomics 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 American 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,

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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 argument that “ a principal reason for introducing borrowing and lending 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 Money 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 households as liabilities, Black was led naturally to conceptualize the larger

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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, equilibrium 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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As leader of the research team that had recently produced the monetary 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 countercyclical monetary policy, but his opposition to Friedman’ s monetarism 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 chapter 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 logical 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 households (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 logical contradiction qualifi es as “ evidence that a government cannot control 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 logical

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consistency of the posited axioms. Inconsistency means that some axiom must be replaced; Black ’ s suggestion is to replace the axiom of active monetary policy with the axiom of passive monetary policy. The Keynesians, not being followers of Quine, were no more convinced by the second paper than they were by the fi rst. They understood quite well that their theories were disequilibrium theories, in the sense that they were theories of an economy away from full equilibrium, although possibly adjusting slowly in the direction of equilibrium. Indeed, their whole rationale for government policy intervention was to help the economy to move more quickly toward equilibrium. Whatever “ consistent, easy to exploit profi t opportunities ” might seem to exist in the theories, the observable fact of business fl uctuations must mean that people do not in fact exploit them, which means that there is a role for government policy. The whole purpose of economic theory, and of the elaborate econometric modeling built on top of that theory, is to provide a scientifi c guide for policy intervention. The economists ’ point of view is not obviously nonsensical. One historical origin of this view is Irving Fisher, who saw business fl uctuations as deviations from equilibrium caused typically by monetary disturbances, the “ dance of the dollar” (Fisher 1923). Arguing in quantity theory terms, Irving Fisher urged government control of the money supply as a way of controlling business fl uctuations. Modern Keynesians (such as Modigliani) understood themselves as merely going one better than Irving Fisher, by using control of government spending as an additional policy instrument, and one possibly better suited for addressing fl uctuations that are not monetary in origin. Modern monetarists (such as Friedman) disagreed with Keynesians not about the disequilibrium character of fl uctuations, but rather only about the effi cacy of activist countercyclical policy (both monetary and fi scal) as a remedy. The debate between the monetarists and the Keynesians was, from this point of view, an intramural debate following agreed ground rules. Black disagreed with the economists’ ground rules, but nonethe- less he tried hard to follow them in order to enter the debate, at least at fi rst. Economists seemed all to agree that, in the long run, the economy could be described as being in equilibrium. Taking advantage of this, Black thought he might be able to bracket the whole fraught issue of disequilibrium by presenting his monetary theory as a theory of the

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long run, and by demonstrating how the quantity theory of money made no sense even in that context. That is what he is trying to do in Chapter 2 (as well as Chapters 4 and 9).1 For this project, however, he found himself almost entirely alone, since essentially all economists, Keynesians and monetarists alike, were monetarists when it came to the long run. Black says, “ There ’ s only one other person I know of who takes a position almost as strong as mine” (p. 99). 2 Black did not mind being alone. Notably, his business-cycle theory says that economic fl uctuations are caused when large numbers of people make the same error because they base their reasoning on the same erroneous information. “ If that information is wrong, it will be wrong in the same direction for everyone. (Except that a few people may have ignored the information or may have assumed that it was wrong.) ” (p. 89). Black thought of himself as one of those few people. The dis- mal economic performance of the 1970s, performance that inspired the neologism stagfl ation to describe the combination of economic stagnation with simultaneous infl ation, was the material consequence of correlated error. In the world of ideas, the consequence was crisis in economic orthodoxy. The New Classical and then Real Business Cycle project to reconstruct macroeconomics on an equilibrium basis was very much in line with Black ’ s own predilections. Having resolved the matter of monetary theory to his own satisfaction, even if no one else’ s, he moved on to the more important matter of building a nonmonetary equilibrium theory of business fl uctuation.

Black’s Business Cycle Theory

In the present book, the development of Black’ s business-cycle theory can be followed in Chapters 6, 10, and 13. However, the underlying idea, that business cycles might be understood as an equilibrium, emerges much earlier in Black’ s own thinking. More or less from the beginning, he seems to have had the idea to extend Treynor’ s CAPM by conceiv- ing of the assets in the model not as ﬁ nancial assets but as real assets, which moreover arise endogenously because someone chooses to make a real investment. Black’ s ﬁ rst sketch of a general equilibrium CAPM, published in 1972 as “Equilibrium in the Creation of Investment Goods

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Under Uncertainty,” was essentially complete already in September 1969 as Financial Note No. 8. There is a continuous thread that runs from this initial paper to “ The ABCs of Business Cycles” (Chapter 10) and “General Equilibrium and Business Cycles” (Chapter 13), and indeed even beyond to his fi nal book Exploring General Equilibrium (1995). The standard fi nancial CAPM starts from the idea that there is an exogenously given supply of various different securities, and proceeds to work out a theory of market-clearing security prices given the risk preferences of wealth holders (Treynor 1962, Sharpe 1964, Lintner 1965). In equilibrium, everyone holds the market portfolio and adjusts risk exposure by borrowing or lending at the riskfree rate. In equilibrium, the expected return on any given risky asset depends on its riski- ness, which is measured by the covariance of its return with the market as a whole. More risk means higher expected return, but not necessarily higher actual return since returns fl uctuate around their expected value. Fischer Black saw in this simple CAPM the seed of a possible model of economic growth and fl uctuation. Business fl uctuation could be thought of as nothing more than the fl uctuating return on our economy ’ s underlying real stock of capital. If our capital investments are risky, then we can expect greater fl uctuation, but the reward will be a higher expected return (and higher economic growth to the extent that the higher return is reinvested). If we don’ t like the fl uctuations, the solution is not government intervention using monetary and fi scal policy, but rather a downward adjustment of the risk (and the associ- ated expected return) embodied in our capital stock. The CAPM analogy doesn’ t work all that well— it requires that we have instantaneous production and a single consumption good— but at least it is an equilibrium model, so we can safely start there and work on building in more reality. That is what Black is doing in the business- cycle chapters in this book. Ultimately, his business-cycle theory relies centrally on the presence of a large number of economic sectors, each producing a distinct good using specialized inputs that must be put in place some time before the good itself is produced. This time-lag feature of production forces everyone to forecast the future state of demand in detail, and errors are inevitable because the world is changing. When errors are few, we have a boom; when errors are many and correlated, we have a recession. Recessions are thus a matter of mismatch between

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the structure of production and the structure of demand, and the way out of recession is adjustment of the structure of production. That means moving people and resources from one sector to another, which takes time and involves some period of unemployment. This way of thinking seems to capture many, but not all, of the fea- tures of the fl uctuations we observe. To make the model more realistic, Black adds successively the idea that some goods are durable, and the idea that production is a team effort; what he does not add is any market failure or monetary disturbance. The general equilibrium model, properly understood, is consistent with almost everything we see; that is the central organizing principle of Black ’ s entire opus. In this respect, one way of understanding Black’ s work is as an attempt to extend the work of Irving Fisher to the case of uncertainty. Like Irving Fisher in his 1907 The Rate of Interest, Black built his fi rst general equilibrium model as the simultaneous solution to the household ’ s problem of “ Individual Investment and Consumption under Uncertainty ” (Black 1969), and the fi rm ’ s problem of “Corporate Investment Decisions” (Treynor and Black 1967). Also like Irving Fisher, Fischer Black went on to build a theory of money and business cycles on these general equilibrium foundations. Even more, Black seems to have taken his underlying vision of the economy from Fisher. In Fisher’ s treatise on accounting, The Nature of Capital and Income (1906), he presents a picture of the economy as a stock of wealth moving through time, throwing off a fl ow of services as its goes. In his formulation all wealth is capital, not just machines and buildings, but also land and even human beings. Indeed, for Fisher, human beings are the most important form of capital because the most versatile. Thus, at the highest level of abstraction, there is no distinction between the traditional categories of labor, capital, and land. All produce a stream of income (services) so all are capital, and their income discounted back to the present is their capital value. Similarly, at the highest level of abstraction, there is no distinction between the traditional categories of wages, profi t, and rent. All are incomes thrown off by capital, hence all are forms of the more general category of interest, which is the rate at which income fl ows from wealth. All this is in Black from the very beginning and throughout his career. The signifi cant state variable in all his macroeconomic work is

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the value of wealth, understood to include both physical and human capital. Further, human capital is quantitatively the more important (as Chapter 6), although measurement problems often prevent us from see- ing this clearly in economic data. As in Fisher, Black’ s emphasis is on the market value of wealth calculated as the expected present value of future income fl ows, rather than on the quantity of wealth calculated as the historical accumulation of saving minus depreciation. This allows Black to treat knowledge and technology as forms of capital, since their expected effects are included when we measure capital at market value. Fischer Black extended Irving Fisher to the case of uncertainty, but in so doing he arrived at some rather different conclusions. It was on precisely those points of divergence that he met resistance, since most economists remained attached to Irving Fisher’ s original conclusions. First, money. In his 1911 The Purchasing Power of Money , Irving Fisher revived the quantity theory of money, in part to provide the theory of the price level that was missing from his version of general equilibrium. Economics followed this lead, but Fischer Black did not, on the grounds that the quantity theory was inconsistent with equilibrium as he understood it. Second, business cycles. Irving Fisher analyzed business cycles as disequilibrium phenomena caused by monetary instability (1911, Chapter 4). In his theory, nominal interest rates adjust only slowly to changes in the rate of infl ation and the resulting changes in the real rate of interest cause real disequilibrium fl uctuations. Monetary stabilization that brings price level stabilization can therefore help to stabilize business cycles. Again, economics followed this lead, but Fischer Black did not. By adding in uncertainty, he could explain fl uctuations in economic activity using the same equilibrium approach that fi nancial economists were already using to explain fl uctuations in asset prices. This departure from the crowd meant that Black’ s work was mostly not publishable in academic journals at the time it was written. Only Chapters 2 and 4 managed to fi nd their way in; all the rest were publishable only in practitioner’ s journals, or by private circulation. Even, or perhaps especially, Chapter 13, “ General Equilibrium and Business Cycles, ” in which Black puts forth his business cycle theory, was rejected outright by the American Economic Review, and so found its fi rst public audience only in the present book. And, truth told, the present book itself was probably publishable only because of Black ’ s standing as

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president of the American Finance Association. Such is the fate of out- siders, no matter how long they spend inside. Probably, Black himself had high hopes for the book. Although his business-cycle theory had been unpublishable in 1982, the publication of papers by Kydland and Prescott (1982) and Long and Plosser (1983) showed that at least some academic journals were will- ing to entertain the idea of a nonmonetary equilibrium business- cycle theory. (Both papers are cited in Chapter 13 as unpublished memoranda.) Black thus had good reason to think that his own work might be appreciated as a forerunner of the Real Business Cycle approach ,3 maybe even as an indication of where that literature would eventually have to go. Black ’ s care to express his ideas in regular lan- guage, rather than formal mathematical models, might also have won for him a larger audience than the papers that found more favor with the academic journals. It didn’ t happen. The Real Business Cycle approach did ﬂ ourish, but in directions that Black found ultimately disappointing— too much mathematical and statistical technique for their own sake, and not enough engagement with the important facts in the material world. Nevertheless, he did not give up, and his second book Exploring General Equilibrium (1995) is an attempt to engage with the burgeoning academic literature. Readers will want to consult that book in order to ﬁ nd out what happened next.

The Crash, Then and Now

One test of a theory is whether it helps to explain what is happening in the world around us. From this point of view, which is very much Black ’ s own point of view, the original publication date of this book was singularly inauspicious. On October 19, 1987, the U.S. stock market experienced its largest ever percentage loss. This would have been the news ringing in people ’ s heads as they considered whether to engage with a book titled Business Cycles and Equilibrium. For anyone whose conception of equilibrium involved stability, the apparent volatility of the market appeared as prima facie evidence against any equilibrium theory. For Black himself, however, the 1987 crash was

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merely a recalcitrant data point that challenged him to think hard, and so he did in “ An Equilibrium Model of the Crash ” (1988). Black’ s story about the 1987 crash was that taste for risk increased as the stock market rose —in part because of portfolio insurance?—but investors did not fully appreciate the consequences of that taste change, so their beliefs about the world came to embody more and more error as prices rose higher and higher. The crash came when investors realized their error and corrected their beliefs, thus correcting also the price overshoot. Technical and psychological factors— Black says “ We might call this element ‘ liquidity ’ ” —came into play also as the crash itself produced trading bottlenecks and fear that drove prices even lower, temporarily. Black ’ s conception of equilibrium in 1988 was apparently much more capacious than it was in 1968, when he started out. Perhaps the most startling addition to his intellectual arsenal is the willingness to consider “ liquidity ” as an independent cause of price. This addition was long in coming, but Chapter 14, “ Noise, ” clearly demonstrates that it was in his mind well before the crash. In that chapter, the concept of liquidity is fundamentally microeconomic, and arises from the need to introduce “ noise traders ” to explain why there is any trade at all. “ The whole structure of fi nancial markets depends on relatively liquid markets in the shares of individual fi rms ” (p. 172). In his analysis of the 1987 crash, however, he extended the concept to the market as a whole. Still he resisted what for many economists would be the next logical step, namely to argue that there is a role for central bank intervention to ensure market liquidity so that markets do not overshoot on the way down. “ This led to a decline in the equilibrium level of the market that was greater than the decline a model would have fi gured — unless it accounted for the psychological factor” (1988, p. 274). What about the crisis that is under way at this very moment? Clearly, Black’ s vision of a world without money has largely come true, but his prescience was even greater than that. In an unpublished memo, titled “ Fundamentals of Liquidity” (June 1970), Black imagined additional dimensions of a future possible fi nancial world:

Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk; and one would bear

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the risk of default. The last two would not have to put up any capital for the bonds, although they might have to post some sort of collateral.

The instruments Black is suggesting are what we know today as interest rate derivatives and credit derivatives and, more speciﬁ cally, interest rate swaps and credit default swaps. A central dimension of Black’ s con- tribution at Goldman, Sachs & Co. was his development of models for pricing interest rate derivatives, but he died before the credit default swap became a standard instrument. Perhaps as much as $60 trillion in notional CDS exposure had been written by the peak of the boom that has now been collapsing ever since August 2007. What would Black have said about that? It is possible to imagine an account of the present crisis analogous to Black’ s account of the 1987 crash. For the present case, the changing taste for risk might most plausibly be located in the market for credit risk— in part because of credit default swaps?— but investors did not fully appreciate the consequences of that taste change, so their beliefs about the world came to embody more and more error as credit spreads grew tighter and tighter. As in 1987, eventually beliefs caught up to reality and the consequence was a price correction. As in 1987, liquidity factors kicked in to push prices even farther. As in 1987, domestic price movements stimu- lated similar price movements worldwide. Because the present crisis involves debt markets rather than equity markets, there is an additional dimension that Black would likely have pointed out. In his very ﬁ rst paper, he notes the possible impor- tance of guarantees on personal notes (pp. 12-13); these guarantees are credit default swaps. However, he also imagines that the providers of those guarantees will supervise the borrower, and that the government might require providers of guarantees to hold capital to ensure payment. In the case of American International Group (AIG), neither of these things happened, and the capital that has ensured payment to AIG counterparties has come from the government after the fact. The present crisis has also affected currency markets, including a breakdown of private forward exchange markets.4 Here as elsewhere, liquidity effects have very clearly been present, and central banks have taken it to be their job to use their own balance sheets to make

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up for the vanishing liquidity in markets generally. Notoriously, the Fed’ s balance sheet has already more than doubled in size. Was that the right thing to do? We cannot know for sure what Fischer Black would have said, but it would be consistent with his 1988 position to argue that central banks should have allowed the market to price the extreme scarcity of liquidity, rather than stepping in to impose an artifi cially low price. Finally, the fi nancial crisis is clearly spilling over into the economy as a whole. All major economies are in recession at the same time, and talk at the recent G20 meeting was all about using fi scal stimulus to substitute for falling aggregate demand. Black ’s view, of course, would be that the recession, global as it is, is an index of the extent of mismatch between the structure of production and the structure of demand. The only way out is to reorganize production by moving resources in order to bring the structure of production more into line. That is something that must happen in each country individually, but also at the global level, so it seems likely to take some time. The danger is that fi scal stimulus delays adjustment and so prolongs the recession. That is not, however, to say that the government should do nothing. Most important, Black would have called our attention to the possibility of a currency trap, which was his explanation of the Great Depression (p. 89-90, 105, 124-25, 162). Nominal interest rates are now practically zero, but prices are falling, and that means that real interest rates are still positive. The zero lower bound on nominal interest rates is a problem, and not one easily solved by quantitative easing because (according to Black) the money supply has very little to do with the price level. Facing such a dilemma, I wonder whether Black might have reconsidered his antipathy for measures that expand government provision of liquidity to take the place of vanishing private provision. That is not to suggest that he would have approved of the attempts by the Fed to impose an artifi cially low price for liquidity. Rather, the problem with the Fed’ s efforts so far is the excessively single- minded focus on liquidity in money markets, rather than in credit markets where the problem originated and where trade has more or less completely broken down.

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One thing is for sure. Fischer Black would not have been sur- prised that standard monetary and ﬁ scal policy measures have so far had so little impact on the crisis. “ Monetary and exchange rate policies accomplish almost nothing, and ﬁ scal policies are unimportant in causing or changing business cycles” (p. xxviii). Then, as now, economic crisis is also crisis for economic theory, and that is potentially a good thing. Crisis by crisis, knowledge advances.

Appendix: Origin of Chapters of Black (1987)

1. “ Banking and Interest Rates in a World without Money: The Effects of Uncontrolled Banking.” Financial Note No. 7 (Sept 5, 1968), revision published as Black (1970). 2. “ Active and Passive Monetary Policy in a Neoclassical Model.” Financial Note No. 17 (December 1, 1970), revision published as Black (1972). 3. “ Rational Economic Behavior and the Balance of Payments.” Financial Note No. 26 (1972), unpublished. 4. “ Uniqueness of the Price Level in Monetary Growth Models with Rational Expectations. ” Financial Note No. 27 (1972), revision published as Black (1974). 5. “ Purchasing Power Parity in an Equilibrium Model.” Unpublished mimeo (April 1974). 6. “ Ups and Downs in Human Capital and Business. ” Fischer Black on Markets No. 4 (March 29, 1976). 7. “ How Passive Monetary Policy Might Work.” Fischer Black on Markets No. 7 (May 10, 1976). 8. “ What a Non-Monetarist Thinks.” Fischer Black on Markets No. 8 (May 24, 1976). 9. “ Global Monetarism in a World of National Currencies.” Unpublished mimeo (September 1976), published as Black (1978). 10. “ The ABCs of Business Cycles. ” Published as Black (1981). 11. “ A Gold Standard with Double Feedback and Near Zero Reserves.” Unpublished mimeo (December 1981). 12. “ The Trouble with Econometric Models. ” Mimeo (April 1974), revision published as Black (1982). 13. “ General Equilibrium and Business Cycles.” Mimeo (April 1978), revised as NBER WP No. 950 (August 1982). 14. “ Noise. ” Speech (December 30, 1985), revision published as Black (1986).

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Notes

1. Chapter 9 is about the international version of the quantity theory. Fischer presents his own alternative theory of international money in Chapters 3 and 5. Initially, he is a supporter of fl exible exchange rates, because he imagines that forward markets will provide suffi cient hedging facility for international trade. Experience with fl exible exchange rates, however, seems to have made him more sympathetic toward a fi xed exchange rate system, as Chapter 11. 2. I asked him once who that person was, and he told me that probably he had been thinking of Arthur Laffer. 3. Jeremy Siegel, reviewing the book for the Journal of Finance (June 1988), said exactly that. 4. Baba, N., F. Packer, and T. Nagano 2008: The spillover of money market tur- bulence to FX swap and cross-currency swap markets, BIS Quarterly Review, March, pp. 73 – 86.

References

Black, Fischer 1969: Individual investment and consumption under uncertainty . Financial Note No. 6. Revised version published as pp. 207–225 in Portfolio Insurance, A Guide to Dynamic Hedging , edited by Donald L. Luskin. New York: John Wiley and Sons, 1988. Black, Fischer 1969: Equilibrium in the creation of investment goods under uncertainty. Financial Note No. 8. Revised version published as pp. 249–265 in Studies in the Theory of Capital Markets , edited by Michael C. Jensen. New York: Praeger, 1972. Black, Fischer 1970: Banking and interest rates in a world without money: The Effects of Uncontrolled Banking. Journal of Bank Research 1 (Autumn): 8–20. Black, Fischer 1972: Active and passive monetary policy in a neoclassical model. Journal of Finance 27 (September): 801–814. Black, Fischer 1974: Uniqueness of the price level in monetary growth models with rational expectations. Journal of Economic Theory 7 (January): 53–65. Black, Fischer 1978: Global monetarism in a world of national currencies. Columbia Journal of World Business 51 (Spring): 27–32. Black, Fischer 1981: The ABCs of business cycles. Financial Analysts Journal 37 (No. 6, November/December): 75–80. Black, Fischer 1982: The trouble with econometric models. Financial Analysts Journal 38 (No. 2, March/April): 29–37. Black, Fischer 1986: Noise. Journal of Finance 41 (No. 3, July): 529–543. Black, Fischer 1988: An equilibrium model of the crash. pp. 269–275 in NBER Macroeconomic Annual, edited by Stanley Fischer. Cambridge, MA: MIT Press.

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Black, Fischer 1995: Exploring General Equilibrium . Cambridge, MA: MIT Press. Fisher, Irving 1906: The Nature of Capital and Income . New York: Macmillan. Fisher, Irving 1907: The Rate of Interest, Its Nature, Determination and Relation to Economic Phenomena . New York: Macmillan. Fisher, Irving 1911: The Purchasing Power of Money . New York: Macmillan. Fisher, Irving 1923: The business cycle largely a ‘d ance of the dollar ’ . American Statistical Association Quarterly 18 No. 144 (December): 1024–26. Kydland, Finn E. and Prescott, Edward 1982: Time to build and aggregate ﬂ uctuations. Econometrica 50 No. 6 (November): 1345–1370. Lintner, John 1965: The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics 47 No. 1 (February): 13–37. Long, John B., Jr., and Plosser, Charles I. 1983: Real business cycles. Journal of Political Economy 91 No. 1 (February): 39–69. Sharpe, William 1964: Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance 19 No. 3 (September): 425–442. Treynor, Jack L. 1962: Toward a theory of market value of risky assets. pp. 15-22 in Asset Pricing and Portfolio Performance , edited by Robert A. Korajczyk. London: Risk Books, 1999. Treynor, Jack L. and Black, Fisher 1967: Corporate investment decisions. Financial Note No. 2 (September 12). Revised version published as pp. 310-327 in Modern Developments in Financial Management, edited by Stewart C. Myers. New York: Praeger, 1976.

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