Finance: The Tug-o'-War Model, 6/2
How I think about financial markets
Image source: https://www.sportsrec.com/164624-tug-of-war-rules.html
The Market can remain irrational longer than you and I can remain solvent
—sometimes attributed to Keynes, but more likely due to Gary Shilling
Both economists and non-economists often treat the market for financial assets as if it were a single person. In economics, this is known as the “representative agent.” We are all identical. The price of Bitcoin settles at $30,000 because we all believe that is the right price, so there is no excess demand or excess supply at that price.
Instead, I carry around in my head what I call the Tug-o’-War Model. There are people on one side who think that government-issued money is headed toward oblivion, and Bitcoin is going to be worth a lot more than $30,000. There are people on the other side who think that Bitcoin is a Ponzi scheme, and it is going to be worth a lot less. The bulls either don’t have the funds to buy more or are too unsure of themselves to want to buy more. The bears are afraid to sell short any more than they already have. Almost no one believes that $30,000 is the right price. The price settles there because there is a balance between the people inclined to tug it higher and the people inclined to tug it lower.
In a tug-o’-war, one side may weaken a bit. Some people stop pulling their hardest. (In financial tug-o’-war, a few people may even switch sides.) When one side weakens a bit, the rope moves a few feet until the sides are pulling equally hard again.
That is how I think the stock market moves up and down. Optimists pull a bit less hard, and so the market goes down. Pessimists pull a bit less hard, and so the market goes up.
As far as I know, the only economist to embrace something like the tug-o’-war model is Mordecai Kurz. Here is one of his papers.
The tug-o’-war model is consistent with Antti Ilmanen’s maxim that in order for you to be able to take a position there has to be someone on the other side. I wrote about Ilmanen’s views here.
Even if you think that you have found an arbitrage opportunity, there is someone on the other side. If you can buy something for $99 here and sell it for $100 there, it must be the case that there are people buying it there for $100 and people selling it here for $99. That is a sobering thought.
When I have a strong opinion about the market, I wonder what the other side is thinking. For example, I don’t understand why stock and bond prices rallied the last full week in May. I believe that in order to bring down inflation, we will need to see either much higher interest rates or a recession, or both. With higher interest rates, long-term bonds will do especially poorly. With a recession, stocks will do especially poorly.
The only scenario that I can see that justifies optimism about stocks and bonds is the scenario I call Immaculate Disinflation. In this scenario, inflation comes down even while interest rates are below the rate of inflation and also while firms are producing near capacity and struggling to find workers. The Fed is forecasting Immaculate Disinflation, and people on the other side from me seem to want to believe the Fed.
I do not think that Immaculate Disinflation is going to happen. But even if I turn out to be right, the other side can keep believing in that scenario longer than you and I can remain solvent.
The Tug of War is a great metaphor. There is no "market", just people, buyers & sellers. Or, a buyer (price too high) and a seller (price too low) who agree to invest according to their beliefs (which often include inside knowledge) (and lots of fake news.), for each transaction. The "market" is a word that means the sum of all the transactions, total buyers tugging up against total sellers tugging down. The price is what is discovered about the aggregate.
I don't believe in huge labor shortage, because a) the employment is high, but not so high, and b) wage growth has been high, but not so high (in most lower paid jobs). Funny how US says employment rate is slightly lower now at 60%
https://tradingeconomics.com/united-states/employment-rate
While OECD stats say US employment rate is at 71%
https://data.oecd.org/emp/employment-rate.htm
If rich country economists can't agree on a definition and what the actual facts are, it's certain that there will not be consistent forecasts about financial future trends.
Despite Libertarians talking about regulations, I don't yet read the Fed talking about regulations and restricting supply is part of what is driving inflation.
This is wrong. The first part of the post is wrong about a price being right. No price is right even in textbooks teaching the forces conditioning prices over time for different goods, services, and assets. In textbooks, "solving for the equilibrium" is just a tool to explain how people interact and how people may respond differently to changes in those forces. In the case of financial assets, bitcoin in particular, we can argue that one important force is the expectation of changes in the assets' purchasing power and we argue it recognizing how people differ, especially about that expectation.
All that is very entertaining --at least for serious economists. But the post's second part is very frustrating for serious economists because everybody hardly knows which prices are changing and how much. Also, we rely heavily on the fake clowns reporting prices and spreading rumors. Yes, the financial press can report how the prices of financial assets are changing and how their purchasing power (measured by baskets of goods and services) has been been changing but reporters cannot infer how prices will be changing even in the next few hours, much less tomorrow. Serious economists know that even their best models can hardly predict well prices' path, and by definition they cannot anticipate "shocks", including what a senile President will do, re-do, and then deny/confirm he had done it. Serious economists know that price indexes may differ a lot because of large differences in the relative weights of the goods, services, and assets actually included in their estimation. Serious economists know that shocks in energy markets will affect price indexes differently --first by their direct impact if energy is included in the estimation, then indirectly because of how many other prices may change due to the shock in energy prices. Yes, Milton Friedman called inflation any continued, generalized increase in the price index of broad basket of goods and services, and made clear that his monetary theory of nominal income assumed that the demand for M was stable and the supply of M was controlled by its only supplier. But there is no M which meets Milton's two conditions. Indeed, it's difficult to explain recent increases in a price index by looking only at past increases in any M (that was why Milton liked to talk about lags). So, don't be surprised that we cannot explain increases in several price indexes in the past 3 years by reference to M0 or M2 or any other M. Worse, some Ms may have increased but in response to the increases in prices (this is what passive money models assume to prevent the shock's negative impact on people's demand for most goods and services). If we work hard, maybe by 2030 we will have a good idea of what happened the past 3 years.