Introducing the Novelty-Narrative Hypothesis

Historically novel events cause the processes driving stock market returns to change in unforeseeable ways. This kind of instability famously eludes representation in terms of standard probability theory, which relies on past data. To deal with so-called “radical” or “Knightian” uncertainty, market participants rely on narrative dynamics to help give shape and contextual meaning to novel events as relationships change in real-time.

This is the essence of the Novelty-Narrative Hypothesis (NNH) that I assess in my new book, How Novelty and Narratives Drive the Stock Market: Black Swans, Animal Spirits and Scapegoats published as part of INET’s book series with Cambridge University Press. This new approach enables researchers, policy-makers, and investors alike to better understand stock market outcomes and confront unforeseeable change and the Knightian uncertainty it engenders with real-world observations and scientific scrutiny. Standard economics relies on probabilistic rules which presume that the future is an exact replica of the past and, as such, is unable to deal with “true” uncertainty. NNH offers a way forward.

Why is change in stock market relationships unforeseeable? Frank Knight famously traced the answer to events that are to some extent historically unique. The last two years perfectly illustrate Knight’s point. Financial markets have had to grapple with an unprecedented pandemic, historic US Congressional stimulus, dramatic supply chain disruptions, and sharp pivots toward more remote forms of both labor and commerce. Simultaneously, there has been an oil war between Saudi Arabia and Russia, the arrival of a new US presidential administration, shifting geopolitical conflicts in the Middle East, and, now, substantive talk of Federal Reserve tapering in the face of creeping inflation. Such events catalyze change in business processes and in the economy’s overall structure. Yet, true uncertainty implies that no one can foresee when such events would occur or, more importantly, how their impacts on future returns are interpreted by market participants at a given point in time.

My book offers the first comprehensive analysis of the role that stories play when novel events cause instability in the stock market. Stories are visceral, contagious, and ever-evolving. Stories share a living symbiotic relationship with the people and communities that tell them. Stories reflect a society’s culture, values, institutions, experiences, diversity, and politics. Stories are the consequence of uncertainty, but also serve as a source of uncertainty themselves. Stories are the currency of uncertainty. People tell stories that others have told them and major events are often the catalysts for many of the most popular story threads coursing through our minds, discussions, news reports, business communications, and social media feeds.

Macro shocks, however, do not occur in isolation. Rather, large-scale non-repetitive events often spill over into a churning stream of novelty at the firm level, think bankruptcies, management shake-ups, legal issues, M&As, new production processes, and so on. What’s more, the interpreted impacts of macro shocks on firm outcomes may be quite ambiguous; often, the distinction lies with short- versus longer-run return forecasts and the accompanying narrative links versus established story threads, respectively.

My book relies on a novel dataset based on millions of identified unscheduled corporate events across the universe of Dow Jones, Wall Street Journal, MarketWatch, and Barron’s financial news reports over the last two decades. I assess the intensity of narrative dynamics through big data analysis of event novelty, inertia, sentiment, and relevance. These metrics are then interacted to show how narrative intensity aligns with formal structural breaks in posited relationships driving returns, volatility, and fund flows. Interestingly, the narrative dynamics of firm-level events correspond rather closely with macro event narratives. But the empirical evidence shows that macro unscheduled events spill over onto future corporate novelty triggering different forms of stock market instability.

Narrative economics is a popular and growing field of research. Unlike other treatments of narrative dynamics in the stock market, my book places psychology in a rational setting of cognitive decision-making under uncertainty. Evidence from other social sciences supporting a rational view of sentiment is overwhelming. What’s more, my book does not trace the source of narrative dynamics to random chance, evolutionary biology, or psychological disorders, as others have contended. Rather, NNH implies that narrative dynamics stem from historically unique events and the unforeseeable structural change they engender in stock market relationships. Put differently, my book advances the view that the role of novelty and narratives reflects the normal state of affairs in inherently unstable asset markets. Consequently, my book breaks away from mechanistic models of contagion used to describe narratives’ impact on market outcomes.

The missing link to deal with inherent instability and uncertainty is narrative dynamics. Story threads are the primary source of soft information for researchers, policy-makers, regulators, and market participants alike. This year, we are witnessing an evolving interplay between the narratives of inflation pressures and narratives following Chair Powell and the Federal Open Market Committee. Yields on 10-year Treasury Notes increased from 1% in February 2021 to over 1.5% through June. Google Trends searches for “Jerome Powell” spiked in March as yields increased. Google Trends searches for “inflation” began to rise in April 2021 and peaked in May. There appears a connection between the stories individuals are participating in and the outcomes observed in financial markets.

In March of 2021, billionaire investor Ray Dalio claimed that “investing in bonds has become stupid.” He has publicly reiterated this view on September 21 which prompted the following Bloomberg News interview query posed to Michelle Seitz, CEO of Russell Investments: “A very common theme here has been 'don’t buy bonds’ ever since Ray Dalio said it (again this morning) and you have said the same. So where do you go?” Are narrative dynamics at play here? Was there an underlying market event that aligned with the timing of the comments? Was Dalio or Seitz providing a narrative link that extends an established story thread or were they cultivating a new narrative angle? Narrative analytics would explore the emotional intensity of the surrounding linguistic context. It would track the stories’ visibility and mileage observed by the general public and by financial institutions. Narrative analytics would investigate the possible contagion and propagation of the view by other major investment figures and personalities. And, narrative analytics would always keep in mind the time-series behaviors of these metrics and their interaction as many other events unfold simultaneously.

The toolkit under NNH can be used in myriad ways by researchers and policy-makers for informing financial market decisions under uncertainty. For example, investigators might consider tracking the narrative attributes surrounding unscheduled events mentioned in 10-K and 8-K corporate statements, IPO prospecti, or in the SEC disclosures of Venture Capital firms. By tracking the way CEOs and other executives discuss particular issues on their shareholder calls or through other investor relations, dynamics of firm-level and industry narratives could be revealed. Which subsets of soft information are they emphasizing? How are they framing the soft information? NNH offers an empirical, pragmatic framework for addressing these questions and many more.

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Models of Temperature and Economic Growth: Some Cautionary Remarks

Several major papers have been published over the last ten years claiming to have detected the impact of either annual variations in weather or climate change on the Gross Domestic Products of most countries in the world. At least seven major papers have been published in this vein, including some that rely primarily rely on the results of previous papers. The results have gotten a fair amount of attention in both the news media and in climate change newsletters.

Many of these papers go on to argue that as average annual temperatures increase in countries in the coming decades the changes in temperature will have a very large impact on GDP growth rates. This literature suggests that cooler countries will tend to have increases in their GDP growth rates while warmer countries will experience decreases in their growth rates.

Unfortunately, because the statistical methodologies relied on by these studies are not scientifically justified, their quantitative and qualitative results are wrong. My new INET Working Paper argues that they seriously mislead the climate change research community, policymakers, and the general public. The key point about these statistical methodologies is that they violate basic principles for the correct use of multivariate regression analysis for scientific research. They do not include any of the appropriate and usual economic factors or variables which are likely to be able to explain changes in GDP or economic growth whether or not climate change has already impacted each country’s economy. The work in these papers, accordingly, suffers from “omitted variable bias,” to use statistical terminology.

Some of these studies also claim that the likely impact on the GDPs of various countries and regions can be calculated for the long-range future well beyond the time period covered by their database – sometimes as far into the future as the year 2100. Climate change is a fact, but my paper also cautions against such sweeping extrapolations.

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Remembering Geoffrey Harcourt (1931 - 2021)

Geoffrey Colin Harcourt passed away in Sydney, Australia on the 7th of December 2021. He was born in Melbourne on the 27th of June 1931.

His signature G.C. Harcourt became a familiar name for the many people the world over who followed his always insightful writings for more than six decades. Harcourt was, with Luigi Pasinetti, a principal heir of the Cambridge Post-Keynesian school of economics. He studied accountancy and economics at the University of Melbourne where – as he himself stated – the famous names of the Cambridge University Economics department were very much part of the academic life there.

In 1955 he went to Cambridge University where he gained his Ph.D. In 1957 the University of Adelaide appointed Harcourt to a Lecturer position and in 1967 he was promoted to a Professor’s Chair. Harcourt rapidly became an important contributor to the Cambridge school of thought. At the University of Adelaide he was among the founders and editor of the Australian Economic Papers in 1963, a journal that became a reference point for heterodox scholars throughout the world. In 1964-66 Geoff Harcourt returned to lecture at the University of Cambridge as a Fellow of Trinity Hall, followed by other lecturing stints in 1972-73 and in 1980. In 1982 he moved permanently to the Economics Department of University of Cambridge where he became Reader. He was Fellow of Jesus College, and its President for most of the time from 1988 to 1992. Harcourt also served for eight years on the Council of the University of Cambridge. Upon retirement in 1998 he was nominated Reader Emeritus in the History of Economic Theory at the University of Cambridge as well as Emeritus Fellow at Jesus. Harcourt returned to Australia where he was appointed Honorary Professor of Economics at the University of New South Wales in Sydney. In 2018 he was made a Companion in the General Division of the Order of Australia for "for eminent service to higher education as an academic economist and author, particularly in the fields of Post-Keynesian economics, capital theory and economic thought."

Harcourt gave a particularly nuanced, refined, and wide-ranging contribution to the famous capital debates, publishing in 1969 what has become a well known article in the Journal of Economic Literature: "Some Cambridge Controversies in the Theory of Capital." That was followed in 1972 by a monograph with the same title published by Cambridge University Press, which is among the most widely read on the subject. The debates were revisited in depth in a joint paper with Avi Cohen titled “Retrospectives: Whatever Happened to the Cambridge Capital Theory Controversies?” published in the 2003 volume of The Journal of Economic Perspectives. Over the decades Harcourt’s essays have been collected in many books. In 2006, with Cambridge University Press, he published The Structure of Post-Keynesian Economics: The Core Contributions of the Pioneers. The volume constitutes a fundamental piece of work as it discusses the whole development of the different strands of the Cambridge School. In 2009, co-authored with Prue Kerr, Harcourt published with Palgrave-Macmillan the definitive book on Joan Robinson. Intellectually and humanly Geoff Harcourt was an exceptional person.

The INET community mourns his passing and extends its deepest condolences to his wife Joan, to their daughters Rebecca and Wendy and their sons Robert and Tim.

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Should Central Bank Liquidity Provision Be a Vehicle for Fiscal Discipline?

Unconventional monetary policies after the financial crisis have been extensively discussed and analyzed, with the notable exception of the collateral policies at their core. The work by Kjell Nyborg is a rare exception. On the basis of an in-depth analysis of the collateral policies pursued by the European Central Bank in the wake of the financial crisis, he argues that those policies aggravated the sovereign debt crisis and put the survival of the euro at risk. Nyborg’s analysis of collateral policy is an important contribution to the literature, but his critique of the ECB’s crisis response is misguided. Moreover, his proposal to retailor haircuts on central bank liquidity in a manner that would deepen the ECB's role in the fiscal disciplining of member states is dangerous: if adopted, it would be profoundly procyclical and destabilizing. Our new INET Working Paper analyses Kjell Nyborg’s work to identify a set of collateral policy principles that likely will ameliorate impending market liquidity crises as opposed to exacerbating them.

What is the role of collateral policy?

Central banking is widely seen as first and foremost a matter of using interest rates to achieve monetary policy goals. Central banks lend not merely at a cost, however, but always against securities. Borrowers pledge assets to access central bank funding. In this sense, the lending is secured. While secured lending exists in many forms, one feature is a constant: what is accepted as collateral varies significantly over time.

What the European Central Bank (ECB) accepted as collateral before and after the financial crisis were two altogether different things. When money and credit markets are liquid and well-functioning, central banks take a conservative approach, accepting only high-quality assets as collateral. In periods of market stress, on the other hand, they usually respond by accepting a wider range of assets as eligible collateral.

Overall, three core factors define the contours of central bank collateral policies. First, eligibility criteria set out what assets are eligible as collateral when banks seek access to central bank money; second, haircuts determine how much central bank money a bank will receive (as a percentage of the market value of the collateral) for different types of eligible collateral; and third, stipulations on counterparty access define what types of financial institutions the central bank is willing to provide lending to.

The haircut can be seen as the central banks’ insurance against liquidity risk. Should the borrower be unable to pay back the loan, the central bank can avoid a net loss, even if it has to sell the collateral at a price below the original market value. In this sense, haircuts are a risk management technique for central banks. Since the global financial crisis, it has become apparent, however, that haircuts have important implications for liquidity in the markets where collateral trades.

Since most collateral in the Eurozone is issued by Member States, the ECB’s collateral policy has significant impacts on liquidity and price in sovereign bond markets – that is, ECB’s collateral policy has significant, if deeply underappreciated, fiscal spillovers. In the early stages of the crisis, spreads between German bonds and ‘periphery’ Eurozone countries were amplified by the ECB’s collateral policy.

What is wrong with Nyborg’s critique of the ECB’s collateral policy?

The main message of Nyborg’s book is that the terms on which ECB supplied money for collateral during the crisis were “overly generous.” We argue that Nyborg’s characterization of the ECB's collateral policy is highly misleading, however. In fact, haircuts were increased several times for assets with low credit ratings. Moreover, haircut differentials – the spread between haircuts on collateral assets with a high and a low credit rating – widened, hence producing a contractionary rather than an expansionary effect on collateral space.

Before October 2008, the ECB applied identical haircuts to all European government debt. There was no distinction between high- and low-quality collateral in this asset class. After the collapse of Lehman, the haircuts on highly-rated government debt remained at the same level, while all lower-rated government debt was assigned haircuts 5 percentage points higher.

Overall, three observations about changes made by the ECB to its haircut schedule stand out. First, haircuts for high-quality collateral were kept low throughout the crisis (and even declining for longer residual maturities). Second, for government bonds with a low credit rating, the opposite trend prevailed. Assets with a low rating faced a dramatic increase in haircuts, in the range of 550 to 850 basis points (depending on residual maturities), seen over the full period. Third, the haircut spread – between assets with a low (B to BBB-) and a high credit rating (A to AAA) – jumped 500 basis points in October 2008, was unaffected by the January 2011 revision, but increased again in October 2013, with 50 to 400 basis points (depending on residual maturities). For short residual maturities, the haircut spread jumped by 50 basis points (from 500 to 550), while for long residual maturities it increased by 400 basis points (from 500 to 900).

Over the full period, haircuts on government bonds with a low credit rating and residual maturity of less than one year were increased 12-fold, from 0.5% to 6%, whereas haircuts for the same class of government bonds with a residual maturity of 7-10 years nearly tripled, from 4.5 % to 13 %. These are hardly trivial increases.

We suggest that the haircut changes do not match their depiction by Nyborg as “overly generous”. On the contrary, it is difficult to imagine that haircut increases at this scale did not add to the already severe liquidity strains of troubled banks and governments in distressed countries.

What’s the way forward for collateral policy?

In Nyborg’s view, future instances of over-borrowing by banks and sovereigns ought to be prevented by using haircuts in a punitive manner. “The idea is simple,” he says, “if a debt-to-GDP ratio of no more than 60 percent is desired,” all you need to do is “increase haircuts progressively in the debt-to-GDP ratio beyond this.” The same mechanism can be established for fiscal deficits, such that haircuts are increased progressively as fiscal deficits exceed agreed thresholds. “My proposal works,” explains Nyborg, “by reducing the liquidity and value of a highly indebted country’s bonds.” By increasing borrowing costs, the “appetite” for borrowing in excess of agreed thresholds should recede.

We strongly oppose Nyborg’s proposal. If haircuts were proportional to fiscal deficits and public debt to GDP, collateral policies would exert a pro-cyclical and destabilizing influence not just on collateral markets, but on the financial systems they anchor. For a central bank to combat a market liquidity crisis effectively, it must decrease haircuts, not increase them – and more so for assets with low ratings, such that haircut differentials narrow rather than widen. This is essential to market liquidity. Incidentally, it is also by far the best risk management strategy, because the need for liquidity injections and asset purchases will be much more speedily satisfied with this policy mix.

Our Working paper argues that the ECB's ambivalent strategy – of providing liquidity but raising haircuts on distressed assets – did not amount to “lending freely, against any and all collateral that is good in normal times”, as we believe Bagehot’s rule advises. By expanding collateral eligibility but raising haircuts and haircut differentials, the ECB was undermining the market liquidity it was trying to restore. To stop collateral valuation spirals, central banks must lower haircuts and haircut differentials – and suspend rather than follow the collateral valuation practices of financial markets.

Should we hold back for fears of moral hazard?

Countercyclical collateral policies are likely to be subjected to a standard criticism against measures that ease access to central bank liquidity. Such policies cause a moral hazard for both governments and banks, who would get access to funding on “subsidized” terms. Notably, lowering haircuts on central bank liquidity would amount to encouragement of “overborrowing” by banks that might in fact be insolvent and hence should not receive central bank funding.

Against such objections, we suggest that one must first acknowledge that liquidity provision and moral hazard are best dealt with separately. In much the same way as it would be “a terrible mistake”, in the words of Paul de Grauwe, if a central bank were to “abandon its role of lender of last resort in the banking sector because there is a risk of moral hazard”, we suggest that compromising collateral expansion by raising haircuts is a highly unfortunate conflation of strategies. The point is not that moral hazard problems should be ignored; only that they should be addressed differently. The solvency of individual banks is a task for micro-prudential regulation and supervision, not a concern that should be held against collateral policies designed to ease a market liquidity crisis.

Research has established that the moral hazard effects of liquidity provision are less detrimental than those resulting from direct recapitalizations of banks, the dominant response to bank insolvencies. The upshot is, we argue, that even if the main objective is to reduce moral hazard issues in banks to the largest possible extent, lowering haircuts likely will in fact contribute positively. By helping abate the liquidity crisis, incidences of banks becoming insolvent are reduced, and hence moral hazard in its severest form is minimized.

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Looking for a Libertarian Who’s Not Afraid of History

The Wall Street Journal opinion section is nothing if not persistent. It rushed to print a critique of my detailed, primary source-based study of how Milton Friedman exploited southern resistance to desegregation to promote his ideas for privatizing public education by Phillip W. Magness. But obviously that wasn’t enough. When another scholar and I answered point by point, including in a longer version on INET’s site, the Journal came back with yet another screed of his.

The latest response is as insubstantial and factually incorrect as the first one. Let’s begin with his claim that “Rather than engage the economist at his word, Ms. MacLean imputes opportunistic motives to the date of Friedman’s 1955 article on the economic theory of school choice—one year after Brown v. Board of Education.”

What my piece actually did was to document how, from 1951 forward, the national press was reporting threats from segregationist officials to turn to private schools if faced with a mandate to desegregate public schools. This renders irrelevant Magness’s suggestion that the pre-Brown timing of Friedman’s drafting of his pro-voucher manifesto is exculpatory on its face. At the same time I was clear that “Whether or not Friedman had Dixie in mind as he drafted his article, he indisputably did all he could to take advantage of the opening created in early 1956 when southern states began ‘massive resistance’ to Brown.”

Friedman’s unpublished correspondence, which I quoted from in the original piece, leaves no doubt about his determination to use the emerging southern white resistance to promote his theory. When Friedman submitted his draft piece in October of 1954, Robert A. Solo, the economist who was editing the collection in which it was to appear, challenged him to consider how it could abet the segregationist cause. Friedman persisted. In answer to Solo’s challenge, Friedman responded that he opposed not only “forced segregation” but also “forced nonsegregation.” That is, he opposed the Supreme Court mandate to integrate southern schools.

Why is that so hard for Magness to admit? After all, Friedman went on to oppose the Civil Rights Act, as did his fellow libertarians. Do their heirs think they can keep such ongoing opposition to anti-discrimination measures a palace secret?

My essay also showed how Friedman found an ally in Leon Dure, a former newspaperman who was then fundraising for two Charlottesville segregation academies and advising southern states on strategy to defy Brown with a better chance of surviving court review. Friedman supplied Dure with ideas he used to win allies to his approach, as well as contacts for his outreach. What does Magness make of those strategy discussions? He doesn’t say; he just ignores them.

Magness then doubles down on his fanciful story of the roots of the strategy of “massive resistance” to the Supreme Court order that another researcher had already written to rebut.

The only difference between Virginia’s 1959 tuition grant plan and what Magness refers to as “the arch-segregationist ‘Massive Resistance’ laws of 1956-57” is that the segregationist backers of both—ultimately the same individuals in key cases--learned they needed to adopt formal color blindness to survive court review. I documented this learning process, aided by Friedman’s economic arguments and Dure’s evangelizing, but Magness, like the proverbial “see no evil” monkey, simply puts his hands over his eyes so he can hold on to his dogma undisturbed.

The NAACP, whose Legal Defense and Education Fund led the fight in the courts, consistently opposed the vouchers that Magness speciously claims were “a tool to achieve” integration. If Magness is right about their purpose, why would those in the best position to know fail to see this? And why did the courts come to agree that the vouchers promoted racial segregation and denied equal protection of the law to African American citizens? Magness never even addresses these points, much less explains why anyone should trust him rather than NAACP attorneys such as Virginia’s Oliver Hill and federal judges.

Milton Friedman himself ignored six years of mounting evidence of the segregationist impact of vouchers between 1956 and the 1962 publication of Capitalism and Freedom, in which he recommended the Virginia Plan, acknowledging that the state government aimed “to avoid racial integration” (p. 100, n. 5; also 118). So, why does Magness call me “brazen” and “conspiratorial” and engaged in “smearing” for sharing this indisputable history?

It’s time that Friedman’s admirers, the Journal’s opinion page, and the many supporters of diverting tax revenues from public education to private schools come to terms with the real history of their cause. They seem to imagine that sound defense requires belligerent denial of the factual record. Is any cause served by such blind faith?

Again, I ask Mr. Magness’s fellow libertarians: is even one of you willing to examine this history without defensiveness but instead with due recognition of the need for honest reckoning?

The disastrous consequences of segregation and the many efforts to revive it for political gain are, I hope, obvious. It’s time libertarians give up disinformation as a strategy of dealing with troubling matters. They could start by grappling seriously with their history in regard to race and education.[1]

Note

[1] See Nancy MacLean, “'Since We Are Greatly Outnumbered’”: Why and How the Koch Network Uses Disinformation to Thwart Democracy,” for The Disinformation Age, eds. Lance Bennett and Steven Livingston (Cambridge University Press and the Social Science Research Council, 2020). Free for downloading here.

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