by Philip Pilkington
A conversation that I was having some time back reminded me of a rather funny point in economic theory. When we consider the value of a financial asset we take into two components: that is, it’s price and it’s income stream. It’s price is a sort of stock variable while it’s income stream is a flow variable.
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Now that’s all rather simple and elementary. But once we subject these two variables to some degree of uncertainty it becomes impossible to truly calculate the value of the asset moving into the future in any meaningful way.
Let’s take a concrete example: that of a government bond. Let’s say that the bond is worth $1,000 and is paying 5% interest a year and must be redeemed in ten years. If time was completely homogenous and the future was identical to the present I can calculate whether I should hold this bond vis-a-vis another financial asset rather easily. The same is true if I know that the future is going to change and in what direction it will change. But if the future is uncertain it becomes well-nigh impossible — at least in any fully rational manner.
I don’t know what will happen in the market between now and the time I want to sell the bond. It’s value might rise substantially vis-a-vis other assets or it might fall. All I can really do is take a punt on it and hope that I have an edge on the other guy; hope that I noticed some trend developing that he missed.
Okay, well that’s all very obvious, right? But now consider the way economic theory tends to think about rates of interest and so forth. James Tobin discusses this on a nice paper entitled Commentary on Irving Fisher, The Nature of Capital and Income reviewing Irving Fisher’s early book on the nature of income and capital. His first example is quite illuminating in this regard.
Would you rather live in economy J or economy U, when U is currently producing and consuming more but J is building more capital facilities and is growing faster? Samuelson’s conclusion is in the spirit of Fisher and of Hicks. Do not compare current incomes on any definition. Instead, measure welfare as the discounted value of the expected consumption stream of an individual or an economy. (p8)
Note already the dreaded word ‘expected’ rears its ugly head. Samuelson and the other marginalists merely say that we should ignore present income and instead make a judgement based on future income. Not only would I argue that this is not the way many people behave but I would also argue that it is not particularly rational because we cannot know the future.
Take an example. Imagine that I am living in London at the moment. I have a free ticket to move to Paris. Real wages are higher in London and all other conditions are identical in both cities, except that house prices are rising faster in London than in Paris. Even though I think that I’m fairly good at spotting housing bubbles I am not sure at all whether there is actually a housing bubble in London, whether it will burst or whether it bursting will have a substantial effect on either my wages or my employment situation. I have quite simply no way of accounting for this. (Although most of this is fiction the situation with property prices in London at the moment is precisely as I say it is).
In such a scenario — which is not totally unrealistic — I have no way of “discounting my future consumption streams” and the decision that I would likely make would be to stay in the high-income city with the rising house prices and take my chances. Indeed, any attempt to try to measure future events on which I cannot even place a realistic numerical probability would be, when all is said and done, a bit deranged. I might as well take up astrology or fortune-telling. To spin such activity as being ‘rational’ is really a bridge too far and actually an affront to what I would consider actual rational discourse.
This goes to a more immediate problem, especially in financial theory. Tobin writes of Fisher’s book:
[The] most important [idea in the book is] that the value of an asset is the capitalization of the stream of future services thrown off by the asset. (p9)
He then goes on to say that in Fisher’s later work this idea would become the basis for “the equilibrium condition for determining interest rates” — in contemporary parlance Fisher would go on to construct a time preference theory of the interest rate (give up consumption now for more consumption in the future) and the equilibrium condition would be the point at which society would maximise its utility at a given moment in time.
But look at the problems this throw up. First of all, how do I measure the “value” of the future services the asset will throw off? I do not know what I will want two days from now, let alone six months from now. An expensive t-shirt is far more ‘valuable’ to me if we have a hot summer than if we have a cold and wet one but there is no way on earth I would base my purchasing decisions on weather forecasts 3-6 months out! Thinking that I can somehow determine how “valuable” the services given out by an asset are in the future in any exact way is as ludicrous as trying to make the decision based on some quasi-numerical calculation as to which city I should work in. What if I get bored of the service the asset produces, for example?
More important than this, however, is the indeterminacy surrounding the price of the asset in question. How can I compare the services of, say, a car or a house to other goods when the relative prices will change in the future in line with (highly uncertain) asset price valuations? For example, if my house is worth £500,000 today I can in some very limited sense compare the “value of its services” with other goods in the economy. But what if the market collapses tomorrow and it falls in value to £250,000? How can I try to calculate the future opportunity cost of not holding another asset when all assets are subject to highly uncertain price dynamics? Simple answer: I can’t. I can only take a punt.
I have a pretty economical mind. I like to think I’m pretty good at making financial decisions and making money. And given that I have a fair grasp of macroeconomics and tend to be able to spot trends I probably have an edge over a substantial amount of the population. If I can’t make these decisions in a perfectly calculating manner then how on earth can economists try to build their theories of how the economy functions based on the idea that everybody in the economy is doing such calculations?
The fact is that anything such a theory produces — any ‘results’ — will only be so much dross. They will have no relevance to the real world whatsoever. Not in this universe, anyway. And that is why the Keynesian idea of uncertainty literally destroys anything resembling mainstream economics — whether micro or macro. Robinson once quipped that Keynes hadn’t taken the twenty minutes necessary to learn the marginalist theory of value. I don’t know if this was actually true but it it was, it would be quite understandable. He had already constructed his theories of probabilities and studied the money markets in depth. What nonsense the old marginalist theory must have looked like to him!