Brad DeLong, May 25:
WHAT ARE THE CORE COMPETENCES OF HIGH FINANCE?
The core competences of high finance are supposed to be (a) assessing risk, and (b) matching people with risks to be carried with people with the risk-bearing capacity to carry them. Robert Waldmann has a different view:
I think their core competencies are (a) finding fools for counterparties and (b) evading regulations/disguising gambling as hedging.
Regulatory arbitrage, and persuading those who do not understand risks that they should bear them–those are not socially-valuable activities.
Brad DeLong, yesterday:
NEXT YEAR’S EXPECTED EQUITY RETURN PREMIUM IS 9%
If you have any risk-bearing capacity at all, now is the time to use it.
So I guess last week’s doubts have been assuaged. Or did he really mean to write “If you have any capacity for being fooled into being a swindler’s counterparty, now is the time to use it”?
EDIT: Oh and then, the post just after that one argued — well, really, assumed — that the current value of Facebook shares gives an unbiased estimate of future Facebook earnings, and therefore of the net wealth that Facebook has created. (I guess not a single dollar of FB revenue comes at the expense of other firms, which must be a first in the history of capitalism.) Is there some way of consistently believing both that current stock values give an unbiased estimate of the present value of future earnings, and that stock values a year from now will be much higher than they are today? I can’t see one. But then I’ve never had the brain for theodicy.
UPDATE: Anyone reading this should immediately go and read rsj’s much better take on the same DeLong post over at Windyanabasis. He explains exactly why DeLong is confused here.
"Is there some way of consistently believing both that current stock values give an unbiased estimate of the present value of future earnings, and that stock values a year from now will be much higher than they are today?"
To me, it looks like pretty standard capital asset pricing theory. Undiversifiable risk is supposed to generate an expected return over the risk-free rate, right? DeLong estimates the equity risk premium to be 9%. I have no idea how he comes up with that particular figure, but it doesn't strike me as nonsense.
K
K,
I wasn't criticizing the claim that there is an expected return of 9 percent on equities this year (tho in fact I don't believe it, at all), but rather the combination of believing that stock prices incorporate a strongly time-varying risk premium, and believing that stock prices give the best available estimate of the present value of a firm's future earnings.
And of course I was also contrasting the confidence with which DeLong assumes finance is all about risk distribution now, compared with the doubts he was expecting last week. Obviously I like the May 22nd version better.