Turns out, you CAN put a price on that...
..., noise is what makes our observations imperfect. It keeps us from knowing the expected return on a stock or portfolio. It keeps us from knowing whether monetary policy affects inflation or unemployment. It keeps us from knowing what, if anything, we can do to make things better.
Capital Thinking - Issue #863 - View Online
The effects of noise on the world, and on our views of the world, are profound.
Noise in the sense of a large number of small events is often a causal factor much more powerful than a small number of large events can be.
FISCHER BLACK | The Journal of Finance:
Noise makes trading in financial markets possible, and thus allows us to observe prices for financial assets. Noise causes markets to be somewhat inefficient, but often prevents us from taking advantage of inefficiencies.
Noise in the form of uncertainty about future tastes and technology by sector causes business cycles, and makes them highly resistant to improvement through government intervention. Noise in the form of expectations that need not follow rational rules causes inflation to be what it is, at least in the absence of a gold standard or fixed exchange rates.
Noise in the form of uncertainty about what relative prices would be with other exchange rates makes us think incorrectly that changes in exchange rates or inflation rates cause changes in trade or investment flows or economic activity.
Most generally, noise makes it very difficult to test either practical or academic theories about the way that financial or economic markets work. We are forced to act largely in the dark.
I use the word “noise” in several senses in this paper.
In my basic model of financial markets, noise is contrasted with information. People sometimes trade on information in the usual way. They are correct in expecting to make profits from these trades.
On the other hand, people sometimes trade on noise as if it were information. If they expect to make profits from noise trading, they are incorrect. However, noise trading is essential to the existence of liquid markets.
In my model of the way we observe the world, noise is what makes our observations imperfect. It keeps us from knowing the expected return on a stock or portfolio. It keeps us from knowing whether monetary policy affects inflation or unemployment. It keeps us from knowing what, if anything, we can do to make things better.
In my model of inflation, noise is the arbitrary element in expectations that leads to an arbitrary rate of inflation consistent with expectations.
In my model of business cycles and unemployment, noise is information that hasn't arrived yet. It is simply uncertainty about future demand and supply conditions within and across sectors. When the information does arrive, the number of sectors where there is a good match between tastes and technology is an index of economic activity.
In my model of the international economy, changing relative prices become noise that makes it difficult to see that demand and supply conditions are largely independent of price levels and exchange rates. Without these relative price changes, we would see that a version of purchasing power parity holds most of the time.
I think of these models as equilibrium models. Not rational equilibrium models, because of the role of noise and because of the unconventional things I allow an individual's utility to depend on, but equilibrium models nonetheless.
They were all derived originally as part of a broad effort to apply the logic behind the capital asset pricing model to markets other than the stock market and to behavior that does not fit conventional notions of optimization.
These models are in very different fields: finance, econometrics, and macroeconomics. Do they have anything in common other than the use of the word “noise” in describing them?
The common element, I think, is the emphasis on a diversified array of unrelated causal elements to explain what happens in the world.
There is no single factor that causes stock prices to stray from theoretical values, nor even a small number of factors. There is no single variable whose neglect causes econometric studies to go astray. And there is no simple single or multiple factor explanation of domestic or international business fluctuations.
While I have made extensive use of the work of others, I recognize that most researchers in these fields will regard many of my conclusions as wrong, or untestable, or unsupported by existing evidence.
I have not been able to think of any conventional empirical tests that would distinguish between my views and the views of others. In the end, my response to the skepticism of others is to make a prediction: someday, these conclusions will be widely accepted. The influence of noise traders will become apparent.
Conventional monetary and fiscal policies will be seen as ineffective. Changes in exchange rates will come to provoke no more comment than changes in the real price of an airline ticket.
Perhaps most important, research will be seen as a process leading to reliable and relevant conclusions only very rarely, because of the noise that creeps in at every step.
If my conclusions are not accepted, I will blame it on noise.
If we were able to observe the economy at a given point in time with two different domestic price levels, we would see that the real equilibrium is largely independent of price levels and exchange rates, and we might call this situation “purchasing power parity.”
Since we must actually observe the economy as it evolves over time, we cannot see that purchasing power parity holds.
We see relative price changes occurring, and fluctuations in the level of economic activity, while exchange rates and money stocks are changing. We think that exchange rates and money are causing relative price changes and business fluctuations.37
But that is only because the noise in the data is clouding our vision.
Photo credit: Black Scholes