Big Players and the Economic Theory of Expectations Also by Roger Koppl SUBJECTIVISM AND ECONOMIC ANALYSIS: Essays in Memory of Ludwig M. Lachmann(edited with Gary Mongiori) Big Players and the Economic Theory of Expectations Roger Koppl Professor of Economics and Finance Fairleigh Dickinson University Madison, New Jersey © Roger Koppl2002 Softcover reprint of the hardcover 1st edition 2002 978-0-333-67826-8 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2002 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the new global academic imprint of the Palgrave Macmillan division of St. Martin’s Press LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 978-1-349-39968-0 ISBN 978-0-230-62924-0 (eBook) DOI 10.1057/9780230629240 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Koppl, Roger, 1957– Big players and the economic theory of expectations / Roger Koppl. p. cm. Includes bibliographical references and index. 1. Rational expectations (Economic theory) 2. Economic forecasting. 3. Business cycles. 4. Money market–Forecasting. 5. Stock price forecasting. 6. Economics–History–20th century. I. Title. HB3722 .K66 2002 339’.01–dc21 2001060270 10 9 8 7 6 5 4 3 2 1 11 10 09 08 07 06 05 04 03 02 To Maria, who brings joy Contents List of Figures ix List of Tables x Preface xi Acknowledgments xiv Part 1 Introduction 1 Introduction and Summary 3 Expectations and economic theory 3 The role of expectations in economics as a social science 8 Outline of the theory 11 Part II Methodology 2 The Misesian Context 25 Introduction 25 The methodology of Ludwig von Mises 26 Schutz and Hayek 38 3 Schutz 40 4 Hayek 56 Part III Theory 5 Language Games and Economic Theory 73 Introduction 73 Language games 74 The economy as a network of language games 83 Coordination does not require common rules 87 Natural selection of language games 92 6 Expectations 96 Introduction 96 Entrepreneurship 96 Cognitive expectations 106 Acognitive expectations 113 Hayekian expectations 115 Correlating cognitive and acognitive expectations 118 vii viii Contents 7 Big Players 120 The general theory of Big Players 120 Modeling Big Players 123 Big Players in asset markets 128 Modeling asset prices in the presence of Big Players 131 Herding and contra-herding as error duration 135 Part IV Applications 8 Big Players in Czarist Russia 141 The policies of Bunge and Vyshnegradsky 141 The ruble and GARCH 147 R/S analysis 154 9 The Angular Distribution of Asset Returns in Delay Space 164 The compass rose 166 Hypothesis testing with theta histograms 168 A simple simulation of X-skewing 174 Big Players induce X-skewing 177 10 Herding in Money Demand 184 Money demand and the theory of Big Players 184 The Federal Reserve as a Big Player 187 Discussion and conclusion 193 Coda How this book relates to the emerging new orthodoxy in economics 195 Some suggestions for further work 199 Appendixes 204 1 What is Verstehen? 204 2 What did Wittgenstein really mean? 208 3 An elementary set-theoretic model of language games 210 4 Notes on reflexivity 212 Notes 218 Bibliography 223 Name Index 237 Subject Index 241 List of Figures 5.1 A simple coordination game 90 5.2 Payoff structure 91 8.1 Daily exchange rate levels 150 8.2 Price-change data 152 8.3 R/S Analysis 159 9.1 Daily returns for Weyerhauser stock on the NYSE, December 1963–December 1993 165 9.2 Crack and Ledoit’s (1986) “compass rose” graph for IBM daily stock returns, January 1, 1980–October 8, 1992 167 9.3 “Theta histogram” of Weyerhauser stock returns 169 9.4 Bootstrapped theta histogram created using the data used to construct Figure 9.3 170 9.5 “Compass rose” graph for a simulated series 176 9.6 Empirical theta histogram, Bunge period 177 9.7 Empirical theta histogram, Vyshnegradsky period 178 9.8 Bootstrapped theta histogram, Bunge period 179 9.9 Bootstrapped theta histogram, Vyshnegradsky period 180 9.10 Compass rose in absolute values, Bunge period 181 9.11 Compass rose in absolute values, Vyshnegradsky period 182 A4.1 Morgenstern’s two-person zero-sum game 213 ix List of Tables 8.1 ADF and Phillips–Perron tests 150 8.2 General statistical information for ruble data 151 8.3 Ftest for equal unconditional variancies between Bunge and Vyshnegradsky periods 152 8.4 Parameter estimates from a traditional GARCH(1,1) model with no dummy interaction variables 153 8.5 Parameter estimates from GARCH(1,1) model with dummy interaction variables on the conditional squared error term and conditional variance term 154 8.6 Estimated values of the Hurst coefficient 162 9.1 χ2hypothesis test for Weyerhauser data 173 9.2 Bernoulli hypothesis test for Weyerhauser data 174 9.3 Results of SAS fit of simulation data to a GARCH(1,1) model 176 9.4 Bernoulli hypothesis tests regardingθ/π= –0.5(±0.005) 181 9.5 Bernoulli hypothesis tests for ruble data, θ/π= ±0.25(±0.005) and ±0.75 (±0.005) 182 9.6 χ2hypothesis tests for ruble data 183 10.1 Hurst coefficients 193 x