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Expectations and asset prices: Keynes meets Hayek

Is the ECB right to buy up sovereign bonds in southern Europe? This column argues that the answer depends on who is right: Keynes or Hayek.

The financial crisis has vividly put into question the alignment of asset prices and fundamental values. For an example of this, look no further than at the current decision made by the ECB president, Mario Draghi, to launch a courageous programme (dubbed Outright Monetary Transactions) to prop up the prices of short-term bonds issued by EU member states that ask for the help of the European stability funds (EFSF and ESM). The thrust of the argument is fairly simple: in the current market conditions, peripheral EU states find it hard to fund themselves in the market, and are forced to pay dearly to convince investors to buy their bonds. This impairs the monetary policy transmission mechanism, which relies on the interest rate set by the ECB. Thus, allowing the ECB to act as a ‘buyer of last resort’ in the secondary market ensures that bond prices don’t spike, hopefully taming interest rates and contributing to restoring the workings of EU monetary policy.

Two important and related ideas underlie this argument. The first is that bond prices in some EU states do not accurately reflect underlying fundamental values. The second one is that that such fundamentals are better impounded in some form of consensus view about those countries’ ability to service their debt. In other words, there appears to be a disconnect between the asset price that market actors contribute to generate with their trades, and the view that several market participants have about the ‘true’ underlying value that such prices should reflect. Such a situation is far from a novel one.

Indeed, a basic model of asset prices which follows a somewhat simplistic version of the Efficient Market Hypothesis posits that trading among rational investors leads prices to gravitate around the consensus estimate (or average expectations) of underlying value given available information (see for example Marks 2011). Keynes thought that this vision does not correspond with the functioning of markets. Indeed, in the General Theory, he distinguished between “enterprise,” or the activity of forecasting the prospective yield of assets over their whole life (where the investor focuses on the “long-term prospects and those only”), and short-term speculation. Keynes thought that while enterprise could anchor prices to fundamentals, in modern stock markets “speculation” would be king. This view contrasts with the ideas of Hayek on the informational efficiency of the market and the modern tradition of rational expectations analysis where market prices are aggregators of the dispersed information in the economy.

There have been quite a few attempts in the literature to explain financial pricing anomalies with recourse to behavioural theories and persistent differences in information. Without denying the plausibility of those approaches, in a recent paper (Cespa and Vives 2012), we address the tension between the Keynesian and the Hayekian visions in a dynamic market where investors have no behavioural bias and hold a common prior belief on the liquidation value of the risky asset. We show that the failure of the simplistic Efficient Market Hypothesis and reported anomalies in asset pricing can be explained in a standard rational expectations model as long as we generalise the model to encompass residual uncertainty on the liquidation value of the asset (so that the collective information of investors is not sufficient to recover the liquidation value) and allow liquidity trading to follow a general process. In other words, rejecting the simplistic Efficient Market Hypothesis does not necessarily imply subscribing to a behavioural view of the stock market.

We find that, in most cases, the simplistic version of the Efficient Market Hypothesis does not hold because long-term investors find it profitable to engage in short-term speculation due to the predictability of the aggregate demand. Low liquidity trades’ persistence together with opaque fundamentals make the evolution of the aggregate demand, and thus of the asset returns, predictable. This lures investors towards the exploitation of these regularities, partially diverting them from the activity of evaluating the fundamentals. As a result, the equilibrium price ends up reflecting both components of investors’ strategies (long and short term speculation), decoupling its dynamic from that of the consensus opinion.

In a stationary environment, investors speculate on the difference between the price and the fundamental value of the asset and prices are aligned with their average expectations about this value. In this context, the price is just a noisy measure of investors’ consensus opinion, and the simplistic Efficient Market Hypothesis holds. In a dynamic market, investors speculate also on short-run price differences. With heterogeneous information, this may misalign prices and investors’ average expectations, potentially leading prices either closer or farther away from the fundamentals compared to consensus. Two key deep parameters, the level of residual payoff uncertainty (that is, the residual uncertainty left after all the information on the asset value is pooled) and the degree of persistence of liquidity trades (that is, the extent to which the positions of liquidity traders revert over time), determine whether prices predict fundamentals better than consensus. When there is no residual uncertainty on the asset liquidation value and liquidity trading follows a random walk then prices are aligned with consensus like in a stationary market. This is one of the boundary cases where rational investors do not have incentives to speculate on short-run price movements. For a given, positive level of residual uncertainty, low persistence deteriorates the predictive power of prices in relation to consensus; conversely, high liquidity trades’ persistence has the opposite effect. This yields a Keynesian region, where prices are farther away from fundamentals than average expectations, and a Hayekian region where the opposite occurs. The boundary of these regions reflects Keynes’ situation where investors concentrate on the long-term prospects and where the simplistic version of the Efficient Market Hypothesis holds. In the Keynesian region short run price speculation based on market making motives (reversion of liquidity trades) predominates, while in the Hayekian region short run price speculation based on information (trend chasing) predominates (see Figure 1).

Figure 1

Notes: The figure shows the Hayekian and Keynesian regions drawn for different values of traders’ risk aversion in the (ß, 1/τδ) space, where 0 < ß < 1 and 1/τδ > 0 , capture, respectively, the persistence of liquidity trades (with ß = 0 not persistent, and ß = 1 a random walk), and the degree of residual uncertainty on the liquidation value of the asset. The Keyesian (Hayekian) region lays to the left (right) of each curve.

Thus our theory explains when traders accommodate the aggregate demand, and when instead they chase the trend, relating these strategies to the informational properties of asset prices compared to consensus.

The Keynesian and Hayekian regions can be characterised in terms of investors’ consensus opinion about the systematic behavior of future price changes. Indeed, in the Hayekian region, investors chase the market because the consensus opinion is that prices will systematically continue a given trend in the upcoming trading period. In the Keynesian region, instead, investors accommodate the aggregate demand because the consensus opinion is that prices will systematically revert. The Keynesian and Hayekian regions, however, do not coincide with the regions where momentum (that is, price run-ups) and reversal (that is, returns to trend) may occur. The reason is that the consensus opinion depends on the signal extraction problem investors face in the presence of heterogeneous information while momentum and reversal are evaluated ex ante from the perspective of an uninformed investor. In fact, reversal and momentum can happen at the frontier between the Keynesian and Hayekian regions, and therefore the simplistic version of the Efficient Market Hypothesis does not preclude return predictability (see Figure 2).

Figure 2

Notes: The Figure shows the interaction between the Hayekian and Keynesian regions (respectively denoted by the letters H and K) and the regions in which momentum or reversal occur (respectively denoted by the letters M and R) in (ß, 1/τδ) space.

In summary, the Efficient Market Hypothesis, in its simplistic version, does not hold in a standard but general dynamic asset pricing model with rational agents, and prices may depart substantially from consensus opinions. To return to the price of sovereign bonds: if we are in the Keynesian region, Mr. Draghi may be right to intervene since prices are far away from fundamentals compared to consensus estimates. However, if we are in the Hayekian region the consensus estimates are farther away from fundamentals than prices, and intervention is not warranted on the grounds of prices being out of line with fundamentals.


Barberis, N and R Thaler (2003), “A survey of behavioral finance”, in GM Constantinides, M Harris, and R Stulz (eds.), Handbook of the Economics of Finance.

Cespa, G and X Vives (2012), “Dynamic Trading and Asset Prices: Keynes vs. Hayek”, Review of Economic Studies, 79(2):539-580.

Marks, H (2011), The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Columbia University Press.

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