The efficient market hypothesis (EMH) is a flavor of economic Lysenkoism
which became popular for the last 30 years in the USA or, in more politically
correct terms, unrealistic idealization of market behavior. Like classic
Lysenkoism it was supported by the state, which in turn was captured by
financial sector.
Still until recent crisis since probably 60th it was floating as the
official doctrine in best Lysenkoism style despite little of none supporting
empirical evidence. All this has changed during the recent financial
crisis. Events have conclusively demonstrated the inadequacy of the
efficient market hypothesis. It neither predicted nor explained
what happened.
On the contrary, the pseudo theories of market “efficiency” and “rationality”
have led economics and economic policy astray in the past decade, with recent
disastrous results.
Fama in his observation that most institutional investors underperform
indexes made a freshman-style mistake: Institutional investors are neither
thinking or behaving rationally. For example most fund managers are benchmarked
against market indexes quarterly, and have cash-holding limits as a matter
of fund policy. These constraints obviously have disadvantaged them and
made it extremely hard to outperform the indexes.
This is why most fund managers are closet indexers. Extra management
costs guarantee that most actively managed mutual funds will under-perform
market indexes. That has nothing to do with market efficiency.
Moreover, regardless how one tries to improve the incentive structure
for institutional investors, nothing could overcome
the incentive distortions inherent in the managing other people's money.
Mutual funds, once hailed as a great tool for individual investors, has
proven ripe with such conflicts of interests that drastically diminish efficiency
(agency problem and "short-termism" are probably the most well studied).
Exact definition of EMH depends on your tolerance for sharp and vulgar
words ;-). Idiotism would the most benign. JK Galbraith said
it best about the people like
Eugene
Fama : economics is the only profession
in which it is possible to rise to eminence without ever once being right.
As one commenter top Delong blog aptly said (Time
to Bang My Head Against the Wall Some More )
If you want to be less tolerant, then Fama is just another white-collar
criminal, not that different from Madoff. EMH laid the foundation for tearing
down the regulatory structure built from the lessons of the Great Depression
so he probably should be tried for the conspiracy to defraud American people.
The efficient market hypothesis, which has had a dominant role the last
two decades presuppose that all relevant information is reflected in the
price. That means that prices move only in response to new information.
The movement of the market will be a “random walk”. The latter conclusion
is empirically false: stock markets exhibit pretty strong “negative serial
correlation”. More simply, there is an effect of reversal to means -- real
returns from stock markets are likely to be lower, if they have recently
been high, and vice versa. That means that theoretically cost averaging
is a wrong strategy. The right time to buy is not when markets have done
well, but when they have done badly. In a way, markets oscillate
around fair value, but what is important is that the period of oscillation
is unknown (which make arbitrage extremely difficult and very risky).
The latter fact was aptly reflected in the famous John Maynard Keynes quote:
"The market can stay irrational longer than you can stay solvent".
But that does not mean that there are well defined opportunities for
arbitrage. In case of borrowed funds arbitrage can be defeated by unpredictability
of the period of oscillations (or reversion to mean in economic speack).
The length of time over which markets can have significant deviated can
measure in decades. that means that such opportunity cannot be exploited
using borrowed funds. Similarly a short seller will go broke long before
the value ship comes in. The difficulty of exploiting such opportunities
is amplified for professional managers, who will lose clients before they
can prove that they are right.
In addition, parasitic financial sector taxes economy and distorts the
market prices. It can create huge inefficiencies (and Chicago School as
shills of banksters helped to amplify this process). High speed financial
masturbation (aka high frequency trading) that is prevalent in financial
markets (with Goldman being really obsessed masturbator) is a perversion
that costs society substantial money enriching useless individuals who happen
to be close to "money river" to drink from it without any restrain.
A Benjamin Friedman noted:
Generally, if profits and compensation in the financial sector go up
that’s an evidence of inefficiency, not efficiency. Those higher profits
mean that customers are paying more for their financial services over time,
not less, which means that financial services are imposing a larger and
larger tax on the economy.
Also as Soros stresses many times markets are composed of thinking participants
who have their own set of forecast and as such are always biased. The famous
trader maxim sates that during the crash nothing rise other then correlations.
In a sense, in short term, market is not so much about the ‘value’ but about
psychology (voting machine, not a weighting machine to site Benjamin Graham).
It is dynamic self-adapting system which actually constantly dynamically
redefines the notion of "expected equilibrium" and thus the direction of
change. As Soros suggested actually functioning of financial markets is
more like a ruthless competition on who’s best at screwing the “great unwashed
masses” or at best completely disregarding their well-being. Success of
Goldman Sachs speaks volumes about the high viability of such strategy.
It is called vampire squid not without the reason.
Another interesting observation that refutes efficient market hypothesis
is that regulators, who in theory should play the role of firefights, actually
enjoy playing the role of arsonists with Greenspan as a classical example.
And their action create another type of shady players who can be called
using the Japanese phrase Kaji-ba dora-bo "thief at the scene of a fire":
someone who turns the misfortune of others into his or her own benefit.
In no way this type of layers is concerned about fair price or other nonsense
that efficient market hypothesis operates with. For example keeping
by Greenspan rate too low created an army of fraudulent migrate originators
who were ready to sell mortgages to anybody with a warm breath without any
consideration about fire price of the house of the ability to a follower
to repay the loan. See also Naomi Klein’s The Shock Doctrine-The Rise
Of Disaster Capitalism which takes this theory to the next level and exposes
the manufacture of crisis to facilitate financial reward. As one commenter
to
Firefighter Arson And Our Macroeconomic Policymakers « The Baseline Scenario
noted:
The efficient market hypothesis played prominent role in shaping how
the country thought and acted in the last 30-plus years. It greatly contributed
to the current financial crises. Like all ideological constructs
of neo-classical economy it has no basis in reality. But it was used to
steal a lot of money from 401K investors.
This Eugene Fama is a really special gift to the economic profession:
he went as far as to deny that bubbles are possible and instead of being
isolated from society managed to preserved his academic position at Chicago
university ;-)
For twenty years or so his hypothesis served as the theoretical justification
of investing in stocks index funds. This "application" of efficient market
hypothesis cost tremendous amount of money to 401K investors: as of July
2009 401K investor who invested using cost averaging into S&P500 lost approximately
45% in comparison with an investor who put all his/her money in a stable
value fund.
While the ideas of self-regulation and feedback loops are definitely
applicable to economic systems, naive (or crooked) belief in "permanent
equilibrium" typical for guys like Fama is really absurd.
Actually, efficient market hypothesis was as a crowbar to promote deregulation
and that led to serious policy mistakes not only in 401K investments, but
for the financial markets as a whole. One tremendously negative side effect
was dismantling Great Deal safeguards.
The second problem with most publicly traded companies is that much of
their business is a black box - without faith you have a hard time valuing
the company since you can't see behind the curtains. That's true even if
you work for the company and have access to some internal data. That means
that situation is quite different from what is written about it in Money
magazine and similar "feel good" publications. As Bill Fleckenstein
The meddlers can't tame the market - MSN Money noted:
When Vanguard PR people try to persuade you that "Whether you're an expert
of not, it's human nature to imagine that have some unique insight into
the market, something that's eluded everyone else" they forget to mention
that this is perfectly applicable to the idea that S&P 500 outperforms bonds
for a given period. Due to changes in S&P500 composition that is no scientific
evidence for that and popular "proofs" smell data mining. The last
15, 10 and 5 years periods provide evidence opposite to this hypothesis.
May 13, 2009 | Knowledge@Wharton
There is a long list of professions that failed to see the financial
crisis brewing. Wall Street bankers and deal-makers top it, but banking
regulators are on it as well, along with the Federal Reserve. Politicians
and journalists have shared the blame, as have mortgage lenders and
even real estate agents.
But what about economists? Of all the experts, weren't they the best
equipped to see around the corners and warn of impending disaster?
Indeed, a sense that they missed the call has led to soul searching
among many economists. While some did warn that home prices were forming
a bubble, others confess to a widespread failure to foresee the damage
the bubble would cause when it burst. Some economists are harsher, arguing
that a free-market bias in the profession, coupled with outmoded and
simplistic analytical tools, blinded many of their colleagues to the
danger.
"It's not just that they missed it, they positively denied that it
would happen," says Wharton finance professor
Franklin
Allen, arguing that many economists used mathematical models that
failed to account for the critical roles that banks and other financial
institutions play in the economy. "Even a lot of the central banks in
the world use these models," Allen said. "That's a large part of the
issue. They simply didn't believe the banks were important."
Over the past 30 years or so, economics has been dominated by an
"academic orthodoxy" which says economic cycles are driven by players
in the "real economy" -- producers and consumers of goods and services
-- while banks and other financial institutions have been assigned little
importance, Allen says. "In many of the major economics departments,
graduate students wouldn't learn anything about banking in any of the
courses."
But it was the financial institutions that fomented the current crisis,
by creating risky products, encouraging excessive borrowing among consumers
and engaging in high-risk behavior themselves, like amassing huge positions
in mortgage-backed securities, Allen says.
As computers have grown more powerful, academics have come to rely
on mathematical models to figure how various economic forces will interact.
But many of those models simply dispense with certain variables that
stand in the way of clear conclusions, says Wharton management professor
Sidney G.
Winter. Commonly missing are hard-to-measure factors like human
psychology and people's expectations about the future, he notes.
Among the most damning examples of the blind spot this created, Winter
says, was the failure by many economists and business people to acknowledge
the common-sense fact that home prices could not continue rising faster
than household incomes.
Says Winter: "The most remarkable fact is that serious people were
willing to commit, both intellectually and financially, to the idea
that housing prices would rise indefinitely, a really bizarre idea."
Although many economists did spot the housing bubble, they failed
to fully understand the implications, says
Richard
J. Herring, professor of international banking at Wharton. Among
those were dangers building in the repo market, where securities backed
by mortgages and other assets are used as collateral for loans. Because
of the collateralization, these loans were thought to be safe, but the
securities turned out to be riskier than borrowers and lenders had thought.
The Dahlem Report
In a highly critical paper titled, "The
Financial Crisis and the Systemic Failure of Academic Economists,"
eight American and European economists argue that academic economists
were too disconnected from the real world to see the crisis forming.
The authors are David Colander, Middlebury College; Hans Follmer, Humboldt
University; Armin Haas, Potsdam Institute for Climate Impact Research;
Michael Goldberg, University of New Hampshire; Katarina Juselius, University
of Copenhagen; Alan Kirman, University d'Aix-Marseille; Thomas Lux,
University of Kiel; and Brigitte Sloth, University of Southern Denmark.
"The economics profession appears to have been unaware of the long
build-up to the current worldwide financial crisis and to have significantly
underestimated its dimensions once it started to unfold," they write.
"In our view, this lack of understanding is due to a misallocation of
research efforts in economics. We trace the deeper roots of this failure
to the profession's insistence on constructing models that, by design,
disregard the key elements driving outcomes in real world markets."
The paper, generally referred to as the Dahlem report, condemns a
growing reliance over the past three decades on mathematical models
that improperly assume markets and economies are inherently stable,
and which disregard influences like differences in the way various economic
players make decisions, revise their forecasting methods and are influenced
by social factors. Standard analysis also failed, in part, because of
the widespread use of new financial products that were poorly understood,
and because economists did not firmly grasp the workings of the increasingly
interconnected global financial system, the authors say.
One result of this, argues Winter, who is not one of the authors
but agrees with much of what they say, is to build into models an assumption
that all market participants -- bankers, lenders, borrowers and consumers
-- behave rationally at all times, as if they were economists making
the most financially favorable choices. Clearly, he says, rational behavior
is not that dependable, or else people would not do self-destructive
things like taking out mortgages they could not afford, a key factor
in the financial crisis. Nor would completely rational executives at
financial firms invest in securities backed by those risky mortgages,
which they did.
By relying so heavily on the view of humans as rational, the paper's
authors argue, economists ignore evidence of irrational behavior that
is well documented in other disciplines like psychology and sociology.
Even if an individual does act rationally, economists are wrong to assume
that large groups of people will react to given conditions as an individual
would, because they often do not. "Economic modeling has to be compatible
with insights from other branches of science on human behavior," they
write. "It is highly problematic to insist on a specific view of humans
in economic settings that is irreconcilable with evidence."
The authors say economists badly underestimated the risks of new
types of derivatives, which are financial instruments whose value fluctuates,
often to extremes, according to the changing values of underlying securities.
Traditional derivatives such as stock options and commodities futures
are well understood. But exotic derivatives devised in recent years,
including securities built upon pools of mortgages, turned out to be
poorly understood, the authors say. Credit default swaps, a form of
derivative used to insure against a borrower's failure to repay a loan,
played a key role in the collapse of American International Group.
Rather than accurately analyzing the risks posed by new derivatives,
many economists simply fell back on faith that creating new financial
products is good, the authors write. According to this belief, which
was promoted by former Federal Reserve chairman Alan Greenspan, a wider
variety of financial products allows market participants to place ever
more refined bets, so the markets as a whole better reflect the combined
wisdom of all the players. But because there was not enough historical
data to put into models used to price these new derivatives, risk and
return assessments turned out to be wrong, the authors argue. These
securities are now the "toxic assets" polluting the balance sheets of
the nation's largest banks.
"While the economic argument in favor of ever new derivatives is
more one of persuasion rather than evidence, important negative effects
have been neglected," they write. "The idea that the system was made
less risky with the development of more derivatives led to financial
actors taking positions with extreme degrees of leverage, and the danger
of this has not been emphasized enough."
'Control Illusion'
When certain price and risk models came into widespread use, they
led many players to place the same kinds of bets, the authors continue.
The market thus lost the benefit of having many participants, since
there was no longer a variety of views offsetting one another. The same
effect, the authors say, occurs if one player becomes dominant in one
aspect of the market. The problem is exacerbated by the "control illusion,"
an unjustified confidence based on the model's apparent mathematical
precision, the authors say. This problem is especially acute among people
who use models they have not developed themselves, as they may be unaware
of the models' flaws, like reliance on uncertain assumptions.
Much of the financial crisis can be blamed on an overreliance on
ratings agencies, which gave complex securities a seal of approval,
says Wharton finance professor
Marshall E.
Blume. "The ratings agencies, of course, use models" which "grossly
underestimated" risks.
"Any model is an abstraction of the world," Blume adds. "The value
of a model is to provide the essence of what is happening with a limited
number of variables. If you think a variable is important, you include
it, but you can't have every variable in the world.... The models may
not have had the right variables."
The false security created by asset-pricing models led banks and
hedge funds to use excessive leverage, borrowing money so they could
make bigger bets, and laying the groundwork for bigger losses when bets
went bad, according to the Dahlem report authors.
At the time, few people knew that major financial institutions had
become so heavily leveraged in real estate-related assets, says Wharton
finance professor Jeremy J. Siegel.
"Had they not been in that situation, we would not have had the crisis,"
he says. "We may not even have had a recession.... Macro economists
really hadn't talked about it because these structured financial products
were relatively new," he adds, arguing that economists will have to
scrutinize the balance sheets of major financial institutions more closely
to detect mushrooming risks.
Lessons Not Learned
Prior to the latest crisis, there were two well-known occasions when
exotic bets, leverage and inadequate modeling combined to create crises,
the paper's authors say, arguing that economists should therefore have
known what could happen. The first case, the stock market crash of 1987,
began with a small drop in prices which triggered an avalanche of sell
orders in computerized trading programs, causing a further price decline
that triggered more automatic sales.
The second case was the 1998 collapse of the Long-Term Capital Management
(LTCM) hedge fund. It had built up a huge position in government bonds
from the U.S. and other countries, and was forced into a wave of selling
after a Russian government bond default knocked bond prices down.
"When there's a default in one kind of bond, it causes reassessment
of all the risks," says Wharton economics professor
Richard
Marston. "I don't think we have really fully learned from the LTCM
crisis, or from other crises, the extent to which things are illiquid."
These crises have shown that market participants can rely too heavily
on the belief they can quickly unload securities that decline in price,
he says. In fact, the downward spiral can be so rapid that it leaves
investors with losses far larger than they had thought possible.
In the current crisis, he says, economists "should get blamed for
the overall unwillingness to take into account liquidity risk. And I
think it's going to force us to reassess that."
Academics also are beginning to reassess business-school curricula.
Wharton management professor
Stephen
J. Kobrin recently moderated a faculty panel that talked about a
wide range of possible responses to the crisis. Among the issues discussed,
he says, was whether Wharton's curriculum should include more on regulation
and risk management, as well as executive education programs for regulators
and other government officials.
Kobrin said he believes many academics share "an ideological fixation
with free markets and lack of regulation" that should be reexamined.
"Obviously, people missed the boat on a lot of the risks that a lot
of financial instruments entailed," he says. "We need to think about
what changes are needed in the curriculum."
A Failed Scientific Revolution, October 24, 2009
By
R.
Albin
(Ann Arbor, Michigan United States) -
See all my reviewsThis is a good, journalistic account of a failed
scientific revolution with substantial public consequences. Fox's goal
is not a detailed scholarly history but rather an accessible popular
account that gives the general public an idea of how these ideas evolved
and why they had such impact. By the late 1960s, a number of economists
had accomplished work that seemed to indicate that financial markers
were "rational." Specifically, this meant that stock prices reflected
the actions of well informed rational agents maximizing utility and
that while individuals departed from rationality, the market as a whole
was rational and stock prices reflected "fundamental" features of the
status of companies. From this conclusion flowed many interesting consequences.
The rational market hypothesis allowed the first calculation of the
value of options. In turn, this seems to have encouraged the development
of financial instruments such as a variety of derivatives based on the
idea that properly constructed derivatives would allow management of
risk more efficiently than market regulation. The idea that CEO performance
should be evaluated by stock price value is also partly a result of
the basic hypothesis. Propagated throughout American departments of
economics and many business schools, this tool kit of ideas was an important
contributor to the deregulation of financial markets and the general
enthusiasm for untrammeled markets. In the last couple of years, the
failure of these ideas become apparent in a nearly catastrophic fashion.
Fox makes clear, however, that problems with this set of ideas appeared
well before the present crisis. A number of important economists demonstrated
flaws of different aspects of the models. The influential Joseph Stiglitz
disproved the strongest form of the efficient markets idea, and Robert
Schiller pointed out both logical flaws and presented data contradicting
the model. Eugene Fama, one of the principal architects of the theory
himself presented data undermining the model and had to introduce ad
hoc modifications that compromised the integrity of the model. Many
aspects of these models were based on data assumed to follow normal
distributions but this assumption proved to be incorrect.
What accounted, then, for the remarkable
success of this set of models in the academy, earning some of the originators
Nobel prizes and generous consulting fees? Fox's answer is a combination
of scientific hubris and institutional defects. He suggests
that many of the originators of these ideas were simply intoxicated
with their achievements and driven by what they perceived as the logical
and mathematical beauty of their concepts. Many also worked within business
schools where there was an emphasis on methods for investing and management,
which these ideas seemed to produce, and a less rigorous intellectual
environment than regular economics departments.
These are very good points, though I
suspect that Fox underestimates the importance of ideological factors.
As he himself points out, many of these ideas emerged from the University
of Chicago, where the dominant figure was the brilliant but somewhat
nutty libertarian economist Milton Friedman. In a classic vicious cycle,
the efficient market idea and its progeny were both driven by and a
driver of the general conservative tone of American life in the past
30 years.
While Fox does a reasonably good job of explaining the basic ideas
but I think the exposition could have been improved significantly. How
many people, for example, really know what constitutes a normal distribution?
Fox understandably avoids equations but a few well done figures and
simple equations would have enhanced understanding considerably. Fox
also doesn't discuss well, I think, one of the major reasons why these
ideas had such power. The last 50 years were in many respects a period
of relative macroeconomic calm and stability in financial markets (The
Great Moderation), at least as compared with the first half of 20th
century and late 19th century. Many interpreted this relative calm as
a result of success of market self-regulation. As conceded recently
by Robert Lucas, himself one of the originators of this set of ideas,
the relative calm had a great deal to do with the success of New Deal
era regulation and activist central banking.
Very interesting history of a deeply irrational economic theory,
September 17, 2009
Economists tend to be love with theory. They tend not to like reality
quite so much. As a rule, their odd views are confined to the academy.
Once in a while, they spill out into the real world and do some real
damage.
In this book, Justin Fox tells the history of one such academic attack
on reality. He begins, very dramaticaly, with an account of Allan Greenspan's
appearance before Congresss, in which he confessed that the Crash of
'08 proved that his opinions had been deeply, deeply wrong. What were
these views? Greenspan believed that the markets are always right. Thus,
if real estate prices were through the roof, why then, by golly, that
meant that real estate was just worth much more than it used to be worth.
The market is always right. (Query. If the markets are always right,
why then did the Fed under Greenspan need to prop them up, with huge
infusions of liquidity, whenever they fell? Funny. In Greenspan's world,
an up market is always right and should be left alone. A down market
is horrifyingly wrong and calls for energetic government intervention.
This is just a personal aside. Fox did not comment on this particular
contradiction in Greenspan's worldview.)
To a practical person, this view sounds insane, as it was. Yes, the
markets tend to be right, over a long period of time, but at any given
moment the markets are almost always out of adjustment. For those tuned
into reality, there is such a thing as the business cycle. In the business
cycle, the market tends to push prices way above reality, in the boom,
and then way below reality, in the bust. Any one who has actually done
business for any length of time knows this is true, not as a matter
of theory, but through his own experience. This is reality. You can
argue about why it happens, but a sane person can not argue that it
does not happen.
That did not stop a long line of famous and celebrated economists
from arguing the contrary. Fox tells their story here. There is no business
cycle, they said. Markets always get everything right, not over the
long haul, but right now, faster than a speeding bullet. And, if you
do not believe this, they have lots of nifty mathematical equations,
which proved it.
While the story drags now and again, by and large, I thought it was
fascinating. Fox brings back to life a whole parade of now mostly forgotten
figures. God willing this history is now just that, history, because
this particular piece of academic idiocy was so totally disproven by
the Crash of '08 that no one will ever believe it again. But that gives
leaves a market hole for the next piece of academic idiocy, which I
am sure will be along shortly.
An Entertaining Overview of Academic Mistakes and Hubris, September
16, 2009
By Professor Donald Mitchell "Jesus Makes Me a P... (Boston)
- See all my reviews
"You say to God, 'My beliefs are flawless and I
am pure in your sight.'" --Job 11:4
I know of no field of study filled with more methodological errors
than the study of how markets work. Someone was bound to see the humor
in all the people with big egos winning global honors for ideas that
someone new to the subject could point out were obviously wrong. Indeed,
many professors have been wearing no clothes for a long time and were
proud of it.
I'm impressed that it is a former Fortune editor who appreciated
the irony of the story and wrote about it in human terms. That magazine
has had a history of jumping on the band wagon of bad economic ideas.
Good for Justin Fox.
The ultimate irony of this subject is
that in 2059, hundreds of thousands of young business school students
will probably still be taught the inaccurate theories that were finally
shown to be wrong in the last two decades. I would wager
that few people today realize that most of the advocates of the efficient
market theory have pulled in their horns in the face of strong evidence
to the contrary. Hopefully, this book will help.
It must have been a tough book to write. The key points could have
been summarized in a short article. The full story would take many volumes.
For the most part, Mr. Fox seems to have kept his story at the right
level to show how a small club of economists happily misled those who
read their work for a long time based on assumptions that no one would
have agreed resembled the real world. The Capital Asset Pricing Model,
for instance, had its assumptions revised every few years by academics
for a long time in a vain attempt to sustain it.
Yet today, I would bet that most Chief Financial
Officers of major companies still make decisions based on CAPM (or its
near cousins) despite the theory clearly being wrong.
The "prize-winning" economics were writing about the world as they
would like to have it: human beings as rational decision-makers where
the highly intelligent quickly move out those who aren't. As we have
seen, smart people can also outsmart themselves . . . such as by assuming
that they have no effect on markets even when they take huge positions
that cannot easily be liquidated (Long-Term Capital Management was an
example).
The book's main weakness is that it doesn't
pay enough attention to the role of company managements relative to
financial markets. Also, the silliness of much of the advice for corporations
that academics and consultants have peddled for the last 50 years isn't
revealed.
My own view (based on many years of unpublished research during the
years when no one thought that psychology played any role in markets
and wouldn't publish such research) is that the markets are more efficient
than is currently believed . . . when you know how to measure them.
But the current measurements are hopelessly flawed and I know of no
current academic research to correct those measurement errors. It may
well be that someone will be able to write an updated version of this
book about the silliness of today's ideas about markets in 50 years.
I don't doubt that the opportunity to do so will exist
Review of Myth of the Rational Market, August 23, 2009
The author reviews the development of the quasi-scientific 'efficient
market hypothesis' into the dominant financial orthodoxy and then the
counter-revolution against the orthodoxy, and increasing interest in
"behavioral finance." This efficient market
orthodoxy has heavily influenced everything from the way mutual funds,
pension funds and individual investors have invested in the market to
the increasing short-term focus of CEOs and the heavy use of options
as compensation incentives. Recent years have probably
seen the orthodoxy perversely create more volatility and instability
in the marketplace (stability breeds instability) and in the mainstream
economy due to the incentives to financial institutions to pursue riskier
and riskier strategies under the dangerous assumptions of non-correlated
security classes and normally distributed 'random walk' style returns.
Justin Fox builds this interesting and important story over a one hundred
year period beginning in the first decade of the 20th century through
the present, emphasizing the key players (including many Nobel prize
winners) in economic and financial theory and their contributions to
and viewpoints of the topic at hand. He covers many of the repeated
failures of rational market pricing assumed by the orthodoxy, including
the 1929 and 1987 (and 2007-09) market crashes, the collapse of the
Nobel Laureate advised Long Term Capital hedge fund, the dot.com bubble
and the recent real estate bubble and subprime and CDO/CDS crisis. Even
one of these events statistically had an extremely low probability -
according to the 'efficient market' models - of occurring within the
one hundred year period. For all of them to have occurred is statistically
impossible during the lifetime of our universe - according to the models.
Ergo, the models are an insufficient description of reality.
The treatment is technical (but without equations) and is a good read
for those who are interested in the theories which explain and shape
economic and financial history. As an astrophysicist by training, I
found some of the analogies to physics somewhat misplaced, but the author
has a good grasp of the subject and conveys it well for a non-technical
reader. He makes the personalities and the battle of ideas come alive
as well.
4.5 stars-The egregious misuse of the Normal distribution
by the economics profession in order to appear " scientific ",
July 19, 2009
By
Michael
Emmett Brady "mandmbrady"
(Bellflower, California ,United States)
Fox's book represents a substantial improvement over Bernstein's
" Against the Gods " in that he demonstrates the intellectual bankruptcy
of a profession that is primarily interested in maintaining the appearance
of being " scientific " rather than being a science.Fox covers the issue
but refrains from drawing the logical conclusion that a profession that
uses no goodness of fit tests or exploratory data analysis BEFORE it
assumes a normal (log normal) distribution is not a science at all but
a profession that wants to maintain the appearance of being scientiific.
In his 1939-40 exchange with Tinbergen over Tinbergen's use of multiple
correlation and regression analysis to explain changes in investment
over the business cycle,Keynes asked Jan Tinbergen very politely to
apply the Lexis Q test [ Keynes dealt with the special case nature of
the normal distribution ,upon which multiple correlation and regression
analysis rests,in chapters 17 and 33 ( A Treatise on Probability,1921,pp.414-422
,especially footnote 1 on p.420)] to show or demonstrate that the time
series data was homgeneous, uniform and dynamically stable over time.
Tinbergen's response to Keynes contained no Lexis Q test ,no goodness
of fit test ,and no exploratory data analysis.Tinbergen never supplied
any such analysis to support any of his Normal distribution based multiple
correlation and regression results in his lifetime. The answer is that
Tinbergen JUST ASSUMED Normality.Keynes has been constantly attacked
by econometricians ever since because he pointed out that they were
just presuming in assuming a Normal distribution .In his last address
before the econometricians before he died, Schumpeter, who was well
aware of the regular irregularity of the time series data on investment,
had bluntly told the econometricians that their multiple correlation
and regression approach ,based on the Normal distribution, would not
work.Schumpeter was ignored.
Fox is to be saluted because he brings this problem ,concerning the
egregious misuse of the Normal distribution by an economics profession
whose main goal is to look scientific, as opposed to being scientific,into
the open with his discussion of the work of Benoit Mandelbrot.Bernstein
attempted to cover this up.
Mandelbrot is a scientist. His examination of the evidence overwhelmingly
demonstrated that the normal distribution could not be used in any study
of financial markets due to the long, thick, fat tails and extreme kurtosis
of the time series data in financial markets. Osborne, a normal distribution
advocate ," told his students that Mandelbrot's ideas about infinite
variance (the distribution that fits the time series data best is the
Cauchy distribution .Its first two moments are infinite expectation
and infinite variance) were " a stew of red herring and baloney ".
Sure, there were jumps and dips in stock prices that couldn't be
shoe-horned into a normal distribution...But for most purposes it was
OK to ignore them " (p.135).What was the result of this anti-scientific
approach by Osborne ? The result was this :" We were seeing things that
were 25-standard deviation moves, several days in a row," said Goldman
Sachs chief financial officer David Viniar in August 2007....Viniar's
point seems to be that what had happened could not possibly have been
predicted-a 25-standard deviation event should only occur every hundred
thousand years.
A better explanation may be that his risk models weren't very good
."(p.316).Keynes had pointed out what was wrong with using the normal
distribution as a model for financial markets in his analogy with seaworthy
ships being build to withstand the relatively rare ocean storm and not
just the normal ocean weather.Unfortunately,modern financial markets
are NOT built to withstand financial turbulence and storms,but only
"Normal" conditions.Mandelbrot's point,like Keynes's ,was that such
storms occur much more often than predicted by the normal distribution.
Fox brings into the open the anti-scientific nature of the economics
profession in his discussion of the efficient markets hypothesis. There
are no goodness of fit tests that support the claims that the statistical
time series data on price changes is normally distributed. However,
this did not matter:" The overwhelming majority of research in finance
in those days was no longer concerned with the question of whether markets
were efficient. One just assumed that they were and proceeded from there,
"(p.182).
There is a severe typographical error on p.183 in the second paragraph.
Bernanke, Krugman, Summers, et. al.,are the most prominent economists
of the early twenty first century, not the twentieth century.
A more important error occurs on p.319.The author incorrectly identifies
Keynes's low interest rate policy recommendation for dealing with the
business cycle ,from pp.321-327 of the General Theory(GT,1936), as the
policy used by Greenspan from 1996-2006.Keynes's low interest rate policy
includes a major second part-bank loans are not to be made to speculators
and rentiers. The unsatisfied fringe of borrowers must consist of speculators
and rentiers. Unfortunately, Greenspan made no effort to prevent loans
from falling into the hands of borrowers who did not meet the most basic
,elementary creditworthiness standards.
In summary, Fox correctly calls into question the current foundation
of neoclassical, mainstream economics, from the Black-Scholes equation,
Capital Asset Pricing Model (CAPM),rational expectations, efficient
market hypothesis, and Subjective Expected Utility theory to the Ptolemaic
economists attempt to add more epicycles(more normal distributions)
through the use of the artificially constructed ARCH,GARCH,GARCH II,FIGARCH,
etc., models created by Granger and Engle in an attempt to bypass Mandelbrot's
major analytic results.
All neoclassical economics is built on
the assumption that the normal distribution fits the time series data
best. There is no historical, statistical, or empirical evidence to
support this claim. Mandelbrot has developed statistical
tests that are useful in identifying when the danger signals will show
up in the time series data concerning possible catastrophic results
in financial markets that spread faster than a tsunami.
A great tour of economics since the 1920s, July 12, 2009
By Stephen R. Laniel (Cambridge, MA USA)
For better or for worse, the starting point for all discussions about
capitalism and its failings is some sort of arbitrage principle. Let's
look at the free-market argument against the possibility of racial discrimination
in hiring, for instance. (I'm fairly certain I've read something like
this in Posner.) Suppose you have a highly qualified black candidate
who doesn't get hired, because his potential boss just doesn't like
the color of his skin. The free-market response would be that someone
else will swoop in and hire that person away -- may, in fact, hire him
for less than an equally-qualified white candidate. Companies that are
systematically racist in their hiring will be beaten by those that aren't.
There are two possible ways of interpreting the arbitrage principle
in here. Either a) all companies will behave in a rational way, which
would actually make racist hiring impossible, or b) some smart company
will behave rationally, thereby beating its racist competitors. Inasmuch
as we agree that racist hiring exists, we can rule out a). Besides,
like any evolutionary-type argument, the claim isn't that all actors
or all organisms act in a certain way, just that competitive pressure
will eventually force a particular outcome.
In any case, even b) depends rather sensitively on the structure of
the market. If there are infinitely many companies competing for customers,
then even the tiniest inefficiency -- racism, say -- will be ruthlessly
purged from the market. If there are only a few car manufacturers, on
the other hand, then inefficiencies may last for a very long time.
You might be asking why I've even bothered to advance the infinitely-many-competitors
alternative here. You might also be asking why I'm starting with an
arbitrage principle rather than the rather more obvious fact there there
exist racists in this world, and they don't act rationally. I think
Paul Krugman hit on the answer in Development, Geography, and Economic
Theory: putting the irrational elements of the human brain into a model
turns out to be hard, at least if you're going to cross all your mathematical
Ts and dot all your mathematical Is in the way that economists trust.
Another way to put it is that the perfect-competition model fits together
in a way that few rival theories have yet been able to match. The Myth
of the Rational Market quotes Richard Thaler to the effect that it's
the difference between being exactly wrong or being vaguely right: the
alternative models know they're on to something, even if they haven't
put all the pieces together yet.
I went into Myth thinking that it wouldn't understand the virtues of
modeling -- that it would just be another hand-waving gesture against
"those stupid economists." I have real problems with this anti-quantitative
attitude. Modeling things mathematically has real virtues: speaking
clearly, stating your assumptions as concisely as possible, and opening
yourself up to the possibility of being proved wrong. More-orthodox
economists are on to something when they suggest that behavioral economics
is a collection of nice stories but nothing to build a theory on. By
now it's clear to me that they're wrong about that, but their hearts
are in the right place.
What's amazing about The Myth of the Rational Market is that it hits
all these notes and many, many more. It explains what orthodox economists
think, and why. It describes behavioral economics of the Thaler school.
It describes behavioral finance of the sort that Andrei Shleifer, Larry
Summers, and Brad DeLong are famous for. It describes Keynesian economics.
It goes into the efficient-markets hypothesis at a decent depth. It
follows Eugene Fama -- the father, if anyone can claim that title, of
the EMH -- for a few decades, eventually catching him laughing at how
much of a turn his own mind has taken. (Earlier, Justin Fox had found
Fama praising the stock market after the 1987 crash: surely the market
had just shown its genius, having collapsed quickly after it discovered
new information. No one could identify what that new information might
be, however. Free marketeers do often have a point that The Market Is
Smarter Than You: just because an economist can't figure out why the
market does something doesn't mean the economist is smarter than the
market. However, it seems clear that the 1987 crash wasn't a shining
hour for Efficient Market Hypothesis.)
In fact, The Myth of the Rational Market follows essentially all of
the economics profession from Irving Fisher to the present, and ends
... at a draw, which is exactly where it should be. The orthodox economists
are right that we need a good theoretical model of irrational behavior
if we're going to do it right and if we're going to incorporate it into
the successful body of rational-actor theory. The behavioral economists
are right that there's too much anti-rational behavior to count it as
mere diversions from "real" economics. Behavioral finance has contributed
a lot to our understanding of the stock market: the concept of a noise
trader, and how he interacts with a rational trader, is an important
one. The fact that there are times (like now!) when arbitrageurs can't
borrow as much money as they would need to capitalize on the market's
irrationality, and that those times are precisely when they need money
the most, is an unfortunately important one.
Fox even follows this historical evolution into places where I wouldn't
have expected him to. He takes us to the Santa Fe Institute for a few
paragraphs. Among other things, SFI tries to simulate, on a computer,
many semi-rational economic actors buying and selling from one another,
then watch the collective behavior of these simulated actors. For instance,
do simulated imperfect humans ever cause a stock market to bubble and
crash? Do arbitrage opportunities persist and, in fact, widen? This
falls under the general heading of "microfoundations": deriving explanations
for high-level phenomena out of the (partially) realistic behavior of
low-level actors. If the high-level macrobehavior that fall out of the
model look like the world we're used to, then that's a start. If the
macrobehavior look right and the economic actors look like real, sometimes-irrational
people, then we're on to something. My limited skim of the literature
suggests that we're not there yet.
Whether we get the models right matters, as a glance as today's newspapers
will tell you. Whether we assume that humans are perfectly rational
actors feeds directly into how skeptically we view mortgage brokers:
if mortgage buyers are rational, why bother protecting them from balloon
mortgages? Why be concerned that they might let Enron zero out their
401(k)s? Humans need a bit of help here and there; rational actors don't.
All of this is in Fox's book, which is a page-turner intended for a
wide audience. It covers a broad enough swath of the discipline that
it has probably singlehandedly killed a dozen other, lesser books on
a few dozen sub-areas of economics. I confess that I went into it expecting
that it would be another opportunistic work, riding the coattails of
behavioral economics or of the recent crash. It does neither; it will
still be readable and informative and fun in a few decades. Highly recommended.
The financial turmoil of the past two years threatened the world’s
economies and markets; it also threatened theories that many believed
supported markets and finance. At the top of the list of things we used
to believe in is the efficient market hypothesis—the idea that markets
are so complete and perfect that they incorporate all known information
into stock prices so the prices are always correct. It follows that
because there is nothing the market doesn’t know, there is no other
information available to anyone who could predict future stock prices
and beat the market. Moreover, since new information arrives in a random
unpredictable fashion, and since changes in stock prices depend on new
information, stock prices must be random. These ideas grew up gradually
over several decades and were largely codified as modern financial theory
over the last 50 to 60 years.
The EMH, as the efficient market hypothesis was nicknamed, became
part of the received wisdom of finance—widely taught and rarely questioned.
This approach to investing led in two directions. First, the EMH joined
with ideas that markets provide the best answers to numerous questions
about determining values and setting prices. A corollary is that regulations
that interfere with markets or shift prices are mistaken or worse. Second,
as the EMH’s formal description took on mathematical elegance, it sped
the growth of formal mathematics within finance.
In the last year or two, the objections to the EMH have become louder
and more aggressive. Looking back on the current financial crisis, people
are asking how the prices could have been “correct” all the time if
the market doubled from 2002 to 2007 and then dropped by more than half
in 18 months; and how home prices could have been correct if they appreciated
by three times in five years before crashing. Certainly there must have
been some information that the market missed at the top—something like
the emperor’s fabled “new clothes” that, when recognized, changed things
dramatically. While the events of the last two years seem, for the moment,
to have sunk the EMH, there are challenges going back over two or three
decades. A few that deserve mention are research showing that stock
prices are far too volatile to be determined only by information on
dividends; that there are times when arbitrage is limited and markets
can’t adjust to information; in addition to arguments that if the market
is efficient, no one will pay to gather the information and the efficiency
will be lost.1
Exploring either the financial crisis or the efficient market hypothesis
could easily consume this entire journal, not just this short column.
Rather than a complete review, the next few paragraphs focus on a few
aspects of the recent developments—saving some good things from the
EMH’s demise, understanding where the simplification in the math became
oversimplification and asking what financial economics should aspire
to.
The Cliffs Notes version of the EMH is
that you can’t beat the market and therefore the only way to invest
is to index. Whatever happens to ideas of market efficiency,
indexing will continue to prosper. The success of indexing depends on
two things, neither of which depend on market efficiency—if anything,
market inefficiency might make indexing more attractive. First,
it is difficult to beat the market. Standard & Poor’s SPIVA reports,
which compare mutual funds to our indices, consistently show that only
two-fifths of the funds, or less, outperform over any three-year period.2
Second, as Bill Sharpe and Jack Bogle have both noted, low fees rather
than market efficiency are the key to the success of indexing.
When one builds a mathematical description of some phenomenon—a market,
the weather or the path for the space www.journalofindexes.com November/December
2009 49 shuttle to follow—there are trade-offs between making the model
tractable and making it true to what is being modeled. Consider modeling
something as complex and detailed as the weather—temperature, wind velocity,
humidity and all their interactions point by point in three dimensions.
Very quickly the scale of the problem can overwhelm. Much the same thing
happens when modeling a market, and the solution in either case is to
make some simplifying assumptions.
In many finance models, a common step to simplicity is to assume
that every trader is independent of every other trader: No one ever
buys a stock because someone bought the stock—no one ever acts on a
recommendation. This independence makes it possible to model markets
with the normal probability distribution, popularly called the “bell
curve.” While this may not seem a big deal, it is. With this bit of
simplicity, the models become much easier to solve because the normal
distribution is well understood. However, some crucial problems creep
in. First, the normal distribution doesn’t work for markets—the volatility
experienced in the last year should not have occurred were the market
obeying a normal distribution. Second, when we assumed that traders
were independent of one another—and surely traders spend a lot of time
and effort trying to figure out what other traders are doing—we assumed
away some information that absolutely affects the market. Yet the EMH
presumes all the information is counted.
Forgetting about the messy and inconsistent interdependence of traders
in order to make the math look elegant is characteristic of a lot of
financial theory. In that particular trade-off between solving the problem
and assuring that the answer can be applied to reality, solving won
out. We would have been better off if the answer were only approximately
right but was truly applicable, instead of more accurate but not very
useful. Moving the balance from elegance toward application is akin
to moving from science to engineering. Science is all about building
models to understand something; engineering is all about using that
science to do something. While we have something called financial engineering,
it has too many assumptions that make it “finance science” and leave
engineering too far from reality. Markets are very messy, and the engineering
models turn out not to be messy enough.
Where does this leave indexing? Index
investing turns out to be successful financial engineering—no claims
are made that it always beats the market or is always the best investment
strategy, nor is there a guarantee that indexing explains what happens
to markets. But for the practical problem of how to invest
in a cost-effective way with a reasonable chance of success, indexing
provides an answer that has survived numerous financial crises, including
the last one.
Endnotes
1 Robert J. Shiller, “Do Stock Prices Move Too Much to be
Justified by Subsequent Changes in Dividends?” vol. 71 No. 3, The American
Economic Review (1981), pp. 421-436; Andrei Shleifer and Robert W. Vishny,
“The Limits of Arbitrage,” vol. 52, No. 1, The Journal of Finance (March
1997), pp. 35-55; Sanford J. Grossman and Joseph E. Stiglitz, “On the
impossibility of informationally efficient markets,” vol. 70, Issue
3, American Economic Review (June 1980), pp. 393-408.
2 See www.SPIVA.standardandpoors.com
Oh boy. John Cochrane does not know something that David Hume did--that
the velocity of monetary circulation is an economic variable rather
than a technological constant. Cochrane:
Fiscal Fallacies: First, if money is not going to be printed,
it has to come from somewhere. If the government borrows a dollar
from you, that is a dollar that you do not spend, or that you do
not lend to a company to spend on new investment. Every dollar of
increased government spending must correspond to one less dollar
of private spending. Jobs created by stimulus spending are
offset by jobs lost from the decline in private spending. We can
build roads instead of factories, but fiscal stimulus can’t help
us to build more of both. This is just accounting, and does not
need a complex argument about “crowding out”...
Let us take this slowly.
Suppose that we have four agents: Alice, Beverly, Carol, and Deborah.
Suppose that Beverly has $500 in cash that she owes Carol, due in
two months. Suppose that Alice and Carol are both unemployed and idle.
In one scenario in two months Beverly goes to Carol and pays her
the $500. End of story.
In a second scenario Beverly says to Alice: "I have a house. Why
don't you build a deck--I will pay you $500 after the work is done.
Here is the contract." Alice takes the contract and goes to Carol. She
shows the contract to Carol and says: "See. I will be good for the debt.
Cook me meals so I will have the strength to build the deck--here's
another contract in which I promise to pay you $500 within 90 days if
you cook for me." Carol agrees.
Two months pass. Carol cooks and feeds Alice. Alice goes and builds
the deck.
Alice then asks Beverly for payment. Beverly says: "Wait a minute."
She goes to Carol and says: "Here is the the $500 cash I owe you." Beverly
pays the money to Carol. Beverly then says: "But now could I borrow
the cash back by offering you a long-term mortgage at an attractive
interest rate secured with an interest in my newly more-valuable house?"
Carol says: "Sure." Beverly files an amended deed showing Carol's mortgage
lien with the town office. Carol gives Beverly back the $500. Beverly
then goes to Alice and pays her the $500. Alice then goes to Carol and
pays her the $500.
The net result? (a) Alice who would otherwise have been idle has
been employed--has traded her labor for meals. (b) Carol who would otherwise
have been idle has been employed--has traded her labor for a secured
lien on Beverly's house. (c) Beverly has taken out a mortgage on her
house and in exchange has gotten a deck built. (d) Carol has the $500
cash that Beverly owed her in the first place.
Alice has more income and consumption expenditure than if she hadn't
taken Beverly's job offer. Carol has more income and saving than if
she hadn't cooked for Alice and then invested her earnings with Beverly.
Beverly has an extra capital asset (the deck) and an extra financial
liability (the mortgage) than if she had never offered to hire Alice.
A deck has gotten built. Meals have been cooked and eaten. Two women
have been employed. And all this has happened without printing any extra
money.
John Cochrane would say that this is impossible. John Cochrane would
say:
[I]f money is not going to be printed, it has to come from somewhere.
If Beverly borrows a dollar from Carol, that is a dollar that Carol
does not spend, or does not lend to Deborah to spend on new investment.
Every dollar of increased Beverly spending must correspond to one
less dollar of Carol or Deborah spending. Alice's job created
by Beverly spending is offset by a job lost from the decline in
Carol or Deborah spending. We can build decks instead of fountains,
but Beverly stimulus can’t help us to build more of both. This is
just accounting, and does not need a complex argument about “crowding
out”...
John Cochrane is wrong.
You sometimes see this mistake in freshmen students in Economics
1, students who do not fully understand either the circular flow of
economic activity or what a credit economy is. They think--like Cochrane--that
the flow of spending must be constant unless somebody "prints
money" because, you see, you need "money" in order to buy things.
The premise is true--you do need "money" to buy things--but the conclusion
is false: the flow of spending is not necessarily constant. In the world
in which Beverly does not hire Alice but instead pays the $500 directly
to Carol, that $500 turns over only once--its velocity of circulation
is equal to one. In the world in which Beverly does hire Alice, the
velocity of circulation of the $500 is four--it goes from Beverly to
Carol, from Carol to Beverly, from Beverly to Alice, and from Alice
to Carol.
Cochrane's mistake--an elementary, freshman mistake--is because he
has not thought enough about how a credit economy works to recognize
that the velocity of circulation can be an economic variable and is
not necessarily a technological constant. And as the velocity of circulation
varies, the amount of the flow of spending varies as well: it is now
longer the case that if Beverly borrows a dollar from Carol that is
a dollar that Carol does not spend.
Milton Friedman knew this. Irving Fisher knew this. Simon Newcomb
knew this. David Hume knew this. John Cochrane does not know this: does
not know that the velocity of circulation is an economic variable rather
than a technological constant.
I do want to pound my head against the wall.
I do not know what else to do...
October 12th, 2009 | The Big
PictureThe odds favorite to win the Nobel, Eugene Fama, lost
the prize to two other Americans, Elinor Ostrom and Oliver Williamson.
Ostrom & Williamson study the way decisions are made outside of markets,
which is the focus of many other economists.
This award is a victory, in small part, for the Behaviorists, whose
studies of our flawed wetware include such normal human foibles as irrationality,
poor decision making, biases, non profit maximizing behavior.
Why? As we noted
last night, the odds on favorite to win was the precise opposite
of the behavioral economists — the father of the efficient market hypothesis,
Eugene Fama. Users of his EMH have created various predictions markets.
These markets had Fama the odds on 2 to 1 favorite to win the
prize this year. There is no small degree of irony here, in that
Fama’s Efficient Market Hypothesis, where markets reflect all information
on a given event, had so much wildly misplaced optimism on this occasion.
In a case of bizarre reflexivity, if these markets had not
been so bullish on Fama’s chances of winning, it would have done more
to prove his theories. Instead, they gave him the best odds to win.
This actually points to a major flaw in their thesis: the false belief
that Humans make good decisions in groups, or that markets accurately
depict the sum total of info on a given subject.
As I have argued in the past, prediction markets work best when their
members mirror those of the group they are seeking to forecast. Jurors,
Boards of Directors, Nobel Prize committees all are terrible groups
for these markets to forecast, as their members rarely have much in
common with prediction market Traders.
Perhaps the greatest irony is that Fama supporters, whose theories
do such a poor job explaining bubbles and busts, were surprised by the
results. Given the failure of the market itself to anticipate its own
collapse, perhaps this was a very poor year to expect much in the way
of recognition of the theories that supported many of the decisions
that led to the collapse.
EMH proponents are apparently as tone deaf politically as they are
economically.
dblwyo:
Actually Williamson and Ostrom work in the “new institutional
economics” which says essentially that the pure theory of markets
ignores the factors, like rule of law, property rights, court systems,
police, etc. that actually lead to the existence of markets. Several
years ago the Nobel was awarded to Doug North and Bob Fogel for
their study of the rise of institutions and the role of those institutions
in promoting market efficiency and effectiveness. This is much more
than a mere quibble as it’s really an existence proof for all that
EMH holds dear and which is not a historic accident but the result
of millenia of careful nurturing. Another guy who should have won
is Mancur Olson but his personality was such nobody wanted to award
it to him and he passed on too young for time to force the issue.
All ten of the letters in the 8-14 August issue of The Economist
are responses to the
critique of academic economics in the 18-24 July issue. My favorite
is from
Meghnad Desai:
"SIR - When I was a student we studied business cycles, but the
topic disappeared with the rise of mathematical equilibrium theorising.
The idea that capitalism is an equilibrium system is common among
Keynesian and neoclassical economists; they only differ as to whether
the equilibrium is at full employment or under employment. The grand
synthesis being taught makes the equilibrium stochastic and dynamic,
but that is all.Capitalism is, however, a disequilibrium dynamic
stochastic system as Marx, Wicksell, Schumpeter and Hayek have told
us over the past two centuries.
Richard
Goodwin tried his best to present a mathematical theory of such
a disequilibrium system. After the crisis we need to revive that
tradition if we are not to be surprised by another crisis."
The
on-line
Lucas
Roundtable at The Economist doesn't have any invited contributions
from left-leaning non-mainstream economists.
Firefighter arson is a serious problem. The U.S. Fire Administration,
part of Homeland Security, concluded in 2003, “A very small percentage
of otherwise trustworthy firefighters cause the very flames they
are dispatched to put out” (p.1). Illustrative and shocking anecdotes
are on pp. 9-15 of that report, as well as here and here.
Macroeconomic policy making now has a similar issue to confront.
As the economy begins to stabilize
and the financial system shows signs of recovery, accolades start
to shower down on various officials, including most recently Ben
Bernanke, who was rewarded this week with renomination – and almost
certain confirmation – to a second term as chairman of the Federal
Reserve Board of Governors.
Bernanke is widely seen as our financial firefighter in chief
(BusinessWeek; USA Today) Similar terms are used to describe Treasury
Secretary Tim Geithner and the entire gigantic financial rescue
effort. Larry Summers, head of the White House National Economic
Council and administration economic guru-at-large, is applauded
as an “experienced crisis manager”, which amounts to the same thing
in this context.
If any of this sounds familiar, you’re probably remembering the
famous cover of Time magazine from November 1999, which depicted
Alan Greenspan, Robert Rubin, and Summers as “The Committee To Save
The World.” The idea then was that crises in Asia, Latin America,
and Russia had spilled over to US financial markets, most notably
in the near failure of Long Term Capital Management, but disaster
had been averted by – essentially – the financial firefighting abilities
of this troika.
But what if the financial crises
in recent decades – you can add the dotcom bubble, the S&Ls fiasco,
and various emerging market debt crises to our recent housing and
banking disaster – is not a sequence of random unfortunate events,
but rather the product of a dangerous financial system?
Given that today’s firefighters also previously held responsibility
for overseeing this system, both recently and as long ago as the
early 1990s, this question is relevant – particularly as the very
same team, in various combinations, repeatedly pronounced on the
system’s fundamental soundness.
Some of today’s firefighters pushed
hard for deregulation of derivatives markets in the 1990s, and this
now proves to have been an important cause of the crisis (Summers
and others). Others had responsibility for the solvency
of Wall Street over the past half decade, yet disguised all potential
warnings in layers of impenetrable opaqueness (e.g., Geithner; see
p.91 in David Wessel’s bestselling In Fed We Trust, Crown Business,
2009). Still others pronounced that
there was no housing bubble exactly as things spiraled out of control
and the potential costs to taxpayers rose (Bernanke and his colleagues
at the Fed; again, pick up Wessel’s book, p.93 is among the most
damaging).
No one is suggesting that our illustrious financial firefighters
deliberately triggered a crisis. But, for over two decades, they
and their close mentors oversaw the operation and development of
a banking and securities system with profound instability hard wired
into its DNA. Don’t take my word for it; review this speech by Summers
in April 2009, or – in the light of what we know now – look at his
talk on crises to the American Economic Association in 2000.
Perhaps that was all a legitimate mistake on their parts and
they have now learned the right lessons. But how then do you explain
their amazing reluctance to reform the financial system today?
President Obama said on Tuesday that Ben Bernanke helped avert
a second Great Depression. That is a considerable achievement, but
why then are this administration and the Federal Reserve proposing
only minor adjustments in oversight and governance for the financial
system that ran amok – producing “financial innovation” that harms
consumers and destabilizes everything?
It makes no sense at all. Unless, of course, they are not afraid
of future financial fires – despite the enormous fiscal cost (likely
40% of GDP from this round alone), the unemployment (heading to
and lingering at 10%, by the administration’s own revised estimates),
and the millions of people hammered hard by lender abuse, house
price collapse, and job losses.
You may not like the implications, but keep in mind this advice:
“To ignore the problem or suggest that
it does not exist will only increase the damage caused by the arson
firefighters involved, as well as destroy the morale of the other
firefighters in their departments” (Minnesota Fire
Chief, March/April 1995 issue, quoted on p.1 of above cited report).
By Simon Johnson
A slightly edited version of this post originally appeared
on NYT.com’s Economix, and from that version you can link directly
to the referenced pages in David Wessel’s book.
This post is reproduced here with permission. If you would like
to use the entire post, please contact the New York Times. The usual
fair use rules apply to short quotations.
Selected comments
Bill Raduchel
The Japanese have a phrase for this: Kaji-ba dora-bo. Literally
thief at the scene of a fire:
someone who turns the misfortune of others into his or her own
benefit.
whess
To understand the complexity of this idea read Mishima’s Temple
of the Golden Pavilion.
Hillbilly Daryl
See also Naomi Klein’s The Shock Doctrine-The Rise Of Disaster
Capitalism which takes this theory to the next level and exposes
the manufacture of crisis to facilitate financial reward.
Russ
No one is suggesting that our illustrious financial firefighters
deliberately triggered a crisis.Actually, lots of people
think exactly that, and although that’s perhaps a conspiracy
theory, it’s not without evidence.
Didn’t John Williamson openly
say that sometimes crisies should be “deliberately provoked”
in order to open up opportunities for disaster capitalism? I
imagine the idea goes back as far as Chicago in the 50s.
My personal view is that they know that exponential debt
and growth can from here (”here” being since the 80s at least)
on be propped up only through bubbles, while disaster tactics
can still reap profit from the inevitable crashes.
So this, named the “Great Moderation”
in classic Orwell fashion, is the new economic model, for as
long as globalization and financialization can be propped up:
1. Blow bubbles, sucking in as much rent as possible along
the way.
2. Capitalize opportunistically during the crashes.
So they hardly have to commit arson when we’re already always
either in the flames or about to topple back into them.
Their kind of warmth demands permanently playing with fire,
which is why they certainly won’t willingly regulate for the
next bubble.
If they can’t blow another bubble, that’ll be the end of
corporatist growth right there. Game over for mass industrial
“capitalism”.
Obviously, keeping this game going as long and as profitably
as they can is their only priority.
Silke
I dont’ believe in conspiracies but I firmly believe in ruthless
competition on who’s best at screwing the “great unwashed” or
at best completely disregarding their well-being. Any protest
against exploitation (Ausbeutung) is nowadays successfully denounced
as a longing for Soviet-style socialism… and those who have
a good chance to win the race to the top always find willing
sucker-ups aspiring to the title of eminence grise, and lots
of Mitläufer (along-runners, me also-s)
Sid
“Any protest against exploitation (Ausbeutung) is nowadays successfully
denounced as a longing for Soviet-style socialism”
D. Christopher Leonard
In “social classes” Schumpeter noted that members of a class
behave towards eachother differently than to those outside the
social group boundaries. Certainly the upper echelons of the
banking/finance community in NYC-London do so. They socialize
together, live proximate to eachother, vacation in the Hamptons,
send their kids to the same schools, and marry amongst eachother
with greater frequency than with marriage partners drawn from
other groups. They purchase university educations from status
good schools (e.g. Oxbridge, the Ivys)to build and maintain
social networks.They certainly plan for the future in as
much as they effectively lobby national governments for policies
favourable to their interest (e.g. no regulation of derivatives,
repeal of Glass-Steagel). So the assertion that ‘people’ don’t
plan isn’t tenable.
While their are probably not formal agreements, the assumption
there must be formal cabals misunderstands the nature of informal
social networks in the construction and maintenance of elites.
There is at least a half century of empirical research on elite
behavior – starting with C.W. Mills that belies your claims.
Try reading a history of the Warburgs, or the Wendels, or
the DuPonts. Or undertake a proserpography of senior management
in U.S. investment banks, money center banks, and brokerage
houses (plus senior staff in treasury, Fed) and it ought to
be an eye-opener. In otherwords, it doesn’t have to look like
a price-fixing cabal in an industrial sector to have informal
but powerful coodination!
aldante
What’s the mob then? What are drug cartels? What about the $200
million conspiracy in San Diego county involving 26 people and
100 properties? No conspiracies……..wow.
Ohhhhhhh R u being facetious?
Patrice Ayme
If one looks at the definition of “great depression” according
to median income averaged over 20 years, it looks worse now
than in the 1930s. Moreover the present crisis threatens the
very core of the USA’s supremacy, and that, the crisis of the
1930s never did.
One cannot have a superior nation if all that it consumes
originates somewhere else.
BTW, the firefighter arsonist problem also occurs in France…
Francois
It has been argued that the 1930s
depression was the a signal crisis that led to the final collapse
of British global dominance, and the consequent rise of U.S.
hegemony.
Of course the industrial and financial groundwork had already
been laid, and of course WWII was a big part of this, but the
1930s economic crisis was certainly a watershed event that helped
usher in this shift in global power relations.
I don’t think it is much of a stretch to see a similar thing
happening in this financial crisis, with the decline of U.S.
global dominance and we can all guess which power is rising
to replace it. In retrospect, this crisis may well be seen in
these terms.
BTW, you’re absolutely right that it occurs in France and
if I’m not mistaken, French firefighters
used to get “primes” or bonuses when they fought fires, which
actually gave them an incentive to start them.
Ideally they would be small and easy to put out, of course,
but occasionally they ran out of control. I’ll let others follow
up on that analogy.
Patrice Ayme
It is WWI that caused the decline of Britain (and France). WWII
was more of the same.
The crisis of 1929-1933 was caused by the bubble economy
of 1920s, itself a result of an attempt to reflate the British
economy. At least such is my understanding from my very long
term memory (I bought, but did not read yet more recent books
on the subject, with the exception of Niall Ferguson, who are
full of unacceptable “explanations”, similar to the “explanations”
of that preceding historian of the Ferguson’s sort, who was
elected in January 1933).
Both WWI and WWII caused the ascent of the USA, and the so
called “American Century” [1945-2001]. The USA profited from
the wars without suffering much from them. Whereas the USSR
lost more than 26.6 million people killed, and all of the rest
of Europe was devastated, except for two countries which collaborated
with Hitler, namely Sweden and Switzerland.
The fact the later two did so well
economically afterwards is a testimony to the fact that war
can be highly profitable, if one avoids massive
destruction while extending one’s economic reach, which is what
the USA did on a massive scale.
For example as International Business Machine was given the
monopoly for computing in Hitler’s Reich, it extended its reach
in (occupied) Europe. By what some
insinuate was not a miracle, none of the 35 factories of IBM
in Germany was damaged enough to stop operations during the
war. As Europe was liberated, Hitler’s IBM (”Dehomag”),
the Nazi octopus, became American IBM, the liberator octopus.
And so on with many American enterprises which had collaborated
with Hitler.
As Europe imploded, the European empire collapsed and were
replaced by American influence, business and value system. That,
too, was highly profitable.
Thus the ascent of the USA is closely related to German becoming
fascist crazy (1914-1945). Russia becoming crazy with Soviet
fascism did help the USA too. As Europe is rebuilding, one can
suspect that the USA, left to its own instruments, will shrink
back because its imperial mentality is not adapted to the loss
of the artificial reason that made it so big.
The Europeans now know that materialism, imperialism, nationalism
and hubris excess can lead to the destruction of civilization.
But America’s main stream ideology
has not integrated that lesson, and thus the elite of the USA
keeps running away with the worst errors, in blitheful impunity.
Excess never last forever.
Patrice Ayme
http://patriceayme.wordpress.com/
Patrice Ayme
Silke: These problems are vast. You are right about the declines
of other powers. Now as far the USA is concerned, it all depends
upon what “USA” means. The GIs on the beaches were heroes, and
so were the crews of the carrier Enterprise.
One has to get away from the national model: inside most
countries, some people behaved well, and others, terribly. No
doubt most Americans behaved very well in WWI and WWII, as they
do now. Most Americans did not support Hitler anymore than most
Americans worked at Goldman Sachs.
It may be more profitable to criticize specific ideas rather
than people.
For IBM, please read “IBM and the Holocaust” (Erwin Black).
I have written more than 2,000 pages on my various sites on
the general subject of the factors that led to WWI and WWII,
and my convictions are numerous, to the point of looking sometimes
contradictory to the untrained mind.
Patrice Ayme
http://patriceayme.wordpress.com/
Silke
I am rather proud of my untrained mind.I am aware of the
IBM-book, it created quite a ruckus at the time in Germany.
there are stories galore like that
and last but not least
I meant the USA as an occupying power in Germany – it gave
little me a prosperous and really good life to date
and to make the the probably most contentious point clear:
I am convinced that the bombing of German cities during WW2
was the right strategy. It made my Herrenmenschen-ancestors
tired enough to not resist occupation. And I take into account
that it made my first 3 years quite unpleasant – though it was
mostly the British who bombed Nuremberg where I lived at the
time, I am glad the US did not stop them doing it
Silke
???
“we can all guess which power is rising to replace it”
To me that sounds like a much too orderly sequence of events.
if the American hegemon should really go into decline my bet
is on an extended period of chaos during which everybody is
trying to grab a piece of the cake whether the current candidate
for “succession” will eventually come out on top is a totally
open gamble
- who would have thought at the time that some Arab desert
sheiks would suddenly appear on the scene and manage to grab
huge chunks of the former Roman empire as well as eventually
East-Rome (Byzantium) also
Patrice Ayme
Silke: Happy you loved the bombing of Hitler’s Germany. I agree,
all the way to Hiroshima (I have some doubts about Nagasaki).
I have no problem with these Anglo-Saxon heroics. Interestingly
the son of ambassador Kennedy, a fascist sympathizer, died in
a quasi suicidal bombing mission against the Nazis. Raffiniert
ist der Herr Gott…Aerial bombing, however atrocious, was
the only way to defeat Hitler, itverpt the breaking of hubris,
but it is not restrcited to Herrenmenschen, which is the subject
at hand.
Silke
I once had a neighbour who was a devoted voluntary fire-fighter
and paramedical to boot considered by the whole village after
careful and reluctant assessment to have started quite some
“good” fires, fortunately without loss of human life, albeit
killing in his greatest “success” a number of cattle and pigs
it seems that in the rural areas of Germany this is not uncommon
at all
whess
Otto: Apes don’t read history.
Wanda: Yes they do, Otto, they just don’t understand it.
whess
When you write that the behavior
seems to be wired into the DNA you are saying the it is unavoidable
in the current system. It fits the patterns of totalitarian
governments, which use crises to legitimize their power.
I shudder at the terms recover, reform, and re-regulate because
none of these involve major changes to the system, changes that
would indicate substantial cultural evolution (and thus changes
in the DNA, to extend the metaphor).
I believe we are in a pre-revolutionary situation in this
country. The respondants to these posts are highly educated
and equally disaffected. We have lost confidence in the government
to address the basic needs and concerns of the majority of the
population. Obama, like many transitional administrations, seeks
to please everyone by its moderate positions. Such an approach
eventually fails because it fails to make radical enough changes
to resolve the underlying grievances.
Simon, your comments reflect
this disilluionment and cynicism that characterizes many intellectuals
today. You write them as if you fail to realize how damning
they really are.
I was struck by the respondant who wrote of U.S. Supremacy.
We were cast in a role after WWII that may have done us more
harm than good; I suggest leadership in any sphere comes from
the qualities of courage, justice, and compassion. U.S. supremacy
has been built on a very different foundation. If we want a
strong national and global economy we learn how play fair and
share the playground.
BTW I love your blog!
Carson Gross
I don’t think the firefighter arsonist metaphor is a good one.
The firefighter arsonist is intentionally causing an evil in
order to participate in the form of a good.
Bernanke’s situation is much closer
to that of The Magician’s Apprentice. He’s playing with a system
far more complicated, chaotic and reflexive than he can possibly
hope to understand, model or control. And, in that sense, his
failure is mixed up with the core failure of our broader academic
class: a lack of humility in the face of the unspeakable complexity
of the world coupled with a quasi-platonic messianism.
Cheers, Carson
egominimus
This is one of the most intelligent posts on this and many blogs.
But, I would quibble further with the dig at academics or “quasi-platonic….”
dont even know what that means.
One of the clearest explanations of what has happened, is
a system complex beyond our understanding.
zic
Many years ago, when my son was in second grade, he entered
a ‘video’ he’d made in a competition for students run by the
Boston Computer Society. He won first place in his division,
simply because there had never been another second-grader produced
video.A few months later he was happily planning his project
when he got an email; there would be no next year. The society
had held its annual meeting, and compared its accomplishments
to its mission, and decided the mission accomplished. Instead
of creating new goals — or lighting more fires — to justify
continued activity, it disbanded.
(In contrast, at the same time, the Mass. Turnpike Authority
met, said it’s mission of paying for the Mass. Turnpike was
accomplished, and invented a new, never-ending mission.)
The Boston Computer Society’s
action still stuns me; it’s an incredibly rare thing.
Most groups follow the example of the Turnpike Authority, and
expand their mission, lighting new fires to put out instead
of taking credit for a job well done and stepping down or stepping
back.
No, I’m not libertarian and think the Federal Reserve should
retire because the “recession” is over. But I do think mission
creep you describe would lead to fewer fires if all public agencies
had more of the “mission accomplished, let it go” mentality.
pacr
Zic: The same thing goes for private corporations, they mutate
through time to justify their continued existence – their original
products become obsolete, so they invent new ones. They gobble
up small companies to eliminate competition etc.
‘Mission creep’ is a universal characteristic
of human activity. It’s up to others – voters
or shareholders- to question the reason for the continuation
of any organization.
Philip H
It makes no sense at all. Unless, of course, they are not afraid
of future financial fires – despite the enormous fiscal cost
(likely 40% of GDP from this round alone), the unemployment
(heading to and lingering at 10%, by the administration’s own
revised estimates), and the millions of people hammered hard
by lender abuse, house price collapse, and job losses.Simon,
I think you missed this mark just slightly. Precisely because
they view themselves as the saviors in all the other crises,
they believe that no reform is really needed BECAUSE they know
they can save us when the relaaly big bubble bursts.
Its a combination of pride, inflated
egos, exagerated sense of control, and blindness to their own
contributions to the problem.
Of course, it doesn’t hurt that they are also mostly ex-financial
sector folks who are routinely lobbied for by many in the industry.
Foxes and hen houses, after all.
tyson
With all do anger to Bernanke and Greespand and the rest of
the individuals who helped perpetuate bubble economics. In the
end, where is the anger on the part of the populace?
Ultimately people get the governments
they deserve, and while I shudder to say it, the US people deserve
this government and the other inevitable consequences of inaction,
laziness and ignorance.
As many posters have noted, all segments of society have
lost their believe that government can do anything of value
or improve their lives, yet their vote in the very same people
year after year. Why on earth would the Bernanke’s of the world
change, they can do what they please and face little to know
consequence, except the possibility of a promotion. Why would
the Dem ever champion true reform when they know faking it will
ensure their re-election? Until the average American gets more
interested in economic policy then Michael Vicks personal activities,
the state is doomed.
The people have been lulled to sleep, and they seem to love
it. I have to agree with Bill Maher,
the US is a dumb country, or perhaps a better way to put it
is selective stupidity. While the average gun
totting protester can probably name the entire staring line
up of the his local college football team, who probably can’t
name his representative or whom the Federal Reserve Chairman
is, or define interest rate. But he could probably unload and
reload a rifle before you could say “screwed up priorities”.
The US ridicules the UK for its
monarchy, yet watch as Senators who preside in ignorance for
40 years only to retire and appoint their children to their
seats. Biden and Dodd have already indicated
this will be the case. They rage against healthcare yet see
no connection between treating their bodies horribly. At the
same time we are debating deductibles, public options, ect,
KFC recently came out with a sandwich with fried chicken as
bread. You can have all the public options you want, if that
is what you eat, you will be unhealthy.
Finally, while I love to come to these sites and read the
posts, this small group of uber-interested policy wonks are
in the minority. After reading some of the comments from congressmen
and the media, I am firmly convinced that we are better informed
and more interested in public policy then they are. That is
scary. When random internet readers can better discuss the details
of banking regulation then elected public officials, your state
is sunk.
jake chase
Don’t blame the voters; they only give us a choice of two, and
half of us haven’t voted for years and years. They skunked us
at the first Constitutional Convention. Only a parliamentary
system can save us. Perhaps, there is a Kennedy or a Bush willing
to serve as monarch? In fact, maybe we should merge with England?
Replace the Supreme Court with a House of Lords? Sell titles
of nobility to retired corporate poobahs and pay down the deficit?
How does the Bank of England work? Is it more to be trusted
than the Fed?
After the South Sea Bubble exploded
(1720) the leading finaglers were stripped of ALL their property.
Makes you believe in ex post facto laws!
tyson
I will have to kindly disagree with you on the two choices part.
Ross Perot came up, Nader has run forever, but no one votes
for them. While neither of these men would be my personal choice,
a viable third or fourth party would do wonders. But because
no one believes that a third party is viable, progressives must
join the democratic party.Perhaps another option for certain
parts of the US. Seriously, let
the South secede. I continue to hear there is
no blue America, no red America rhetoric, but believe me there
is.
People in Seattle have far more
in common with Canadians then with people from Texas.
Part of the US want to be a progressive, democratic country
based on secular values, the embrace of science, and a more
moderated version of capitalism.
The other wants to turn back the clocks, teach creationism
as science, burn any book other then the bible and let the chips
fall where they may. Why not let them?
As a Canadian, I invite all interested American States to
join Canada. I think we all know which states would want to
join, and which ones would join the sovereign Texan Republic
and start a war with Mexico. Its a little cold, and you would
have to embarce the metric system, but I think most would enjoy
it.
pacr
“After the South Sea Bubble exploded (1720) the leading finaglers
were stripped of ALL their property.”is it known how many
of them made it back to positions of eminence?
Silke
Simon: Is this a personal failure
by folks like Bernanke, Geithner etc. Or is it systemic?
Yes some people ’saw’ the bubble ahead of time, but
were they mavericks? Mostly, it seems. This implies that orthodoxy
failed, not just the purveyors of orthodoxy. So those firefighters
cannot be blamed because they didn’t realize that they were
playing with matches – who knew matches start fires?Clearly
orthodox economists had no clue about the economy they were
overseeing. That much we know. If they did then they are morally
culpable. If they didn’t they are ignorant. Either way we shouldn’t
trust them now.
But what choice do we have? Where is the new theory?
Yakkis mocks ‘complexity’ – I agree it is too often a crutch
when we don’t understand something – but it seems economists
have simplified their models to the point, not just of irrelevancy,
but of starting fires.
Is that what you are saying?
jake chase
Anyone who understood the dynamic
relationship between credit and collateral could see the crisis
coming, but economists focus only on published statistics and
there are no statistics for collateral values.
Mainstream economists can neither explain nor predict anything,
but they provide useful justification for existing power relations.
They tell us GDP is up three percent. Who knows how they count
it? For all they care it was buoyed by a boom in child pornography
sales. When aggregates are inconvenient they stop counting,
as for example with unemployment.
They define inflation out of existence by excluding things
people buy out of necessity and focusing on the price of computing
power.
JK Galbraith said it best: economics
is the only profession in which it is possible to rise to eminence
without ever once being right.
Silke
Churchill said: “Statistics are like a drunk with a lamppost:
used more for support than illumination.”
and “the only statistics you can trust are those you falsified
yourself”
jake chase
What is interesting about the euphoria over Bernanke is that
it has arisen before the development of ANY real recovery.
What Bernanke saved was the power of the financial elite
who have begun renewed mischief in the stock and
currency markets, blowing another bubble because there is no
current use for credit apart from fueling speculation.
What, no productive lending?
Why is this surprising when new construction is comatose
and industry operates at 60% of capacity? No mortage lending?
Who can afford one of these still overvalued houses, particularly
now that he is expected to pony up a hefty down payment and
perhaps even required to prove his claimed income?
It would appear the Administration
is counting on reviving consumer spending by creating CONFIDENCE,
but what is the basis for confidence?
We have phony statistics and inflated stock prices and artificially
stimulated vehicle sales (whose primary beneficiary seems to
have been Toyota), and chump change tax credits to stimulate
new home purchases by anyone who somehow can still afford one.
Meanwhile, banks continue to rachet up the terms on consumer
credit, and the whole fiasco continues hostage to the Treasury
bond market which is expected, I suppose, to continue bubbling
forever because, because why? Because lending to our federal
government for ten years at less than four percent, and for
thirty years at less than five, makes economic sense? To whom?
Are the Chinese as gullible as Japanese real estate investors?
If what we have these days is not another house of cards I will
have spent forty years studying finance and economics for nothing.
But the ominous question remains: what comes next?
D. Christopher Leonard
Accepting that financial elites
(banking) transit to government and then back again – perhaps
akin to setting the fox to watch the chickens, we might want
a broader historical perspective on the behavior of American
financial elites both in and out of government.
Over the same period, there has been widening income inequality
(v. Saez’ work) and manufacturing has declined.
The U.S. exports armaments, primary agricultural products,
and sovereign debt.
Over the same period, the terms of political discourse have
been defined by the Reagan-ite ‘government is the problem/enemy
and so we have dis-invested in infra-structure, education (more
broadly social capital) pensions were shifted from defined benefit
to define contribution, shifting risk onto those least able
to bear it.
To note that these co-occur is not to prove that they are
by design linked. But it may be useful to think about why capitalist
elites have felt that there needed to be a new wave of accumulation,
and that the traditional bases of U.S. strength – a very well
endowed, big continent,the absence of industrial competition
for 30 years after WWII, and a huge national market – were diminished
and ‘we’ were no longer internationally as competitive – except
in as much as an imperial power can always exact compliance
or at least deference.
Think about the boosterism of Summers, Rubin, Greenspan,
etc in that light.
Yakkis
No one is suggesting that our illustrious financial firefighters
deliberately triggered a crisis.
Exactly. Who knew that if you poured gasoline on the economy
making it overheat and then lit a match that the whole thing
could go up in flames?
Silke
Yakkis, you underestimate human stupidity
Yakkis
There is this wonderful type of
stupidity where you accidentally become rich beyond anyone’s
wildest dreams.
Silke
Yepbecause why should people who are so notoriously bad at
planning and predicting be good at it when they happen to be
villains – stupidity and ruthlessness/recklessness go very well
together
If I hadn’t seen so many utterly stupid people succeed beyond
any measure of imagination I would agree with you – but so personal
experience makes me wary of atrributing the power of planning
this to them
nevertheless they are of course they are wholly accountable
for what they did – if they claim they are not the place for
them to be is the lunatic asylum (not the modern kind though-
hopefully)
Yakkis
I find your words strangely comforting, as if I too could achieve
the American dream.
chas
Our financial system is under the control of a group of pseudo-intellectuals
who’ve convinced themselves & everybody else that they’re really
smart.They talk like they’re smart, they look like they’re
smart, they sound like they’re smart, they act like they’re
smart. But they’re all really, really stupid.
Patrice Ayme
Chas: That is why the Greek discovered
the concept of hubris: superiority pushed to the point of completely
idiotic madness. The Greeks discovered it the
very hard way: their civilization never came back…
Silke
Greek hubris is also supposed to make the Gods jealous
wonder who will turn out to be the Gods this time
Greek civilization came never back?
their culture survived not only in Rome but in Byzantium also
and clad as an ideal to this day
Patrice Ayme
Silke: Elements of Greek culture survived in the Greco-Roman
empire. Constantinople was all the opposite of Antique Greece:
the demos spoke Greek, true, but had no mind.
Greek civilization is fully born again today, true, and even
in Athens. But it had gone extinct, at least in Greece, for
22 centuries (from Alexander to the flight of the Ottomans).
Patrice Ayme
And, as far as jealousy is concerned (good question), the whole
world has long been jealous of the USA… Yesterday’s rest of
the world, tomorrow’s gods?
pacr
I assume you’re referring to economists, especially financial
economists. Peer reviewed journals helped them self-select themselves
into oblivion. The trouble is: they took us with them.They
need to be held accountable. Maybe we should ‘deregulate’ economics:
abandon tenure, open up the market for ideas, eliminate the
oligopolists running the journals.
Could be fun to do to them what they did to us.
Paul Handover
Chas, echo that for politicians.See this http://waugh.standard.co.uk/2009/08/brown-ignored-warnings-re-toxic-loans-and-financial-crisis.html
In that article Jim Chanos and Paul Singer, both financial
bods, come out of it pretty well.
Earl Killian
Perhaps a better analogy would have
been a fire chief who fights to prevent the national electrical
code from adopting rules that reduce fires caused by faulty
wiring. The fire chief reasons that electricity
has benefits, and so shouldn’t be burdened with rules, and besides,
and the fires that result can be handled by his fire department.
The debate never seems to include the option that you can have
the national electric code without reducing innovation in electrical
products.
Yakkis
…where the firechief has been appointed by the local arsonists
who need for the fire department not to put out the fires until
there has been a total loss.
MarkS
Don’t count me in on the firefighter theory. The reason for
our serial bubble economy is simple: Our credit driven banking
regime, and our culture’s unwillingness to sacrifice short-term
advantages for long-term properity.Our financial system generates
money on the basis of the promissory notes accepted by the banking
system. At some point in the growth of the money supply, debt
will exceed the income available to service it. At that point,
two options are possible:
1. Deleverage – Write-down those debts that can not be serviced
and properly value assets that decline in price. (Take your
medicine)
2. Re-Inflate – Pump-up different assets’ market value with
new banking loans that will briefly compensate for the old loans
in default. (Hair of the dog)
I think that the Fire Insurance
analogy is more apt. Allowing the financial industry to issue
Credit Default Swaps in excess of the value of the assets being
insured created the perverse incentive to bankrupt the securities.
Ted K
The thing I think is, you need someone who generally cares for
other people, and the citizens of America–the “smallguy”.
Everything in Lawrence Summers’ demeanor, tone, and body
language says he doesn’t.
His whole attitude is one that can’t understand why other
people can’t just be born in a family of wealth and privilege
like he was.
His facial expression screams “Why can’t everyone just draw
squiggly lines on a supply and demand graph and make millions
like me?” He’s not only arrogant, he is PROUD of his arrogance.
We have other people like Alan Blinder and Joseph Stiglitz
who can draw lines on a supply and demand graph who genuinely
show more concern for the “small fry”. Why do they always get
lost in the mix???
chas
Precisely.
And why can’t we find some political candidates SOMEWHERE,
to run for Congress or the Presidency, with some genuine empathy
for Main Street Americans?
For the skilled workers & unskilled laborers who work hard
all day every work day to produce the stuff consumed by the
parasites in Congress, the Administration, at the Fed & big
bank management.
Silke
“And why can’t we find some political candidates SOMEWHERE”
from afar it looks like by now only Saints qualify and to get
a saint who has the shrewdness of getting deals made, being
devious, threatening and upright honest all at the same time,
as gifted negiotators have always been, seems very improbable
to me.
in some way the current job description for politicians in
democracies have to be rewritten – maybe regularly confessing
past and current sins with the promise of not repeating them
would do
Uncle Billy the Un-Cunctator
“No one is suggesting that our illustrious financial firefighters
deliberately triggered a crisis.”Are you saying that Nemo
is suggesting this?
You are wrong. There are plenty who are suggesting this,
just not many who have any solid evidence. The fact that they
might not have a PR machine that gives them a platform does
not mean they are “no one.”
Refer again to Jamie Dimon’s smirking comment to Charlie
Rose. Something like: “Buying a house is not the same thing
as buying a house on fire.”
http://paul.kedrosky.com/archives/2008/07/09/an_hour_with_ja.html
Refer again to this paper from 2002 called “Home is where
the equity is” (Univ. of Chicago academic, btw) It offered a
suggestion for policy — let people suck the equity out of their
houses. Doesn’t the title remind you of Willy Sutton’s famous
quip? “That’s where the money is”? Willy Sutton, the bank robber?
Are there lots more clever titles on papers out there that helped
us blow our bubbles?
http://faculty.chicagobooth.edu/erik.hurst/research/equity_resubmission_jmcb_final_aug2002.pdf
Silke, there is far more stupidity and chaos out there than
conspiracy. This is not, I believe a reason to discount the
possibility that our crisis(es) were engineered systematically.
Silke
forgot:
as those who engineered the steps towards the abyss got paid
for their “expertise” they have forfeited their right to that
money just as any car salesman would forfeit his if the car
deviated in a major let alone catastrophic way from the sales
pamphlet.make them bankrupt and put them on food-stamps or
whatever your American equivalent of Hartz IV is and do it not
only to the bonus collectors among them do it also to the professors
who promoted the theory/dogma.
Whether assistant professors and clerks, journalists
and TV-persons need to be included has to be evaluated.
All those who claim to have been duped, to have been unable
to foresee it failed and/or cheated on the job and should make
amends that amount to more than confessions.
what happens instead? Ackermann had a birthday dinner at
Merkel’s chancellory – Ackermann is head of Deutsche Bank who
carried away 12 bn of US-bail-out money refusing at the same
time German bail-out – that needs to be rewarded? doesn’t it?
(I doubt that the dinner was lavish though – presently lavish
is not in fashion over here -http://www.thepeninsulaqatar.com/Display_news.asp?section=Business_News&subsection=market+news&month=August2009&file=Business_News2009082611950.xml)
Tom
“We have the best government money can buy”. Edward Kennedy.
Why would we expect them to look out for the public interest?
I can’t imagine why. Until we change that, the government won’t
be any help in loosening the stranglehold that entrenched interests
have in preserving their entrenched interest.
This is true in every important area of society: Energy,
Health, Education, Finance and Banking…..
For me that is the crux of the matter.
Hillbilly Dary
The first thing we do is kill all the economists (figuratively
speaking).
In my view there are two types, both of which have proven
to have very limited utility (to coin an economic term):
- The academic/research wonks that analyze data that by
definition must be historical and apply historical questions
and assumptions to it to attempt to make future prognostications.
These folks fail because they lack the ability to ask the
right questions because we haven’t been there yet-tomorrow
isn’t yesterday until two days from now.
- The tinkerers that operate with the inate belief that
lifting here, tucking there, adding a little botox here,
triming over there, will result in a a super model. Veritable
masters of the universe. Unfortunately, all too often they
end up with Michael Jackson’s face.
Both perpetuate the system. The academics crunch the numbers
for the tinkerers. The tinkerers in turn attempt to create tomorrow’s
tomorrow numbers for the academics to crunch three days from
now.
But the whole charade is based on linear as opposed to dynamic
thinking, and is premised on the faulty logic that one can linearly
influence a dynamic system that one doesn’t understand, can’t
understand, and can’t possibly ask the right questions to predict.
There is too much meddling in my view to begin with.
Benjamin Friedman, in the
Financial Times (hat tip
Yves Smith), questions the high cost (read: compensation)
of our financial sector. But he does not simply say that
huge bonuses for bankers are unfair. Instead, he says that
the costs of financial services need to be balanced against
their benefits.
The discussion of the costs associated with our financial
system has mostly focused on the paper value of its
recent mistakes and what taxpayers have had to put up
to supply first aid. The estimated $4,000bn of losses
in US mortgage-related securities are just the surface
of the story. Beneath those losses are real economic
costs due to wasted resources: mortgage mis-pricing
led the US to build far too many houses. Similar pricing
errors in the telecoms bubble a decade ago led to millions
of miles of unused fibre-optic cable being laid.
The misused resources and the output foregone due
to the recession are still part of the calculation of
how (in)efficient our financial system is. What has
somehow escaped attention is the cost of running the
system.
In particular, Friedman wonders at the relationship between
the value provided by financial services and the opportunity
cost involved: “Perversely, the largest individual returns
seem to flow to those whose job is to ensure that microscopically
small deviations from observable regularities in asset price
relationships persist for only one millisecond instead of
three. These talented and energetic young citizens could
surely be doing something more useful.”
This reminds me of something
Felix Salmon wrote about a while back: If profits and
compensation in the financial sector go up and keep going
up, that’s a priori evidence of inefficiency, not efficiency.
Those higher profits mean that customers are paying more
for their financial services over time, not less, which
means that financial services are imposing a larger and
larger tax on the economy. Now, it is possible that they
are also increasing in value fast enough to cover the tax,
but that is something to be proven.
By James Kwak
FT.com
Published: August 24 2009 21:57 | Last updated: August 24 2009 21:57
“If they see me planting too much cocoa, they’ll do things to
my land and my family, and they won’t bear fruit; really bad
things; puripuri and other witchcraft.” This was how
Peter explained to me why he had only cultivated half of the
three-hectare block the Papua New Guinean government had given
him after he was evacuated from his home during a volcanic eruption
eight years earlier. He was also providing a response to an
accusation I had often heard levelled at his fellow villagers
by government officials and development workers in the course
of my anthropological field research: that the people were lazy
or stupid because, like Peter, none had planted the whole of
their blocks of land.
Such an avoidance of profit maximisation might have appeared
economically irrational. But from the perspective of those villagers,
putting in extra work just to make oneself a target for the
jealousy of one’s neighbours would be highly irrational behaviour.
Critics of untrammelled free markets have long attacked the
assumption that markets are rational, driven by rational self-interested
economic actors. But the question of economic rationality has
returned with a vengeance in the wake of the current crisis.
Both advocates and critics of the rational economic actor
model are usually keen to stress that it is a rationality that
measures economic value and does not take into account the social
setting. Yet, field research clearly shows that the actions
of individuals vary massively depending on social context.
Living in Papua New Guinea, one is struck by the resources
expended on gigantic ceremonial gift exchanges. The “big men”
running such systems did not call in debts to maximise the number
of pigs or modern wealth items such as money or trucks in their
possession. But academics continued to assume that the aim was
to profit over the long term, with the discrepancy between this
assumption and the big men’s actual activities being explained
as the result of “selective amnesia”. It was only when the assumption
of economic rationality was dropped that it was possible to
understand the big men in their own terms. Their aim was to
increase the number of those dependent upon them, and so, like
a Mafia godfather, their aim was to create debts that would
never be repaid. Like Mafiosi, their actions were neither the
result of what one economist described as “an inferior mentality”,
or a lack of rationality. They were entirely rational within
a context in which building up an army of followers was at times
a more pressing demand than stockpiling wealth objects.
One response to the current crisis has been a rise in the
popularity of behavioural economics, which examines the psychological
and emotional factors behind transactions. These models drop
the assumption of the rational actor yet implicitly keep the
same model of economic rationality at their heart. We may diverge
from the path of rationality for all sorts of psychological
reasons but only because emotion, Keynes’s famous “animal spirits”,
clouds our judgment.
Clearly the stress, fear and excitement that run through
investors’ nervous systems can have as strong an impact on their
investment choices as they can on gamblers caught up in the
enthusiasm of a race meeting. But it is also important to remember
that rationality can often be a matter of perspective and context.
From a theoretical perspective it may be irrational to sell
an investment for less than its true value. But, if everyone
else is selling, are you going to risk your job as a professional
investor holding on to those securities?
That sell decision is as rational in a Wall Street context
as the Papua New Guinean’s decision not to maximise the returns
from his block of land are in his, even if in the long term
your interests may be better served by holding on to those securities.
At certain points the interests of individual investors,
investment funds and the market as a whole may coincide. At
such points reaching a consensus on what is rational is rather
easy. At other times, however, they will diverge. In such contexts,
rather than assuming that non-textbook behaviour is the result
of a fall from rationality, our understanding of how markets
work may be better served by an examination of how different
measures of rationality emerge in different contexts, and how
to manage them when they come into conflict.
The writer is a lecturer in social anthropology
at Manchester University
Wow, it’s already Friday. I’ll feel that I’ve short-changed you if
we don’t do some Finance Theory before I go.
Did you see
this roundtable about the state of macroeconomics in The Economist’s
Free Exchange? Fascinating stuff; in particular it became a bit
of an odd defense of the Efficient Markets Hypthosis (EMH). A representative
comment was made
by William Easterly, in defense of EMH:
The most important part of the much-maligned Efficient Markets
Hypothesis (EMH) is that nobody can systematically beat the stock
market. Which implies nobody can predict a market crash, because
if you could, then you would obviously beat the market. This applies
also to other asset markets like housing prices.
This is not true, and I want us to walk through why it isn’t. In
March of 1997, Andrei Shleifer and Robert Vishny published a paper titled
The Limits of Arbitrage (pdf) in the Journal of Finance. I think
it’s the most important finance paper of the past 15 years, something
everyone even remotely connected to financial markets should become
familiar with. It builds on and summarizes a decade long research project,
research they conducted with people such as Joseph Lakonishok and Brad
Delong. In it they say that arbitrageurs,
the very smart and talented traders at hedge funds who
will take prices that are out of line and bring them back into line,
making a good fee and making prices reflect all available information,
the very building block necessary for EMH to work,
can’t do their job if they are time or credit
constrained. Specifically, if they are highly leveraged,
and prices move against their position before they return to their fundamental
value – if the market stays irrational longer than they can remain solvent
– they’ll collapse before they can do their
job.
And sure enough, a year later in 1998, Long
Term Capital Management, very smart highly leveraged arbitrageurs, found
themselves in a situation where prices moved away from them,
and they had no capital with which to keep themselves afloat, just like
Limits Of Arbitrage predicted. (This is the standard narrative in finance
research seminars; it also appears this way, correctly, in Justin Fox’s
The Myth of the Rational Market, a very excellent book that gets
these details correct.)
There’s an argument that says “If the market is inefficient, why
aren’t you rich?” This gives us the framework to understand why markets
could deviate from true value but there isn’t a way to capitalize on
bringing them back to true value – sometimes there is risk inherent
in arbitrage, and sometimes there are situations where it is difficult
to get on the other side of a trade. And specifically, it’s risk that
isn’t compensated.
Here’s an example of how this works. Let’s say something is trading
at $5. You are positive it is going to reach $10. Positive. It
must. No chance it won’t at some point in the future. So you buy it,
telling your boss/manager/investors you are going to make $10-$5 = $5
for free. But the price goes to $2.50. What happens? You should buy
a lot more. Now you are going to make $7.50! However your boss/manager/investor
thinks you are insane and have lost them all kinds of money, as they
now have half of what they gave you, and wants to pull your trading
funds – if you sell then, you lose money, and put downward pressure
on the price. Also, depending on how you were leveraged, you may also
be bankrupt. That’s how this works.
This gives us a guideline for figuring out how markets can get out
of alignment with value – if it is difficult
to attract arbitrageurs, who are necessary to keep prices in alignment,
we should expect the market to have prices that are more prone to manipulation
and bubbles. What attracts arbitrageurs? The bond market
– it is easy to calculate the value of a bond, and easy to realize the
value quickly. Foreign exchange markets – it’s relatively easy for arbitrageurs
to go after central banks attempts to maintain nonmarket exchange rates.
What doesn’t attract arbitrageurs as
easily? The stock market. The absolute and relative value of a stock
is harder to estimate, and it may take a long period of time to realize
your gain. (If you are comfortable with the terms, expected
alpha doesn’t increase in proportion to volatility if volatility includes
fundamental risk – read the paper, it’s excellent!) And though it isn’t
covered in the paper, housing.
There’s no real way to go short housing. You can go short the bank
issuing mortgages, but if the bank has two internal businesses – jumbo
subprime loans and boring small business loans – might it not be sensible
for them to turn down the business loan division in response to the
market shorting? You need to be able to exert price pressure directly
onto the market itself – the more intermediaries, the more likely it
is your signal is converted into noise. There’s talk about how in the
future we’ll all trade derivatives contracts on each other’s neighborhoods;
depending on how that’s implemented, it would be something to say “I
want to go short Detroit and Peoria in my portfolio.” Is there moral
hazard to drive down those prices then? And life would be more interesting
if the investment firm of “My Ex-Girlfriends LLC” could take out a derivative
insurance contract that pays out to them if my house burns down over
the next year. Thankfully that market is still some time away, if it
ever gets here, so we can iron out the difficulties.
There’s a lot more research to be done here, but
contrary to popular belief we do have an
intellectual framework to know how markets can get out of whack, one
that takes the EMH are brings it to a reality where we face actual constraints
over scarce resources such as time and capital.
Selected comments
So-called efficient market theory sometimes fails -- spectacularly
-- to predict Wall Street's behavior, yet the theory lives on. So what's
a rational investor to do?
I remember watching in horrified fascination in October 1987 as the
stock market crashed. The Dow Jones Industrial Average
($INDU)
dropped 22.6% as $500 billion evaporated in a single day.
As a (relatively) young business editor, I got pressed into service
calling up the smartest people on Wall Street to ask them what had happened.
Money managers on the Street were in shock. "This can't be happening,"
more than one told me. "Prices don't behave like this."
"Prices don't behave like this." That phrase connects the financial
disasters of the past 20 years, from the collapse of portfolio insurance
in 1987 to the collapse of
mortgage-backed derivatives in 2007.
It will be the theme song for the next financial market disaster,
too, because efficient market theory, the set of assumptions that underpins
these events, just won't die. It may be intellectual Swiss cheese, but
it's far too profitable for Wall Street to let it go.
Rational market a myth?
Justin Fox has just published an extraordinarily interesting and readable
history of efficient market theory titled "The
Myth of the Rational Market: A History of Risk, Reward, and Delusion
on Wall Street."
Read it and you'll understand how we got here, why Wall Street will
keep recreating these disasters and how you can tiptoe around the worst
of the damage.
What Fox is best at is showing the reader the assumptions behind
efficient market theory from its development in the 1960s to its triumphant
takeover of business schools, Wall Street and corporate boardrooms in
the 1980s. (I had the key formulas of efficient market theory, models
such as the
capital asset pricing model, drilled into me in the year I spent
in business school in the early part of that decade.)
What are some of those key assumptions?
-
That human beings are driven to maximize their self-advantage.
-
That human beings rationally decide what their self-advantage is.
-
That information flow in financial markets is free and instantaneous.
-
That prices always accurately reflect all the available information.
-
That markets always clear to equilibrium because enough buyers and
sellers will always emerge.
Fox is extraordinarily fair to the great names of economics and finance
who put this structure in place:
Franco Modigliani,
Eugene Fama,
Merton Miller,
Fischer Black,
Harry Markowitz,
Milton Friedman,
Myron Scholes and others. They never come across as anything other
than what they are: brilliant thinkers who knew they were making radically
simplified assumptions about reality so that their models would work.
Fox's most interesting chapters are his discussions of such honest
thinkers as Black, who never forgot that his theories were built on
simplified versions of reality. I can't imagine being tough enough to
constantly question the validity of your life's work, but some of these
folks did exactly that.
Events, of course, helped them along, because reality struck back
hard not too long after efficient market theory became the ruling orthodoxy.
The first of these was the
1987 stock market crash, which was facilitated, if not created,
by a financial product called
portfolio insurance, built out of the pricing models created by
efficient market theory.
Hedge fund debt disaster
Then there was the collapse of the Long-Term Capital Management hedge
fund in 1998. Some of the best minds on Wall Street had devised immensely
profitable strategies that exploited tiny, unjustified differences in
the prices of financial assets such as Treasury bonds with 30 years
until maturity and Treasury bonds with 29.75 years until maturity. In
the first several years after its founding in 1993, Long-Term Capital
averaged returns of 40% annually.
But by 1998, Long-Term Capital had borrowed billions -- $124.5 billion,
to be precise -- to get more bang from the tiny price discrepancies
its computers had identified. Then a financial crisis in Russia triggered
a chain of events that led to losses at Long-Term Capital of $4.6 billion
in less than four months. Prices for its portfolio assets collapsed
-- which shouldn't happen in an efficient market -- and liquidity dried
up -- also not part of the theory. The New York Federal Reserve Bank
eventually engineered an orderly unwinding of the fund to prevent its
problems from rippling out through the global financial system.
Tech stock bubble blows up
There are more recent examples, too. Then-Federal Reserve Chairman
Alan Greenspan's decision not to prick the technology bubble in
1998 or 1999 led to irrationally high stock prices, which then collapsed
to irrational lows. Where was the efficiency to a market that valued
Cisco Systems (CSCO,
news,
msgs) at $80.06 a share on March 27, 2000, and at $8.60 on
Oct. 8, 2002?
Surely one, or perhaps both, of these
prices is better explained by the behavior of lemmings leaping into
the ocean than by the rational decision-making of efficient market theory.
Debt derivatives trigger panic
And now in the current crisis, investors have received a painful
refresher course in how panic -- by definition neither efficient nor
rational -- can so dry up market liquidity that there are no prices,
efficient or otherwise, for some assets at all. It's hard to get to
price equilibrium when no one is bidding.
Fox's book also makes it depressingly clear why, despite its failures
and its role in global financial disasters, efficient market theory
isn't about to go away. The theory provides a set of mathematical formulas
that let people on Wall Street calculate price and quantify risk for
things like options and their increasingly complex descendents in the
derivatives world. And the bottom line on Wall Street is that if you
can price a product and give it a risk rating, you can sell it.
After watching the flood of profits created by new products that
priced the risk of mortgage-backed assets, do you doubt that for a moment?
And as we know so clearly, the rewards for creating profitable instruments
based on this flawed theory far outweigh the punishment for being wrong.
Sure, a Lehman Bros. (LEHMQ,
news,
msgs) goes under, but life and bonuses go on at
Goldman Sachs (GS,
news,
msgs) and even at Merrill Lynch.
My God, how a person who is a university professor (and Eugene Fama
is a university professor) can be such an idiot ?
I’m working on the relationship between economic theory and the current
crisis, and one thread obviously involves the role of efficient market
theory in breeding complacency. So I ran across this revealing late-2007
interview with Eugene Fama. In it, Fama dismisses the whole idea
of bubbles:
Well, economists are arrogant people. And because they can’t
explain something, it becomes irrational. The way I look at it,
there were two crashes in the last century. One turned out to be
too small. The ’29 crash was too small; the market went down subsequently.
The ’87 crash turned out to be too big; the market went up afterwards.
So you have two cases: One was an underreaction; the other was an
overreaction. That’s exactly what you’d expect if the market’s efficient.
The word “bubble” drives me nuts. For example, people say “the
Internet bubble.” Well, if you go back to that time, most people
were saying the Internet was going to revolutionize business, so
companies that had a leg up on the Internet were going to become
very successful.
I did a calculation. Microsoft was an example of a corporation
that came from the previous revolution, the computer revolution.
It was hugely profitable and successful. How many Microsofts would
it have taken to justify the whole set of Internet valuations? I
think I estimated it to be something like 1.4.
And he expresses confidence over housing (rather late in the game,
wouldn’t you say?):
Housing markets are less liquid, but people are very careful
when they buy houses. It’s typically the biggest investment they’re
going to make, so they look around very carefully and they compare
prices. The bidding process is very detailed.
What this made me think of was an
old paper by Larry Summers mocking finance economists as the equivalent
of “ketchup economists”, who believe that they’ve demonstrated market
efficiency by showing that two-quart bottles of ketchup always sell
for twice the price of one-quart bottles.
In the case of housing, buyers do carefully compare prices —
with the prices of other houses. That is, they make sure that two-quart
bottles of ketchup are the same price as one-quart bottles. As we’ve
seen, however, they don’t do a very good job of checking whether the
overall level of housing prices makes sense.
Yes, it was a bubble — and as Larry said way back when, the ketchup
test just isn’t enough.
Jul 16th 2009 | Economist
Rational fools
These important caveats, however, should not obscure the fact that
two central parts of the discipline—macroeconomics and financial economics—are
now, rightly, being severely re-examined (see
article,
article). There are three main critiques: that macro and financial
economists helped cause the crisis, that they failed to spot it, and
that they have no idea how to fix it.
The first charge is half right. Macroeconomists, especially within
central banks, were too fixated on taming inflation and too cavalier
about asset bubbles. Financial economists, meanwhile, formalised theories
of the efficiency of markets, fuelling the notion that markets would
regulate themselves and financial innovation was always beneficial.
Wall Street’s most esoteric instruments were built on these ideas.
But economists were hardly naive believers in market efficiency.
Financial academics have spent much of the past 30 years poking holes
in the “efficient market hypothesis”. A recent ranking of academic economists
was topped by Joseph Stiglitz and Andrei Shleifer, two prominent hole-pokers.
A newly prominent field, behavioural economics, concentrates on the
consequences of irrational actions.
So there were caveats aplenty. But as insights from academia arrived
in the rough and tumble of Wall Street, such delicacies were put aside.
And absurd assumptions were added. No economic theory suggests you should
value mortgage derivatives on the basis that house prices would always
rise. Finance professors are not to blame for this, but they might have
shouted more loudly that their insights were being misused. Instead
many cheered the party along (often from within banks). Put that together
with the complacency of the macroeconomists and there were too few voices
shouting stop.
Jul 06 | FT Alphaville
Marco Annunziata, chief Economist at UniCredit Group, has fired a
couple of rounds at critics of efficient markets hypothesis, including
Soc Gen’s GMO’s
James Montier and the FT’s
Gillian Tett.
He says simplistic attempts to throw EMH out of the window will not
help improve our understanding of financial markets or strengthen institutions
to limit the risk of future crisis.
The full piece (including a useful bibliography) can be
found in the Long Room, but this summary provides a good overview
of his argument.
To sum up: it is disingenuous to argue
that universal and uncritical acceptance of the EMH was at the root
of the crisis. The EMH has been challenged and criticized for the last
thirty years, in a controversy that is still unresolved, and will not
be resolved by the current crisis either. If anything, the crisis has
been fuelled by behaviors that displayed a blatant disregard for the
EMH.
The latest bubble
confirms that markets can be frighteningly efficient at amplifying periods
of collective madness with disastrous consequence, and that the ideas
of behavioral finance, bounded rationality and evolutionary psychology
among others are extremely relevant to the analysis of financial markets.
But the EMH’s basic underlying notion that if there are obvious opportunities
to earn excess risk-adjusted returns people will flock to exploit them
until they disappear is as reasonable and common-sense as anything put
forward by the EMH critics. Systematically
beating the market remains awfully hard, and the EMH remains an extremely
useful working hypothesis. Augmenting it and improving
it is extremely desirable, discarding it as hopelessly flawed and irrelevant
would be just plain stupid.
Related link:
The Dead Parrot of Finance - Long Room
Promote one who welcomes the death of EMH - FT Alphaville
This entry was posted by Neil Hume on Monday,
July 6th, 2009 at 15:25 and is filed under
Capital markets,
People. Tagged with
Effiecent markets hypothesis,
gillian tett,
james montier,
Marco
Annunziata,
unicredit.
February 25, 2009 | Information
Processing
Another great EconTalk
podcast, this time a discussion with
Alan Meltzer of CMU, a leading expert on monetary policy and the
history of the Federal Reserve, and a confidante of officials like Alan
Greenspan.
At about minute 45 of the podcast we are treated to a revealing 10
minute dialog between Meltzer, a member of the cult of Efficient Markets
(EM), and recovering cult member Russ Roberts (host of EconTalk and
GMU econ professor), who is starting to realize that reality diverges
from the teachings of the cult. Meltzer's thesis is that reckless behavior
by bank executives was largely driven by expectations that they would
be bailed out in case of disaster. He claims this crisis was caused
by moral hazard and the banksters knew full well the risks they were
taking. (And the pension funds and sovereign wealth funds that also
bought the toxic stuff? Were they expecting a bailout too?) Russ wonders
whether top executives really understood the structured finance of mortgages,
perhaps neglected fat tail events, perhaps were irrationally overconfident.
Roberts' points sound very "behavioral" and not at all EM.
Meltzer cannot bear to admit that the market is not all-knowing.
Throughout most of the podcast he steadfastly maintains that current
share prices of banks give an implicit (and more accurate than any other)
valuation of the complex mortgage securities on their books. This is
about as nutty as the thinking that got us into the crisis in the first
place! The markets have been valuing CDO tranches from the beginning;
why did they get it so wrong for so long? Now people trading bank equity
have got it right? (How many are just gambling on probabilities of different
rescue / nationalization outcomes?) Meltzer even mentions that the Fed
rescue of LTCM was a source of moral hazard, neglecting the fact that
the investors and principals were completely wiped out in the rescue.
Russ has made great progress in his thinking during the last few
years of doing EconTalk interviews. It's a tribute to his intellectual
honesty and common sense that he can, at this advanced age, overcome
the conditioning he received from his education within the Chicago EM
cult. Most cult members are more like Meltzer. He cannot abandon the
faith, even in the face of a market failure of these historical proportions.
But of course it is Meltzer I see on national TV, holding forth with
utter certainty on the crisis. For some reason it is he, not Russ, who
gets to make
expert predictions.
June 6, 2009
In this morning’s
NYT, Joe Nocera takes on one of my favorite subjects: Why
the market is neither rational nor efficient.
He does a nice job, interviewing both Jeremy Grantham and Burton
Malkiel. Along the way, he mentions Justin Fox’s new book,
The Myth of the Rational Market: A History of Risk, Reward, and Delusion
on Wall Street.
Excerpt:
“In the last decade, the efficient market hypothesis, which had
been near dogma since the early 1970s, has taken some serious body
blows. First came the rise of the behavioral economists, like Richard
H. Thaler at the University of Chicago and Robert J. Shiller at
Yale, who convincingly showed that mass psychology, herd behavior
and the like can have an enormous effect on stock prices — meaning
that perhaps the market isn’t quite so efficient after all. Then
came a bit more tangible proof: the dot-com bubble, quickly followed
by the housing bubble.
Quod erat demonstrandum.
These days, you would be hard-pressed to find anybody, even on
the University of Chicago campus, who would claim that the market
is perfectly efficient. Yet Mr. Grantham, who was a critic of the
efficient market hypothesis long before such criticism was in vogue,
has hardly been mollified by its decline. In his view, it did a
lot of damage in its heyday — damage that we’re still dealing with.
How much damage? In Mr. Grantham’s view, the efficient market hypothesis
is more or less directly responsible for the financial crisis.
I prefer
Res Ipsa Loquitur, but hey, its all Latin to me.
I am about halfway through
The Myth of the Rational Market, and so far, its good wonky
fun. (Justin, there’s your pull quote: good wonky fun“).
When I’m finished, I will post a review, though I expect my experience
in writing a book to have eliminated all objectivity when it comes to
reviewing other books.
>
Source:
Poking Holes in a Theory on Markets
JOE NOCERA
NYT, June 5, 2009
http://www.nytimes.com/2009/06/06/business/06nocera.html
Talking Business - Poking Holes in a Theory on Markets - By
JOE NOCERA
June 5, 2009
NYTimes.com
For some months now, Jeremy Grantham, a respected market strategist
with GMO, an institutional asset management company, has been railing
about — of all things — the efficient market hypothesis.
“Our default reflex is that the world
knows what it is doing,” says Jeremy Grantham, a market
strategist with GMO.
You know what the efficient market hypothesis is, don’t you? It’s
a theory that grew out of the
University of Chicago’s finance department, and long held sway in
academic circles, that the stock market can’t be beaten on any consistent
basis because all available information is already built into stock
prices. The stock market, in other words, is rational.
In the last decade, the efficient market hypothesis, which had been
near dogma since the early 1970s, has taken some serious body blows.
First came the rise of the behavioral economists, like Richard H. Thaler
at the University of Chicago and
Robert J. Shiller at Yale, who convincingly showed that mass psychology,
herd behavior and the like can have an enormous effect on stock prices
— meaning that perhaps the market isn’t quite so efficient after all.
Then came a bit more tangible proof: the dot-com bubble, quickly followed
by the housing bubble. Quod erat demonstrandum.
These days, you would be hard-pressed to find anybody, even on the
University of Chicago campus, who would claim that the market is perfectly
efficient. Yet Mr. Grantham, who was a critic of the efficient market
hypothesis long before such criticism was in vogue, has hardly been
mollified by its decline. In his view, it did a lot of damage in its
heyday — damage that we’re still dealing with. How much damage? In Mr.
Grantham’s view, the efficient market hypothesis is more or less directly
responsible for the financial crisis.
“In their desire for mathematical order and elegant models,” he wrote
in his firm’s quarterly letter to clients earlier this year, “the economic
establishment played down the role of bad behavior” — not to mention
“flat-out bursts of irrationality.”
He continued: “The incredibly inaccurate efficient market theory
was believed in totality by many of our financial leaders, and believed
in part by almost all. It left our economic and government establishment
sitting by confidently, even as a lethally dangerous combination of
asset bubbles, lax controls, pernicious incentives and wickedly complicated
instruments led to our current plight. ‘Surely, none of this could be
happening in a rational, efficient world,’ they seemed to be thinking.
And the absolutely worst part of this belief set was that it led to
a chronic underestimation of the dangers of asset bubbles breaking.”
(Mr. Grantham concluded: “Well, it’s nice to get that off my chest
again!”)
I couldn’t help thinking about Mr. Grantham’s screed as I was reading
Justin Fox’s new book, “The Myth of The Rational Market,” an engaging
history of what might be called the rise and fall of the efficient market
hypothesis.
Mr. Fox is a business columnist for
Time magazine (and a former colleague of mine) who has long been
interested in academic finance. His thesis, essentially, is that the
efficient marketeers were originally on to a good idea. But sealed off
in their academic cocoons — and writing papers in their mathematical
jargon — they developed an internal logic quite divorced from market
realities. It took a new group of young economists, the behavioralists,
to nudge the profession back toward reality.
Mr. Fox argues, echoing Mr. Grantham, that the efficient market hypothesis
played an outsize role in shaping how the country thought and acted
in the last 30-plus years. But Mr. Fox parts company with him by also
arguing that the effect wasn’t necessarily all bad. As for the question
of whether an academic theory hatched in Chicago led to the financial
crisis, suffice it to say that some questions can never be answered
definitively. Which isn’t to say they shouldn’t be asked.
•
“There are no easy ways to beat the market,” Mr. Fox said when I
spoke to him a few days ago. If you want to point to the single best
thing the efficient market hypothesis taught us, that is the lesson:
we can’t beat the market. Indeed, the vast majority of professional
money managers can’t beat the market either, at least not on a regular
basis.
As Mr. Fox describes it, much of the early academic work that led
to the efficient market theory was aimed at simply showing that most
predictive stock charts were glorified voodoo — just because a pattern
had developed didn’t mean it would continue, or even that it had any
real meaning. Dissertations were written showing how 20 randomly chosen
stocks outperformed actively managed
mutual funds. (Hence the phrase “random walk,” to connote the near
impossibility of beating the market regularly.) Mr. Thaler, the Chicago
behavioralist, says that evidence on this point — “the no free lunch
principle,” he calls it — is clear and convincing.
In time, this insight led to the rise of passive index funds that
simply matched the market instead of trying to beat it. Unless you’re
Warren Buffett, an index fund is where you should put your money.
Even people who don’t follow that advice know they should.
As it turns out, Mr. Grantham was an early advocate of index funds,
mainly for unsophisticated investors who have no hope of beating the
market. But he also believes that professionals should do better precisely
because, as he puts it, “the market is full of major league inefficiencies.”
“There are incredible aberrations,” he told me over lunch not long
ago. “The U.S. housing market in 2007. Japan in the 1980s. Nasdaq. In
2000, growth stocks were three times their fair value. We were quoted
in The Economist in 2000 saying that the Nasdaq would drop by 75 percent.
In an efficient world, you wouldn’t have that in a lifetime. If the
market were truly efficient, it would mean that growth stocks had become
permanently more valuable.”
As Mr. Grantham sees it, if professional investors had been willing
to acknowledge these aberrations — and trade on the fact that the market
was out of whack — they should have been able to beat the market. But
thanks to the efficient market hypothesis, no one was willing to call
a bubble a bubble — because, after all, stock prices were rational.
“It helped mold the ‘this time it’s different’ mentality,” he said.
Indeed, professional money managers who tried to buck the tide wound
up losing their jobs — because everybody else was making money by riding
the bubble for all it was worth. Meanwhile, government officials, starting
with
Alan Greenspan, were unwilling to burst the bubble precisely because
they were unwilling to even judge that it was
a bubble. “Our default reflex is that the world knows what it is doing,
and that is extravagant nonsense,” Mr. Grantham said.
But as much as I’ve admired Mr. Grantham’s writings over the years,
I think the truth, in this case, is a little more subtle. Given the
long history of bubbles, I suspect this crisis would have taken place
with or without the aid of the efficient market hypothesis. People thought
“it’s different this time” in the 1920s, long before anyone was writing
about efficient markets. And over the course of history, professional
money managers have been just as fearful of bucking the trend as they
were during the Internet bubble.
Mr. Fox sees it somewhat differently. On the one hand, he says, the
efficient market theoreticians always assumed that smart market participants
would force stock prices to become rational. How? By doing exactly what
they don’t do in real life: take the other side of trades if prices
get out of whack. Their ivory tower view reflected an idealized market
that simply doesn’t exist.
On the other hand, Mr. Fox says, what was truly pernicious about
the efficient market hypothesis is the way it allowed us to put asset
prices on a pedestal that they never deserved. Stock options — supposedly
based on a rational price — became prevalent in part because higher
stock prices were supposed to be the rational reward for good performance.
Or take the modern emphasis on market capitalization. “At some point
in the early 1990s (or maybe it was in the late 1980s), market capitalization
became accepted as the best measure of a company’s importance,” Mr.
Fox wrote me in an e-mail message. “Before then it was usually profits
or revenue. I think that’s a classic example of the way efficient market
theory seeped into popular discourse and shaped how we perceived the
world. It wasn’t entirely stupid — profits and revenue are flawed, limited
measures, and market value does tell you something useful about a company.
But it was another one of the ways in which asset prices came to rule
the world, which eventually turned out to be a bad thing.”
•
A few days ago, I called Burton G. Malkiel, the Princeton economist,
to ask him what he thought of Mr. Grantham’s theories. Mr. Malkiel is
the author of “A Random Walk Down Wall Street,” surely one of the greatest
popularizers of any academic theory that’s ever been written.
“It’s ridiculous” to blame the financial crisis on the efficient
market hypothesis, Mr. Malkiel said. “If you are leveraged 33-1, and
you’re holding long-term securities and using short-term indebtedness,
and then there’s a run on the bank — which is what happened to
Bear Stearns — how can you blame that on efficient market theory?”
But then we started talking about bubbles. “I do think bubbles exist,”
he said. “The problem with bubbles is that you cannot recognize them
in advance. We now know that stock prices were crazy in March of 2000.
We know that condo prices were nuts.”
I thought to myself: if a smart guy like Burton Malkiel had to wait
for the Internet bubble to end to realize we had been in one, then maybe
Mr. Grantham has a point after all.
The Myth of the Rational Market
Amazon.com- The Myth of the Rational Market- A History of Risk ...
Good Times
After a year of epic financial crisis, 2009 will — if all goes well
— be a time for digging ourselves out of the mess and figuring out how
to prevent a repeat. Before we can do that, we have to have some idea
of what went wrong. People are still arguing about what caused the Depression
of the 1930s, so don't expect a definitive diagnosis anytime soon. But
here's my current list of blame, or at least the first dozen items on
it, in descending order of culpability.
Hardly anyone expected things to go wrong because things hadn't gone
truly, pants-wettingly, oh-my-god wrong on the financial front in the
U.S. since the 1930s. Yes, there had been deep stock-market slumps in
the 1970s and early 2000s, real estate busts in the 1980s and early
1990s, and occasional short-lived financial scares like the Asian crisis
of 1997. But the U.S. hadn't been through a serious panic in the memories
of most everyone on Wall Street and in government.
We began to behave as if one couldn't happen; we were told it couldn't.
Blithe behavior begat trouble. The upside is that everybody is now so
shell-shocked that we probably don't have to worry about a repeat anytime
soon.
Alan Greenspan
It was to smother financial panics that Congress created the Federal
Reserve in 1913. During Alan Greenspan's tenure as chairman, the Fed
jumped in to keep the 1987 stock-market crash, the 1998 Long-Term Capital
Management scare and the 2000-01 tech-stock collapse from spiraling
into something worse. But that very successful firefighting fostered
the risk-ignoring attitudes that brought on a conflagration. There are
some — like 2008 presidential candidate Ron Paul — who argue that the
lesson here is that we'd be better off without the Fed. A more palatable
interpretation is that if the Fed is going to step in to prevent panics,
it needs to do more to deflate the bubbles that inevitably precede those
panics. Fed policy over the past quarter-century has been asymmetrical:
it bailed institutions out of trouble but did ever less to restrain
them during fulsome times. That has to change.
Twisted Regulation
What has happened in the financial sector since the 1970s isn't exactly
deregulation. Banks have remained as closely supervised as ever. But
new institutions that grant mortgages, lend money, fund deals — businesses
once monopolized by banks — have been allowed to grow with little oversight.
Lawmakers and regulators responded in the 1990s not by setting parameters
for these new players — investment banks, hedge funds, private-equity
funds, etc. — but by giving bank-holding companies more freedom to enter
underregulated lines of business. The perverse result was that the new
and untested gained an unfair advantage over the tried and true.
Wall Street
The shift of financial activity from bank balance sheets to the off-balance-sheet
realm of securitization and derivatization loosely defined as Wall Street
wouldn't have been such a disaster if it had actually worked as advertised
— spreading risk, encouraging innovation, bringing the best minds to
bear on the biggest financial problems. Instead, Wall Street's leaders
did an atrocious job — rewarding the foolhardy, steering capital to
the least productive uses and running away from responsibility for their
errors. And they got paid tens of millions of dollars a year for it.
The Homeownership Obsession
During the 2008 election campaign, Republicans attempted to pin blame
for the crisis on the Community Reinvestment Act (CRA) and mortgage
giants Fannie Mae and Freddie Mac. Nice try: there's virtually no evidence
to back up the CRA charge, and while Fannie and Freddie aren't blameless,
they were mostly sidelined during the worst of the mortgage frenzy,
from 2003 to 2006. But the decades-long bipartisan government effort
to encourage homeownership — of which CRA, Fannie and Freddie were but
a small part — did tragically overshoot the mark. Homeownership generally
is a good thing. Massively subsidizing it via the tax code might not
be so smart. And turning a blind eye to crazy lending practices because
they seem to encourage it definitely is not.
Too Much Money
Lots of people worried for years that the gigantic trade deficits
the U.S. ran up with first Japan and then China were hurting domestic
manufacturers. But the flip side of those trade deficits — gigantic
capital flows into the U.S. — may have been even more dangerous. It
was the capital gusher from China in particular that inflated the 2000s
real estate bubble.
The Myth of the Rational Market
For decades, the accepted academic response to concerns that
the economy might be on an unsustainable trajectory was that financial
markets knew best. Got a backup? Markets are spectacularly efficient
processors of information and opinion. But they also have a tendency
(by now well documented) to overshoot on both the upside and the
downside.
You and Me
None of this would have happened if millions of us hadn't come
to believe we could get something for nothing by taking on debts
we couldn't repay. That this misconception was fostered by lenders
and politicians is a partial excuse but not a complete one. Thanks
to the Panic of 2008, though, we can count on nobody making this
mistake again, at least not for a while.
George W. Bush
A lot of the government decisions that led to our current pass
were bipartisan. Some were the doing of Democrats. But you can't
be a two-term President with your own party in charge of Congress
for most of your time in office and escape blame for an economic
debacle that unfolds as you prepare to leave town. The specific
Bush act that probably contributed most to today's difficulties?
His reckless disregard for sound fiscal policy, as his tax cuts
and war spending combined to turn budget surpluses into chronic
deficits.
Commodity Futures Modernization Act
If you had to pick a single government move that did more than
any other to muck things up, it was probably this bill, passed by
a Republican Congress and signed into law by lame-duck President
Bill Clinton in December 2000. It effectively banned regulators
from sticking their noses into over-the-counter derivatives like
credit default swaps. There's no guarantee that regulators would
have sniffed out the dangers in time. But banning them from even
looking sent a pretty clear anything-goes message to OTC derivatives
markets.
The Rating Agencies
Their failings were part of the larger inability of Wall Street
to do securitization right, and their employees didn't get paid
nearly as much as the investment-bank guys engineering the dodgy
investment products they rated. That's why the rating agencies aren't
in the top 10. But the willingness of Moody's, S&P and Fitch to
grant top ratings to untested new securities like collateralized
debt obligations made possible a lot of staggeringly dumb deals
that otherwise would never have seen the light of day.
Letting Lehman Go
This is a hard one, given that I've already taken the Fed to
task for bailing us out so often. But once the precedent had been
established with Bear Stearns, Fannie Mae and Freddie Mac, letting
Lehman go under in disorderly fashion in September shocked markets
and seems to have led to the near financial meltdown that followed.
It's not clear exactly how the Fed and Treasury could have managed
a better Lehman conclusion, given the laws in place at the time
and the lack of a buyer. But what we got was pure bad news.
By jquiggin | January 2, 2009
I’m starting my long-promised series of posts on economic doctrines and
policy proposals that have been refuted or rendered obsolete by the financial
crisis. There will be a bit of repetition of material I’ve already posted
and I’ll probably edit the posts in response to points raised in discussion.
Number One on the list is a topic I’ve covered plenty of times before
(in fact, I was writing about it
fifteen years ago), the efficient (financial) markets hypothesis. It’s
going first because it is really the central microeconomic issue in a wide
range of policy debates that will (I hope) be covered later in this series.
Broadly speaking, the efficient markets hypothesis says that the prices
generated by financial markets represent the best possible estimate of the
values of the underlying assets.
The hypothesis comes in three forms.
The weak version (which stands up well, though not perfectly, to empirical
testing) says that it is impossible to predict future movements in asset
prices on the basis of past movements, in the manner supposedly done by
sharemarket chartists. While most of what is described by chartists as ‘technical
analysis’ is mere mumbo-jumbo, there is some evidence of longer-term reversion
to mean values that may violate the weak form of the EMH.
The strong version, which gained some credence during the financial bubble
era says that asset prices represent the best possible estimate taking account
of all information, both public and private. It was this claim that lay
behind the proposal for ‘terrorism futures’ put forward, and quickly abandoned
a couple of years ago. It seems unlikely that strong-form EMH is going to
be taken seriously in the foreseeable future, given the magnitude of asset
pricing failures revealed by the crisis.
For most policy issues, the important issue is the “semi-strong” version
which says that asset prices are at least as good as any estimate that can
be made on the basis of publicly available information. It follows, in the
absence of distorting taxes or other market failures that the best way to
allocate scarce capital and other resources is to seek to maximise the market
value of the associated assets. Another way of presenting the semi-strong
EMH is to say whether or not markets are perfectly efficient, they’re better
than any other possible capital allocation method, or at least, better than
any practically feasible alternative.
The hypothesis can be tested in various ways. First, it is possible to
undertake econometric tests of its predictions. Most obviously, the weak
form of the hypothesis precludes the existence of predictable patterns in
asset prices (unless predictability is so low that transactions costs exceed
the profits that could be gained by trading on them). This test is generally
passed. On the other hand, a number of studies have suggested that the volatility
of asset prices is greater than is predicted by semi-strong and strong forms
of the hypothesis (note to readers - can anyone recommend a good literature
survey on this point).
While econometric tests can be given a rigorous justification, they are
rarely conclusive, since it is usually possible to get somewhat different
results with a different specification or a different data set. Most people
are more likely to form their views on the EMH on the basis of beliefs about
the presence or absence of ‘bubbles’ in asset prices, that is, periods in
which prices move steadily further and further away from underlying values.
For those who still believed the EMH, the recent crisis should have shaken
their faith greatly. But, although the consequences were less severe, the
dotcom bubble of the late 1990s was, to my mind, are more clear-cut and
convincing example of an asset price bubble. Anyone could see, and
many said, that this was a bubble, but those, like George Soros, who
tried to profit by shortselling lost their money when the bubble lasted
longer than expected (perhaps long-dated put options would have provided
a safer way to bet on an eventual bursting of the bubble, but Soros didn’t
try this, and neither did I.)
More important than asset markets themselves is their role in the allocation
of investment. As Keynes (allegedly) said, this job is unlikely to be well
done when it is a by-product of the activities of a casino. So, if the superficial
resemblance of asset markets to gigantic casinos reflects reality, we would
expect to see distortions in patterns of savings and investment. The dotcom
bubble provides a good example, with around a trillion dollars of investment
capital being poured into speculative investments. Some of this was totally
dissipated, while much of the remainder was used in a massive, and premature,
expansion of the capacity of optical fibre networks (the fraudulent claims
of Worldcom played a big role here). Eventually, most of this “dark fibre”
bandwidth was taken up, but in investment allocation timing is just as important
as project selection.
The dotcom bubble was just one component of a massive asset price bubble
that began in the early 1990s and is only now coming to an end. Throughout
this period, patterns of savings and investment made little sense. Household
savings plunged to zero and below in a number of developed countries (including
nearly all English-speaking countries) and the resulting current account
deficits were met by borrowing from rapidly growing poor countries like
China (standard economics would suggest that capital flows should go in
the other direction). The massive growth of the financial sector itself,
which accounted for nearly half of all corporate profits by the end of the
bubble, diverted physical and particularly human capital from the production
of goods and services.
Finally, it is useful to look at the actual operations of the financial
sector. Even the strongest advocates of the EMH would not seek to apply
it to, say, the Albanian financial sector in the 1990s, which was little
more than a series of Ponzi schemes. They would however want to argue that
the massively sophisticated global financial markets of today, with the
multiple safeguards of domestic and international financial regulation,
private sector ratings agencies and the teams of analysts employed by Wall
Street investment banks is not susceptible to such systemic problems, and
is capable of correcting them quickly as they arise, without any need for
large-scale and intrusive government intervention. I’ll leave it to readers
to make their own judgements (maybe with some links when I get around to
it).
Once the EMH is abandoned, it seems likely that markets will do better
than governments in planning investments in some cases (those where a good
judgement of consumer demand is important, for example) and worse in others
(those requiring long-term planning, for example). The logical implication
is that a mixed economy will outperform both central planning and laissez
faire, as was indeed the experience of the 20th century. More to follow!
Recommended Links
Efficient-market
hypothesis - Wikipedia, the free encyclopedia
|
Well done! An example so simple that it can not really be misunderstood that also highlights the fact that a credit economy is an economy of trust and institutions (the loans, promises to pay, contracts, and liens that do the lifting) rather than an economy where counting specie and physically handing it to people is the only way of creating and moving value.
Yours is a good example of banking.
Cochrane is a decent empirical asset pricer with an excessive ideological commitment to efficient markets. He has also just prove beyond any doubt that he doesn't know shit about macro economics.
Or would that just be a case of us virtually pounding your head against his wall?
If there is one unit of labor available in a day, and you use that unit of labor to build a deck, then you cannot use that unit of labor the build a bridge. That is the aggregate resource constraint. In that world, no amount of any government policy will make that unit magically two units.
Your example seems to be: there are many units of labor available, and most of them are sitting around, so hire one unit of labor today to build a deck and have them use the promised payment to simultaneous hire someone to feed them. Everything balances out in the end.
By reading of that essay was that people are now wanting to conserve on the promises (money) and we need to make satiated with promises so that they start using them to buy things-real investments or consumption.
Is it any more complicated?
My reading of that essay was that people are now wanting to conserve on the promises (money) and we need to make people satiated with promises so that they start using them to buy things-real investments or consumption instead of holding onto them.
Yes you can, thanks to the miracle known as Capital, which, if invested wisely in machines, education or infrastructure, multiplies the economic output of a unit of labor via the magic wand called Productivity.
Beverly had an an unexpected realization that decks add value, otherwise the original $500 would carry the interest rate of the total yield for the added value of a deck.
John covers this with:
"Since we are seeing lower quantities sold and easing inflation, we must also be seeing a “demand shock,” and we need to understand its source. "
Stimulus works when unexpected expectations are understood. One possibility is we unexpected realized what a dufas George Bush was, we see unexpected fraud. The other possibility is a fundamental technology shock. The third is a bunch of shocks that are utilizing this unstable moment to correct themselves.
At the beginning of the period, capital is fixed. Or if you want, replace 'one unit of labor' with 'production possibilities possible with the given inputs,' which includes capital available.
In the real world, there is a simpler explanation of why he is wrong.
"John: The US is an open economy. Increased government spending can come at the cost of private spending or by borrowing from foreigners. Increased government consumption can come at the cost of the private sector or by increasing net imports."
This does not require knowledge about the velocity of money. It just requires knowledge of the accounting identity.
Anyone who want to understand this can take the time and walk through it--no need to be a PhD in economics. That kind of clarity, that kind of transparency, is what is needed in times like now.
Says who?
We have MV=PY. In his example its really decreasing M by 1/2. People holding more cash with nothing injected into the system by a central bank leads to a decrease in money supply. So in order for it to work out, he saying P must decrease.
1) What if Carol $500 can be spent in two ways: construction of Beverly's deck which will provide a week's labor and meals for Alice, or capital for a business that may employ Alice full-time? To the extent that Carol's money is placed with the former project (via taxation) to fund deck construction, does this not prevent its employment in the later project?
2) Finally, what if once Carol is taxed $500 and the money diverted into Beverly's backyard Xanadu, it is determined the deck is really only worth $200. Has Carol suffered a loss of $300 due to wasted taxes? Conversely, Beverly retains full enjoyment of the deck and Alice is gainfully employed. Thus, does taxation to fund stimulus separate the risk of loss from the benefit, thereby leading to poor capital allocation?
Maybe.
Or maybe that's not his error at all.
Maybe he's saying as an implicit case that an increase in velocity induced by government spending will be offset by a decrease in velocity due to a reduction in private spending.
He may still be making an error, but not because he hasn't thought of velocity.
And immediately above that when he says:
"Well, suppose the Government could borrow money from people or banks who are pathologically sitting on cash, but are willing to take Treasury debt instead. Suppose the government could direct that money to people who are willing to keep spending it on consumption or lend it to companies who will spend it on investment goods. Then overall demand for goods and services could increase, as overall demand for money decreases."
Cochrane is also talking about fiscal policy causing an increase in velocity by taking money out of idle cash.
Cochrane's problem is not that he (always) assumes velocity is fixed. It's a bit more puzzling than that. As far as I can tell, he agrees that fiscal policy could work by increasing velocity, but then says that in that case, it's really just monetary policy in disguise.
It's a badly-structured paper, and I don't blame Brad DeLong for missing that section of his paper. But it is clearly not true that Cochrane thinks that velocity is a technological constant.
Does this rely on the existence of idle resources? Is this depression economics, or something that can be done in ordinary times?
I guess if everybody was already employed, increasing the velocity of money and raising economic activity would still be feasible so long as the intervention caused people to do more: raise productivity. We don't normally think of governments as being able to engineer an increase in productivity, but I suppose that depends on whether you see productivity as a technological constraint, supply side thing, or whether you think an injection of demand can drive an increase in productivity. How about Japan's long expansion via public works and soft loans (the inflationary effect of which was, I think but could be wrong, partially sterilized by holding export earnings as dollar assets and not converting back into yen). Could that be seen as a long duration expansion of the economic activity and the velocity of money via government sponsored demand?
In undergraduate macroeconomics, when students are taught that an expansion of aggregate demand, without shifting the supply curve, just causes inflation (eventually), is an increase in the velocity of money an alternative outcome (to inflation) or would an increase in the velocity of money amount to shifting the supply curve (because it can only come about via an increase in economic activity)?
Fewer people would misunderstand.
Or perhaps an water pump powered by a windmill, on a remote area of a ranch withhout access to power, so you can graze catle there and the investment is repaid in hamburgers?
carpenter
rancher
butcher
chef
a. Carol stuffs the cash in her mattress
b. Carol lends to Beverly
c. The government taxes Carol's money
d. Carol lends the government money by buying a t-bill
e. The government prints money, Carol second guesses the government and decides not to lend to Beverly because she knows eventually the government will tax her.
The notion of velocity appears when one considers subsequent small time intervals where each of the contracts are negotiated so that more employment and output are produced, but I think Dr. Cochrane is focusing on a single point in time and focusing on stocks, before subsequently addressing flows.
Hence the key questions in this world view would be:
1. Why wouldn't Carol lend to Beverly? (fear, mistrust, etc)
2. Why wouldn't Beverly build a deck (precautionary saving)
3. Why wouldn't Alice agree to build a deck for $500 (Alice may have built a previous deck for $600, Alice may not know how to build a deck, Beverly may not know Alice or know she knows how to build a deck)?
4. If the government taxed Carol or borrowed from her, they too could spawn a chain of transactions like this, but how is that any better than what Carol, Beverly, and Alice have done anyway?
In your small economy, you multiply velocity by four without changes in interest rate.
I do not know what else to do...
Perhaps if you let Alice pound you in the head with a 2x4, you would save the damage to the wall that would otherwise have to be repaired by Carol.
Beverly could tend your wounds, earning the money to repay Carol.
You could thus simultaneously reduce the velocity of money in your example, contribute to the inflation in the medical industry, retire Beverly's outstanding debt, and occupy Alice's idle hands.
And since Deborah was doing nothing in your example, she'll remain idle in this one, unless she enjoys watching people get hit in the head by a piece of wood.
Seriously, though, it was a fine example, except I'm honestly trying to figure out what happened to poor idle Deborah. Is she Ben Stein's friend with the alimony, $2mil house, and the black hole of a small business?
That would increase his assets (measured in knowledge) and the college would have an additional $5000. The college could then hire a professor to teach Econ 101. That professor could then use the money to pay his daughter's college tuition at that same school. Meanwhile, with a great economist and professor teaching him, Cochrane could win the school's $5000 prize for excellence in economics and repay the money you loaned him....
Now, all we need to do is find a econ professor whose daughter's college bills are coming due.... :)
I disagree and my clue is the phrase "idle cash". Any cash holding shrink the money supply, taking cash holdings and investing will increase the money supply.
Of course trying to parse this model is ridiculous because its assuming a world in which the Fed targets a monetary base instead of interest rates. In the world we operate in changes in money demand are met by changes in money supply by the Fed to keep the interest rate target.
Where do the transcontinental railroads, interstate highway system, hydroelectric projects, flood-control systems, and so forth fall into this? Are they not considered as increasing productivity? Or are they not considered as government projects because the government only paid for them, while private contractors supplied the materials and labor?
I expressed myself badly. Yes the provision public goods etc. can increase productivity, and governments do raise productivity in lots of ways. But if things were as simple as "government spends, and productivity increases", then expansionary government spending could increase output indefinitely, without inflation. We don't usually think of governments being able to do that.
Is she writing John Cochrane's column about how what Alice, Beverly, and Carol are doing cannot possibly be happening?
Cochrane's argument was made just this morning by someone from the Heritage Foundation speaking on WHYY's "Radio Times with Marty Moss-Coane" program. The pro-stimulus guest did a poor job of exposing the fallacy. I hope that you and others who understand may have opportunity to speak in more widely heard forums. That might be an alternative to head-banging. I did write to the program with a link to your site (this piece) and a suggestion that they contact you.
Thanks so much for educating the rest of us, and don't despair.
Sincerely,
Sam Conner
[Yes--for some definitions of the "money supply." But what that means is that the "money supply" can grow by a lot without the government actually printing any money...]
Sure some of the people in the story bargain with each other but they do get bank involvement to make it work.
Thank you. I googled Cash In Advance models and I believe that is what I was trying to ask at January 27, 2009 at 03:58 AM.
OK, I see what you mean. I've just been somewhat perturbed by the attitude coming from some politicians and economists, that just because the money is being spent by the government, it must be wasted, compared to the uses to which private industry would put the same money. To me, it doesn't really matter whether a concrete-pourer's wages are paid by the government building Hoover Dam, or by a private developer putting in a new subdivision in the Inland Empire. Either way, the man is employed, and will be spending that money on other goods, employing more people.
Also - as those examples were just carefully chosen to show - government spending can improve productivity, and private spending can be misdirected to activities which turn out not to be economically useful. Not only that, but sometimes (Hoover Dam again) the government can spend money on projects that private enterprise will not, precisely because the government does not have to focus on the bottom line. (Though Hoover Dam actually made back all its construction costs, through electricity sales, but only over several decades, which was perhaps not feasible for any private contractor in the 1930s - or even now.)
I think this argument should be tabled until Treasury securities are earning more than 0%. Remember, those things are sold at auction; the private sector is choosing to lend their money to the government, and get zero return, rather than lend it to something more profitable (i.e., anything else).
"...and creates "jobs" that, due to political nonsense, cost twice the private sector's average wage, thereby decreasing employment."
One of my personal fascinations is with the history of Hoover Dam. I will just say that, at least in its case, your description is completely at variance with the actual project. The Six Companies even called in government troops at one point to suppress a strike by the workers demanding better pay.
January 28, 2009 at 07:35 Andrey said...
Deborah is not needed in the story, though.