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Softpanorama Bulletin
Vol 25, No.12 (December, 2013)

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Rational Fools vs. Efficient Crooks:
Efficient Markets Hypothesis

"Rational, or sane? Those are very different standards..."

From slashot comment July 17, 2013

"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."

Jeremy Grantham

Fama's last reasonable chance to retire (without making Sveriges Riksbank a laughingstock) may have been last year...

(comment from 1997 forum)

News Casino Capitalism Recommended Links


The efficient market hypothesis (EMH) is a flavor of economic Lysenkoism which became popular for the last 30 years in the USA. It is a pseudo scientific theory or, in more politically correct terms, unrealistic idealization of market behavior. Like classic Lysenkoism in the past was supported by Stalin's totalitarian state, it was supported by the power of neoliberal state, which is the state captured by financial oligarchy (see Casino Capitalism and Quite coup for more details).

Among the factors ignored by EMH is the positive feedback loop inherent in any system based on factional reserve banking, the level of market players ignorance, unequal access to the real information about the markets. the level of brainwashing performed on "lemmings" by controlled by elite MSM and market manipulation by the largest players and the state (ignorance).

Economics, it is said, is the study of scarcity. There is, however, one thing that certainly isn't scarce, but which deserves the attention of economists - ignorance.

...Conventional economics analyses how individuals choose - maybe rationally, maybe not - from a range of options. But this raises the question: how do they know what these options are? Many feasible - even optimum - options might not occur to them. This fact has some important implications. ...

Slightly simplifying, we can say that (financial) markets are mainly efficient in separation of fools and their money... And efficient market hypothesis mostly bypasses important question about how the inequity of resources which inevitably affects the outcomes of market participants. For example, the level of education of market players is one aspect of the inequity of resources. Herd behavior is another important, but overlooked in EMH factor.

There is a proven tendency of pseudo-scientific economic theories to act as smoke screen to financial gangsterism, as a tool for ideological capture. Instead of complex question about how to maintain a balance of market based economy and effective government regulation, it provides a "magic solution". Just abolish regulation, so that the unscrupulous can tear down the protections erected by previous generations, to lure the foolish and gullible with their siren songs of quickly and effortlessly acquired prosperity. Those crooks should be seen for what they really are: the direct descendants of financial gangsters of 20th of the XX century with the same unsaturable greed and the same old bag of dirty tricks. One of the most efficient ways to achieve their goals proved to be seducing or outright bribing of economists in leading universities (that is what $100K lectures by Summers and Co. are about). Capture on economic departments in major universities in turn allows to brainwash students and in a generation to achieve general acceptance of a bizarre, but very profitable nonsense as a sound theory. Maoist brainwashers can only dream about such an efficiency. That was done starting from 1980th when "market fundamentalism" school captured several major economics departments. See Noug Noland interesting analysis at

Another important factor working against EMH is the ignorance of history. It looks like mankind has a propensity to forget the lessons of previous generation in approximately 50-70 years. For "investors" this period is probably shorter then a decade ;-). As a result, there is a strong tendency to step on the same rake again and again. Baby-boomers proved to sufficiently brainwashed to go into this trap "en mass" two times: in 2000 and 2008. If market tanks in, say, 2015, that would be the third time the same trick worked with the same lemmings. I think 401K investors should remember Ian Fleming quote "Once is happenstance. Twice is coincidence. Three times is enemy action." Note the part about enemy action in view of position in a food chain Street and 401K investors (with their role of plankton for financial whales). Even twice (2000 and 2008) to lose a considerable part of savings due to selling at the bottom or close to it probably should be enough to learn the lesson. Unfortunately, as we see in 2013, it is not. As Bernard Show noted "If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience."

Remember Ian Fleming quote "Once is happenstance. Twice is coincidence. Three times is enemy action." Note the part about enemy action in view of relationship between Wall Street and 401K investors. Even twice (2000 and 2008) to lose a considerable part of savings due to selling at the bottom or close to it probably should be enough to learn the lesson. Unfortunately, as we see in 2013, it is not. As Bernard Show noted "If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience."

Due to financial industry support and huge amount of money injected into system to support EMH since probably 60th this unscientific garbage was floating as the official economic doctrine and is now included into all textbooks used in the best US (and not only US) universities despite little or no supporting empirical evidence. All this did not change even after the most recent financial crisis. That's why we can talk about EMH as a part of neoliberal ideology, not a part of scientific discourse.

At the same time events, which happened during dominance of neoliberal ideology (from 1970 till now) have conclusively demonstrated the inadequacy of the efficient market hypothesis. It neither predicted nor explained what happened. In other words is an ideological doctrine. Or even religious doctrine of sort, if we assume the neoliberalism is a secular religion, which become state religion of the USA instead of Christianity, much like previous Marxism in Russia since 1917. EMH is one of the sings of the partial fusion of religious conservatism and neoliberalism in the US. And it would be only fitting to merge economic department of say Chicago University with the department of theology and gave degrees as "master of divinity", instead of "master of arts" (or, better, "master of sacred economic doctrine").

Like in Marxism in the past the proclaimed ideas and reality drastically differ. The pseudo theories of market "efficiency" and "rationality" have led economics and, what is more important, economic policy in the direction favorable to financial oligarchy during the past decade, with recent disastrous results.

Fama and others, including Greenspan, Rubin, Summers, etc. have done huge damage with the EMH-based push for deregulation. I suspect that their suppressed by still primary motivation was greed. Nobody in the US has ever seriously proposed eliminating all of the laws prohibiting murder, assault etc. and eliminating the police because people are naturally "self-regulating" since it would be in their rational self-interests not to kill and maim people because people may do the same to you.

Just imagine the reaction of the proposal to remove red lights on intersection because it is in best interest of motorists to avoid a fatal crash. But we are daily forced fed with the equally childish notion that de-regulating the financial sector is a sound idea, because the market will efficiently price everything anyway due to availability of perfect information.

In reality, there is always a group of psychopaths who take advantage of any weakness of laws and regulations in financial markets, to further their own self-interests, regardless of the impact on society. We already saw these group of psychopaths in action twice, first in 2000 and then in 2008. That's why the real game in the market is between majority of rational fools (lemmings) vs. will organized and possessing huge financial resources group of efficient crooks (canning psychopaths who consider own enrichment above everything else, including the health of the society in which they live).

History of the concept

According to Wikipedia the "Lysenkoist in chief" was Eugene Fama (with Burton Malkiel, John Bogle and The Vanguard Group in supporting roles; actually Bogle has its own variant -- "lowest cost, same returns" or superiority of index funds hypothesis). Huge support of financial oligarchy led to the situation in which the they managed to push the hypothesis into mainstream, despite the fact that evidence was scant and contradictory:

The efficient-market hypothesis was developed by Professor Eugene Fama at the University of Chicago Booth School of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school. It was widely accepted up until the 1990s, when behavioral finance economists, who were a fringe element, became mainstream.[1]

Empirical analyses have consistently found problems with the efficient markets hypothesis, the most consistent being that stocks with low price to earnings (and similarly, low price to cash-flow or book value) outperform other stocks.[2][3] Alternative theories have proposed that cognitive biases cause these inefficiencies, leading investors to purchase overpriced growth stocks rather than value stocks.[1]

Although the efficient markets hypothesis has become controversial because substantial and lasting inefficiencies are observed, Beechey et. al. (2000) consider that it remains a worthwhile starting point.[4]

The efficient-market hypothesis was first expressed by Louis Bachelier, a French mathematician, in his 1900 dissertation, "The Theory of Speculation". His work was largely ignored until the 1950s; however beginning in the 30s scattered, independent work corroborated his thesis. A small number of studies indicated that US stock prices and related financial series followed a random walk model.[5] Research by Alfred Cowles in the '30s and '40s suggested that professional investors were in general unable to outperform the market.

The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul Samuelson had begun to circulate Bachelier's work among economists. In 1964 Bachelier's dissertation along with the empirical studies mentioned above were published in an anthology edited by Paul Cootner.[6] In 1965 Eugene Fama published his dissertation arguing for the random walk hypothesis,[7] and Samuelson published a proof for a version of the efficient-market hypothesis.[8] In 1970 Fama published a review of both the theory and the evidence for the hypothesis. The paper extended and refined the theory, included the definitions for three forms of financial market efficiency: weak, semi-strong and strong (see below).[9]

Further to this evidence that the UK stock market is weak-form efficient, other studies of capital markets have pointed toward their being semi-strong-form efficient. Studies by Firth (1976, 1979, and 1980) in the United Kingdom have compared the share prices existing after a takeover announcement with the bid offer. Firth found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi-strong-form efficient. However, the market's ability to efficiently respond to a short term, widely publicized event such as a takeover announcement does not necessarily prove market efficiency related to other more long term, amorphous factors.

David Dreman has criticized the evidence provided by this instant "efficient" response, pointing out that an immediate response is not necessarily efficient, and that the long-term performance of the stock in response to certain movements are better indications. A study on stocks response to dividend cuts or increases over three years found that after an announcement of a dividend cut, stocks underperformed the market by 15.3% for the three-year period, while stocks outperformed 24.8% for the three years afterward after a dividend increase announcement.[10]

Fama freshman-style mistake

Fama in his observation that most managed mutual funds underperform index funds made a freshman-style mistake: he assumed that managers of mutual funds are thinking and behaving rationally. But in reality this is not the case due to institutional contains on their behaviour. For example, most mutual 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 behave rationally. In addition fund managers are afraid more of not catching the speculative wave (underperforming in the bull market and missing bonuses) then going down with the crowd (when bonuses are history, anyway). That reinforces herd behaviour.

This is why most large managed fund managers are closet indexers and this tendency increases with the size of the fund (which coincides with its success among the investors). In those circumstances extra management costs and fees virtually guarantee that large actively managed mutual funds under-perform market indexes. This has nothing to do with market efficiency.

Most large managed fund managers are closet indexers and this tendency increases with the size of the fund (which coincides with its success among the investors). In those circumstances extra management costs and fees virtually guarantee that large actively managed mutual funds under-perform market indexes. This has nothing to do with market efficiency.

Moreover, regardless how one tries to improve the incentive structure for managers of mutual funds, 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 conflicts of interests that drastically diminish efficiency (agency problem and "short-termism" are probably two the most well studied).

Exact definition of EMH depends on your tolerance for sharp and vulgar words ;-). John K. Galbraith said it best about the economists 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 aptly said in Delong blog (Time to Bang My Head Against the Wall Some More )

Cochrane is a decent empirical asset pricer with an excessive ideological commitment to efficient markets. He has also just proved beyond any doubt that he doesn't know shit about macro economics.

If you want to be less tolerant, then Fama is just another white-collar academic 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. Actually RICO statute might be applicable to at least some of economic departments of major universities. See Harvard Mafia, Andrei Shleifer and the economic rape of Russia.

Negative serial correlation and profitability of arbitrage as counterarguments to hypothesis of efficiency of the markets

The efficient market hypothesis, which has had a dominant role the last three 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 in this case will correspond to the "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. In a sense, the right time to buy is not when markets have done well, but when they have done badly. We can assume that markets oscillate around fair value (and during panic oscillations can be substantial as drop of S&P500 from almost 1500 to 666 in 2009; I would like to see Fama explanation of this ;-). But what is important is that the period of oscillation and the level of overshooting/slump is unknown (which make arbitrage extremely difficult and very risky).

Another interesting fact that refutes efficient market hypothesis is that arbitrage is profitable "in a long run". It is used by a large number of financial players for a long time and this fact is incompatible with EMH. This is another proof that EMH is in its core an ideological construct supported by the state, not so much different from the idea of proletariat to be a God chosen progressive class that will lead societies from capitalism to socialism in Marxism.

When inertia (or herd mentality, if you wish) drives particular asset prices too high or too low arbitrager can exploit inefficiencies. Moreover, some large financial players like Goldman Sachs managed even simultaneously contribute to the creation of inefficiencies (dot com boom and then subprime mortgages bubble) and exploit them.

It still a very risky strategy, but it is a risky strategy for the reasons that has nothing to do with the efficient market hypothesis. In case of borrowed funds, "honest" arbitrage can be defeated by unpredictability of the period of oscillations (or "reversion to mean" in economic speak). The length of time over which markets can have significant deviation can measure in decades. In other words it is very risky to exploit such opportunities using borrowed funds. Similarly short sellers often go broke long before the value ship comes in and market proved them right. The difficulty of exploiting such opportunities is amplified for professional managers by the necessity to preserve a critical mass of customers. The danger is to lose most of the clients long before they can prove that they are right. This fact was aptly reflected in the famous John Maynard Keynes maxim: "The market can stay irrational longer than you can stay solvent".

Oversized financial sector as an argument against market efficiency

Another argument against EMH is profitability of HFT (high frequency trading). That suggests that oversized financial system can create "built-in" inefficiencies in the system which it successfully exploits. From the point of view of EMH high speed trading should not be profitable. But it is. Moreover it is now prevalent in financial markets with most trades performed by HFT machines working with their proprietary algorithms

So contrary to EMH, the "real" market does provide an opportunity for enrichment of useless individuals who happen to be close to "money river" to drink from it without any restrain. A Benjamin Friedman noted:

"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."

Generally, if profits and compensation in the financial sector go up that's an evidence of inefficiency, not efficiency of the markets. In this sense oversized profits of financial companies is a strong arguments against EMH and suggest that markets are rigged favoring the largest players. In other way they are able to imposing a tax on the "real" economy and extract the rent.

Market as voting machine

Also, as Soros stresses many times, markets are composed of thinking participants who have their own set of forecasts and as such are always biased. The famous trader maxim states that during the crash nothing rise other then correlations. In a sense, in short term, market is not so much about the 'value' (aka efficiency), 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. That means that multiple equilibriums can exist as a huge external shock is not necessary to move the market from one equilibrium to another. So unlike EMH suggests, the market is "self-propelled" not only "information propelled" and thus defy the notion of static equilibrium. Minsky theory suggests that market self-generates bull markets which ends in crashes due to the nature of fractional reserve banking, which create a positive feedback loop in the economy. Fractional reserve banking periodically causes the credit collapse, when the leveraged credit expansion goes into reverse.

As Soros suggested, actually functioning of financial markets is more like a ruthless competition on who's the best at screwing the "great unwashed masses". Success of Goldman Sachs speaks volumes about the high viability of such strategy. It is called vampire squid not without the reason.

Corruption of regulators and Kaji-ba dora-bo
("thief at the scene of a fire")

Another interesting observation that refutes efficient market hypothesis is that regulators, who in theory should play the role of arbiters and firefighters, actually enjoy playing the role of arsonists with Greenspan as a classical example. Under neoliberal regime, they are simultaneously arbiters and (via revolving door mechanism) market players. In their role of market players they are easily corrupted by the most powerful players on the market, the financial oligarchy.

While Corruption of regulators is a problem under all social regimes, be it feudalism, socialism or industrial capitalism, it is a systemic problem under neoliberalism (aka casino capitalism), where greed is officially declared a virtue in an interesting above face with Christianity. So much "In God we trust" for the modern USA. Coexistence of neoliberalism and Christianity the USA is something approaching the level of famous British hypocrisy as Pope Francis recently observed in his exhortation. In this sense we can state that neoliberal regime is the most corrupt regime in history of humanity, because its ideology elevates the greed to the level of virtue ("Greed is good").

Moreover, the corruption of regulators (and especially their propensity to create bubbles and subsequent reaction to crisis directed on saving the biggest players at the cost for taxpayers) creates 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 players is concerned about fair price or other nonsense that efficient market hypothesis operates with. They actually understand that a crisis can make them richer and that they can with impunity pursue the antisocial course of action which is creating "disequilibrium", not equilibrium. "Too big to fail" (TBTF) financial institutions represent exactly this type of players.

For example, by keeping the FED rate too low by Greenspan created a happy army of fraudulent mortgage originators, who were ready to sell mortgages to anybody with a warm breath without any consideration about fair price of the house, or the ability to repay the loan. And those players understood that in case of acute crisis they will be saved by government, so they consciously adopted destructive for society course of actions.

As one commenter to Firefighter Arson And Our Macroeconomic Policymakers " The Baseline Scenario noted:

My personal view is that they [regulators -- NNB] 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.

In a sense FED is deeply politicized institution the pursue the policies directly related to creation of two last bubbles in vain attempt to stimulate growth. So much about naive postulate that multiple players on the market by their actions tend to create an equilibrium. What efficiency we can talk in this context is completely unclear. It is politics pure and simple.

Disaster Capitalism

The same trick of creating deep disequilibrium (crisis) in order to profit from it is used by multinationals on international arena as a way to loot the third world and xUSSR countries. See Naomi Klein's The Shock Doctrine --The Rise Of Disaster Capitalism for detailed explanation of the mechanisms involved. The book exposes the sad fact that manufacturing of crisis in third word and xUSSR space countries is a well established method of facilitating financial reward for multinationals.

Such an anti-social behavior is actually an integral part of neoliberalism, as an ideology (a part of Randism, to be precise) and is stimulated by neoliberalism dominance. So, paradoxically, while efficient market hypothesis is a part of neoliberal ideology, it is incompatible with the actual practice of neoliberal players such TBTF financial institutions and multinational.

Neoliberalism and free market hypothesis: the fear of being seen as "market-unfriendly" paralyzing fiscal and regulatory policy

As a part of neoliberal doctrine the efficient market hypothesis played prominent role in shaping how the country thought and acted in the last 30-plus years. And the ability of free market hypotheses to paralyze fiscal and regulatory policies greatly contributed to the current financial crises, the crisis that seriously wounded, if not killed, neoliberalism as an ideology. Like all ideological constructs of neo-classical economy it has no basis in reality. But it was shrewdly used by unscrupulous players (aka financial oligarchy) as a very effective smoke screen which allows to pursue their actions in redistributing wealth in the society with impunity. For example it allowed to steal a lot of money from 401K investors by luring them into stock market, where they served the role of Financial Plankton for larger Wall Street fish.

In other words, the efficient market hypothesis was used as a crowbar by financial oligarchy 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.

Susan Strange called the resulting social organization Casino Capitalism, a variant of neoliberalism typical for G7 countries. As Sushil Wadhwani in the Insight column How efficient markets theory gave rise to policy mistakes (please remember that FT is a City publication and the bastion of conservative economic thinking) noted:

Clients frequently tell me they are puzzled that policymakers allowed such a significant crisis to develop. Their incomprehension is deepened by the recognition that, in recent years, many countries made their central banks independent, and these are typically run by people with formidable reputations as academics.

I wonder whether a common thread running through many of the policy mistakes is a belief in the efficient markets hypothesis (EMH).

Over the past decade, while the bubbles were emerging, it was frequently argued that central bankers had neither more information nor greater expertise in valuing an asset than private market participants. This was often one of the primary explanations for central banks not attempting to "lean against the wind" with respect to emerging bubbles.

As I argue in my recent National Institute article, it is likely that, had central banks raised interest rates by more than was justified by a fixed-horizon inflation target while house prices were rising above most conventional valuation measures, the size of the eventual bubble would have been smaller. At least as importantly, because of the fear of being seen as "market-unfriendly", fiscal and regulatory policy did not lean against the wind either. Our economies would plausibly have exhibited greater stability if tax policy had been used in an anti-bubble fashion (e.g. a counter-cyclical land tax) and if regulatory policy had been more activist (e.g. a ceiling on loan-value ratios) and contra-cyclical (e.g. time-varying bank capital requirements).

Once the recent bubbles burst in 2007, some central banks (including many of those in Europe) were surprisingly slow to cut interest rates, and this policy mistake may well lead the current recession to be longer and deeper than it might have been. One reason for their reluctance to cut interest rates was the significant rise in commodity prices. In relying on the EMH yet again, policymakers used longer-dated futures prices for these commodities in preparing their inflation projections. Their failure to allow for the then widely discussed possibility that a "bubble" had developed in the commodity markets thereby led them significantly to overestimate prospective inflationary pressures.

Recently the Nobel laureate George Akerlof has, with Robert Shiller, argued that Keynes's explanations for excessive financial market volatility and depressions relied importantly on the possibility that individuals can act irrationally and for non-economic reasons. However, modern-day "Keynesian" models of the economy typically ignore this essential insight and can therefore be a deficient tool for setting policy. Personally, I find this neglect of Keynes surprising as at least some fund management companies (including the hedge funds I help manage) assign an important role to this insight in their investment process.

This failure to incorporate the role of what Keynes described as "animal spirits" might well have permitted the naive belief that recapitalizing the banks would lead them to lend again. Once "confidence" has evaporated, banks will not lend however well-capitalized they may be. Unsurprisingly, governments are now having to explore other ways of making banks lend, and one has to wonder whether they might be driven to full-scale nationalization.

Of course, because of "animal spirits" one can find that monetary policy becomes surprisingly ineffective in slumps. Hence, although it is laudable the Bank of England has cut UK interest rates significantly in recent months, we should all have been much better off if it had reduced rates more pre-emptively. Now we will need so-called quantitative easing - with, perhaps, the Treasury guaranteeing assets acquired by the Bank.

This financial crisis should not have surprised anybody: financial history is littered with examples of bubbles, manias and crashes.

The main lesson is that our monetary, fiscal and regulatory policies must be designed to protect the many innocent people in the rest of the economy from the consequences of excessive financial market volatility.

(The writer is chief executive of Wadhwani Asset Management and a former member of the Bank of England's monetary policy committee FT Syndication Service)

Now we do need to revise economic textbooks on the efficiency of markets. As a responses to Seeking Alpha post Technical Rally Could Indicate Computerized Panic Buying suggested the following edit might be appropriate:

Change "Markets provide an efficient pricing mechanism" to "In the long term, markets may be efficient, but in the short term, it is far more important to have a double head and shoulders pattern with broken candlesticks under the full moon eating a muffin with an Italian Coffee, but watch your Taylor series conversion."

... ... ...

Like almost everybody, I was taught to believe in the efficiency of the markets. And therein lies the problem. One market paradigm that is always true is that the market likes to disprove as many people as possible. So, once the efficient markets model universally accepted and followed, the markets will adapt in such a way as to render the model incorrect.

Another problem with the model is that it assumes that all players in the markets are investors who are concerned entirely with future earnings prospects. Unfortunately, market participants are simply not a homogenous group. Some participants care about earnings, others care about momentum, statistics, and so forth. This latter group can and sometimes does set prices. In fact, when the momentum players really get a hold on things, many of the purported "earnings-oriented" crowd start to join in and become momentum obsessed themselves. Efficiency by that time gets tossed by the wayside, because as an investment model, it's not making as much money for you as other models (like momentum) are. There are different types of participants in the market, but they all do share one characteristic: they like to make money, and the ones who are good at that will adopt any approach that makes money, and discard any approach that does not.

You make an interesting second point, which is that in the long term, perhaps efficiency does matter. My question then is, how would we know that?

Okay, one consequence of market efficiency is that nobody can beat the market's average performance over the long term. Why? Because any information they have is already priced in, so there's no way to get an edge. In fact, what we see is that most investors out there end up performing at or below the market's average. There are the Buffetts and Soroses of the world, but those are the exceptions that prove the rule. The law of averages catches up to most folks in the end, so it looks like efficiency is at work. At least that's the obvious answer. But look behind the curtain a little bit, and you'll find that there are many, many, many traders who quietly beat the market for years and years. I've drafted quite a few estate plans for guys like this who you've never heard of and probably never will. Why? They're smart enough to quit while they're ahead (or, in some cases, way way way ahead). And guess what. Most of them aren't crunching income statements and reading analyst reports, either. These guys tend to be crackerjack mathematicians, who know how to spot a trend, leverage up, and profit from it.

Free market hypothesis and excessive 401K investing in stock market

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 (or 10 year bonds). That does not mean that this can't change this this situation is probably way too extreme. But there is no guarantee that it will and those who need to retire in 2009 and used this method are royally screwed. No question about it.

The second important 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:

We have just come through a decade-plus in which the Fed intervened "successfully" enough so that folks came to look upon the stock market (and then the real-estate market) as pet kittens that spit out hundred-thousand-dollar bills. Markets are not like that at all. They are more like savage beasts looking to rip your head off.

The era of "pet markets" that effortlessly make people rich is definitely behind us.

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 "long enough" period. Due to changes in S&P500 composition there 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.

Ezra Klein once noted about quality of advice of two clowns: Jim Cramer, the famous financial advice clown and Larry Kudlow -- a prominent supply side clown ( December 2008):

CXO Advisory Group tracked Jim Cramer's picks for awhile and concluded "Based on subsequent stock market performance and our judgments about his forecasts for overall stock market direction, Jim Cramer is right about 46% of the time with his stock market predictions, a little below average." Stunning performance. Meanwhile, anyone who has ever read Larry Kudlow wonders how he's able to manage a folding chair without assistance, much less other people's money. He's the sort of guy who monocausally attributes market movement to Obama's standing in the polls. Indeed, if markets are half as efficient as he believes, than his show exists in stark contradiction to the implications of efficient markets.

But he has a finance show. Because like with political commentary, ratings come from entertainment, not insight and accuracy. And a broadcast that was all doom and destruction and frank admissions of ignorance wouldn't be very fun to watch.

I think that his line of thinking is perfectly applicable to Fama and friends. Fama existence in academy is a stark contradiction to the efficient markets hypothesis :-).


The concept of EMH evolved with time and gradually became an ideological construct belief in which is a required postulate of the neoliberalism, as a secular religion which serves as a state ideology in the USA. As such it is enforced by the power of state.

As any idealized system EMH might be useful not because it is an accurate descriptions of the market (it is not, although accidentally it may come close for certain short periods), but only as a benchmark to measure departures of the real market behaviour from an idealized model: deviation from an idealized model can sometimes serve as a useful indicator. For example, although we discussed Fama freshmen-style mistake, comparison of performance of mutual funds with the performance of S&P 500 become very common since early 90th and outside the periods of market crashes might have some value. But to the extent financial oligarchy encourages policy makers to use flawed models ("cognitive capture"), they are in the same moral position as physicists who encourage engineering of mechanisms while ignoring friction, or the engineers who did not understand the influence of low temperatures on the O-ring behaviour.

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.

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.

Like most of neoclassic economy this idea serves the interests of financial oligarchy to the detriment of other economic players. It was used to loot 401K investors by luring them into stock market and fleecing them during the crisis, when the panic allow bigger fish, who understood that they will be saved by regulators, to buy assets that are sold during the panic by 401K lemmings for pennies on the dollar.

Professor Eugene Fama is a really special gift to the economic profession: later 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 ;-) As for classical dilemma of "intellectual dishonesty or fundamental ignorance" I am inclined to see him probably as 50:50 split (equally ignorant and intellectually dishonest :-).

The fact that Fama got The Sveriges Riksbank Prize in Economic Sciences (Aka Nobel Prize in Economics which was created in 1968) also tells us something about the group which award it. One comment to Philip Mirowski video Why Is There a Nobel Memorial Prize in Economics aptly noted

"...the corruption and incompetence of the tight, mafia-like group of fanatics that controlled (and still controls) economics in Sweden. The power of this group was (and still is) largely based in their control of the Nobel prize."

Here is the full post (by Jorge Buzaglo on Thu, 12/29/2011):

Grassman, Sven, 1940-1992
Det tysta riket : skildringar från falsifikatens och jubileumsfondernas tidevarv : [svensk ekonomi från föredöme till problembarn] / 1981

This is a very important book related to your research project. Sven Grassman was a Keynesian economist marginalized by his colleagues at the Institute of International Economics, University of Stockholm (the same group, leaded by Assar Lindbeck, which was deciding on the Nobel prize). I think that this cruel persecution by his colleagues led to his early death (at 52). In this book Sven Grassman describes the corruption and incompetence of the tight, mafia-like group of fanatics that controlled (and still controls) economics in Sweden. The power of this group was (and still is) largely based in their control of the Nobel prize.

The greatly increased political ascendancy of this fundamentalist group of economists was perhaps not unrelated to the sharp increase of inequality in Sweden - Sweden is by far the OCDE country where inequality increased the most since the mid-1980s (Gini increased by 31% in 1985-2010; see

Other highly relevant books by Grassman are:


A newer version of this article might be available at Rational Fools vs. Efficient Crooks: The efficient markets hypothesis

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[Nov 16, 2013] 'Ignorance'

November 06, 2013 | Economist's View

Ignorance: Economics, it is said, is the study of scarcity. There is, however, one thing that certainly isn't scarce, but which deserves the attention of economists - ignorance. A recent paper by Richard Zeckhauser and Devjani Roy - which introduces a new method of economic research - shows that this is unjustly neglected in economics.

Conventional economics analyses how individuals choose - maybe rationally, maybe not - from a range of options. But this raises the question: how do they know what these options are? Many feasible - even optimum - options might not occur to them. This fact has some important implications. ...

... In a brilliant post, Will Davies gives a lovely example of this. Academics making funding applications, he says:

have to describe the entire project, its outcomes and 'impact' in advance. These pieces of science fiction serve little purpose of ensuring that money goes to the 'best' recipients, but a great purpose in reassuring the state that nothing unexpected will happen.

But the entire point of economics - and indeed of life - is that the unexpected does happen. An ideology which overlooks ignorance is therefore a fiction. And worse still, a potentially costly one.


Psychology pays a lot of attention to this. Dunning-Kruger effect, anyone? This is another instance where economics really needs to start paying attention o the research results of other social sciences. Alas, their meta ignorance of what they're missing keeps them ignorant even of where to look...

Wisdom Seeker
Yet more proof that "Economics" is not (yet) a science.

Also, the unexpected should not be unexpected. Most of the time the "unexpected" is really just proof that "this time isn't different". But policymakers and other econogandists* must feign ignorance of the "unexpected" in order to avoid receiving career-ending blame.

And yes, grant writing is a stylized exercise in science fiction.

* Econoganda - economic propaganda, see

reason :

People are missing the point of this. Chris Dillow's real target is "managerialism". (And to a lesser extent I suppose the presumptiveness of stock market driven investment - not to mention the strong rational expectations hypothesis).

Fama Has Shiller to Thank for his Nobel Prize

The Big Picture

[Oct 15, 2013] Are Rationality and the Efficient Markets Hypothesis Useful?

Economist's View

Just a quick note on the efficient markets hypothesis, rationality, and all that. I view these as important contributions not because they are accurate descriptions of the world (though they may come close in some cases), but rather because they give us an important benchmark to measure departures from an ideal world.

It's somewhat like studying the effects of gravity in an idealized system with no wind, etc. -- in a vacuum -- as a first step. If people say, yes, but it's always windy here, then we can account for those effects (though if we are dropping 100 pound weighs from 10 feet accounting for wind may not matter much, but if we are dropping something light from a much higher distance then we would need to incorporate these forces).

Same for the efficient markets hypothesis and rationality. If people say, if effect, but it's always windy here -- those models miss important behavioral effects, e.g., -- then the models need to be amended appropriately (though, like dropping heavy weights short distances in the wind, some markets may act close enough to idealized conditions to allow these models to be used). We have not done enough to amend models to account for departures from the ideal, but that doesn't mean the ideal models aren't useful benchmarks.

Anyway, just a quick thought...

[Oct 15, 2013] Philip Mirowski - Why Is There a Nobel Memorial Prize in Economics by Jorge Buzaglo

"In this book Sven Grassman describes the corruption and incompetence of the tight, mafia-like group of fanatics that controlled (and still controls) economics in Sweden. The power of this group was (and still is) largely based in their control of the Nobel prize."
12/29/2011 | The Institute for New Economic Thinking

Grassman, Sven, 1940-1992
Det tysta riket : skildringar från falsifikatens och jubileumsfondernas tidevarv : [svensk ekonomi från föredöme till problembarn] / 1981

This is a very important book related to your research project. Sven Grassman was a Keynesian economist marginalized by his colleagues at the Institute of International Economics, University of Stockholm (the same group, leaded by Assar Lindbeck, which was deciding on the Nobel prize). I think that this cruel persecution by his colleagues led to his early death (at 52). In this book Sven Grassman describes the corruption and incompetence of the tight, mafia-like group of fanatics that controlled (and still controls) economics in Sweden. The power of this group was (and still is) largely based in their control of the Nobel prize.

The greatly increased political ascendancy of this fundamentalist group of economists was perhaps not unrelated to the sharp increase of inequality in Sweden - Sweden is by far the OCDE country where inequality increased the most since the mid-1980s (Gini increased by 31% in 1985-2010; see

Other highly relevant books by Grassman are:

Why do we still have a Nobel Prize in economics by John Quiggin

"I think it primarily exists to give a sense of self-satisfaction to the people who go to considerable lengths to let all and sundry know that "It's not a real Nobel, don't you know." Because of course the fact that old Alfred did not include economics in his original list is a damning indictment into the state of "scientific" economic research, the bunch of political hacks they are, don't you know."
October 14, 2013 | Crooked Timber

Ingrid links to some fascinating discussion from Philip Mirowski of the role of Swedish domestic politics in the establishment of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, with emphasis on the way in which claims of "scientific" status for economics helped the claim of the Swedish central bank to independence from government.

In the broader context, it seems pretty clear that, if the idea had arisen even a few years later, it would have been rejected. In 1969, economics really did seem like a progressively developing science in which new discoveries built on old ones. There were some challenges to the dominant Keynesian-neoclassical synthesis but they were either marginalized (Marxists, institutionalists) or appeared to reflect disagreements about parameter values that could fit within the mainstream synthesis.

Only a few years later, all of this was in ruins. The rational expectations revolution sought, with considerable success, to discredit Keynesian macroeconomics, while promising to develop a New Classical model in which macroeconomic fluctuations were explained by Real Business Cycles. This project was a failure, but led to the award of a string of Nobels, before macroeconomists converged on the idea of Dynamic Stochastic General Equilibrium models, which failed miserably in the context of the global financial crisis. The big debate in macro can be phrased as "where did it all go wrong". Robert Gordon says 1978, I've gone for 1958, while the New Classical position implies that the big mistake was Keynes' General Theory in 1936

The failure in finance is even worse, as is illustrated by this year's awards where Eugene Fama gets a prize for formulating the Efficient Markets Hypothesis and Robert Shiller for his leading role in demolishing it. Microeconomics is in a somewhat better state: the rise of behavioral economics has the promise of improved realism in the description of economic decisions.

Overall, economics is still at a pre-scientific stage, at least, as the idea of science is exemplified by Physics and Chemistry. Economists have made some important discoveries, and a knowledge of economics helps us to understand crucial issues, but there is no agreement on fundamental issues. The result is that prizes are awarded both for "discoveries" and for the refutation of those discoveries.

[Oct 15, 2013] Economists Clash on Theory, but Will Still Share the Nobel By BINYAMIN APPELBAUM

Swiss banks really like Fama ;-)

The economist Robert J. Shiller in 2005 described the rapid rise of housing prices as a bubble and warned that prices could fall by 40 percent.

Five years later, with home prices well on the way to fulfilling Mr. Shiller's prediction, the economist Eugene F. Fama said he still did not believe there had been a bubble.

"I don't even know what a bubble means," said Mr. Fama, the author of the theory that asset prices perfectly reflect all available information. "These words have become popular. I don't think they have any meaning."

The two men, leading proponents of opposing views about the rationality of financial markets - a dispute with important implications for investment strategy, financial regulation and economic policy - were joined in unlikely union Monday as winners of the Nobel Memorial Prize in Economic Science.

Mr. Fama's seminal theory of rational, efficient markets inspired the rise of index funds and contributed to the decline of financial regulation. Mr. Shiller, perhaps his most influential critic, carefully assembled evidence of irrational, inefficient behavior and gained a measure of fame by predicting the fall of stock prices in 2000 as well as the housing crash that began in 2006.

They will share the award with a third American economist, Lars Peter Hansen, who developed a method of statistical analysis to evaluate theories about price movements that is now widely used by other social scientists.

The three economists, who worked independently, were described as collectively illuminating the workings of financial markets by showing that stock and bond prices move unpredictably in the short term but with greater predictability over longer periods. The prize committee said these findings showed that markets were moved by a mix of rational calculus and irrational behavior.

Mr. Fama and Mr. Hansen are professors at the University of Chicago, known as the principal home of free market economics; Mr. Shiller is a professor at Yale University. Their work "laid the foundation for the current understanding of asset prices," according to a statement from the Royal Swedish Academy of Sciences, which awards the annual prize.

Yet in jointly honoring the work of Mr. Fama and Mr. Shiller, the committee also highlighted how far the economics profession remains from agreeing on the answer to a basic and consequential question: How do markets work?

"It encapsulates the state of modern economics," said Justin Wolfers, an economist at the University of Michigan. "We have big important questions that remain largely open and we have giants bringing evidence to bear. And the answer turns out to be more complicated than markets are efficient - or markets are inefficient."

The dispute is not merely academic. The deregulation of financial markets beginning in the 1980s was justified by the view that markets are rational and efficient. Complacence about rising home prices in the 2000s similarly reflected the view that prices are inherently rational. In the aftermath of the crisis, conversely, the work of Mr. Shiller and other proponents of behavioral economics - the integration of psychology into economic models - has been influential in shaping an intensification of financial regulation. And Federal Reserve officials are now debating whether bubbles can be identified and when they should be popped.

Mr. Fama, 74, was honored for showing in the 1960s that asset prices are "extremely hard to predict over short horizons." He has said the seeds of his theory were planted as an undergraduate at Tufts University, while working for a professor who ran a stock market forecasting service. Mr. Fama was charged with devising and testing forecasting schemes, which invariably failed to work. He later coined the term "efficient markets" to describe his view that asset price movements could not be predicted because prices fully reflected all available information.

The theory basically asserted, in the words of the economist Burton Malkiel, that "a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts."

It has been repeatedly validated, sometimes in experiments involving actual monkeys. And while many market prognosticators on Wall Street still thrive in part by claiming that they can offer investments that will consistently beat the market averages, Mr. Fama's well-established theory has influenced the way millions of people now invest, contributing to the popularity of index funds that hold broad, diversified baskets of equities.

Mr. Shiller, 67, introduced in the early 1980s an important limitation on the idea that markets operate efficiently. He showed that the volatility of stock prices was greater than the volatility in corporate dividends. Moreover, he found that some of those irrational deviations fell into predictable patterns.

Mr. Fama is among the economists who have since documented other patterns of predictable price movements, although he explains these patterns as a form of compensation for the greater risk associated with some assets.

Mr. Shiller, by contrast, has argued that the predictability of prices reflects irrational but repeating patterns in human behavior, and he is among a group of prominent economists who are trying to integrate behavioral theories from psychology and other social sciences into rigorous models of economic activity.

An enthusiastic popularizer, Mr. Shiller wrote in "Market Volatility," a 1989 book published by MIT Press, that the assertion stock prices were rational was "one of the most remarkable errors in the history of economic thought." Instead, he wrote, "Mass psychology may well be the dominant cause of movements in the price of the aggregate stock market."

Bubbles are one of the most tangible manifestations of the disagreement between Mr. Shiller and Mr. Fama. The housing crash that began in 2006 is widely regarded as evidence that prices had climbed to irrational heights, and Mr. Shiller's accuracy in diagnosing the problem suggests that future bubbles could be identified, too.

Janet L. Yellen, nominated earlier this month to lead the Fed, has said the central bank needs to reconsider its traditional view that bubbles cannot be spotted and should not be popped - or restrained from growing too large.

But Mr. Fama, like other proponents of efficient markets theory, is dismissive of Mr. Shiller's record as a forecaster and more broadly, of claims that it is possible to consistently identify asset bubbles before a collapse.

Asked in 2010 about those who warned that housing prices would crash, he responded, "Right. For example, Shiller was saying that since 1996."

Mr. Hansen, 60, on Monday found himself temporarily labeled "the youngster." He was honored for developing the "generalized method of moments," a technique for evaluating relationships among explanatory factors that allows social scientists to work around the absence of some kinds of information.

He said that he learned he had won while walking his dog.

Mr. Shiller, in a news conference at Yale, said he rushed from the shower to answer the phone. After learning he had won, he called his brother in Detroit.

"Did you hear the news?" he asked. "Yeah," his brother said. "The Tigers lost."

Mr. Fama, asked whether he had anticipated this moment, said, "I didn't want to presume that I would win." He added, "I knew that I would be thrilled, of course."

[Jul 18, 2013] Is Economics a Science or a Religion - by Mark Buchanan

Neo-classic economy is really just an ideology of neoliberalism with fig leaf of mathematic equations of top of free-market exited economists selling themselves to highest bidder.
Jul 17, 2013 | Bloomberg

Is economics a science or a religion? Its practitioners like to think of it as akin to the former. The blind faith with which many do so suggests it has become too much like the latter, with potentially dire consequences for the real people the discipline is intended to help.

The idea of economics as religion harks back to at least 2001, when economist Robert Nelson published a book on the subject. Nelson argued that the policy advice economists draw from their theories is never "value-neutral" but foists their values, dressed up to look like objective science, on the rest of us.

Take, for example, free trade. In judging its desirability, economists weigh projected costs and benefits, an approach that superficially seems objective. Yet economists decide what enters the analysis and what gets ignored. Such things as savings in wages or transport lend themselves easily to measurement in monetary terms, while others, such as the social disruption of a community, do not. The mathematical calculations give the analysis a scientific wrapping, even when the content is just an expression of values.

Similar biases influence policy considerations on everything from labor laws to climate change. As Nelson put it, "the priesthood of a modern secular religion of economic progress" has pushed a narrow vision of economic "efficiency," wholly undeterred by a history of disastrous outcomes.

Rational Responses

The economic zeal reached its peak several years back, when a number of economists openly celebrated what they called economic imperialism -- the notion that the inherent superiority of their way of thinking would lead it to displace all other social sciences. Academics sought to bring the advanced calculus of rationality -- with its assumption that everything can be explained by people's perfectly rational responses to incentives -- to the primitives in fields ranging from sociology to anthropology.

The imperial adventure lost much of its momentum in the wake of the 2008 financial crisis. More attention has turned to the psychological, or behavioral, revolution, which has established that the rational ideal of economic theory isn't even a good starting point as a crude caricature of the way real people act. We're often goal-oriented, of course, but we seek those goals through imperfect heuristic rules and trial and error, learning as we go. If anything, rationality is the anomaly in human life.

Of equal significance is a growing acceptance of Nelson's larger point: that economics is riddled with hidden value judgments that make its advice far from scientific. In one notable development, the Journal of Economic Perspectives published a paper by economists Daron Acemoglu and James Robinson that examines how value judgments -- in this case, the dismissal of political repercussions -- have undermined well-intentioned economic interventions.

Most economists, for instance, see the weakening of trade unions in the U.S. and other Western nations in the past few decades as a good thing, because unions' monopoly power over wages impairs companies' ability to adapt to the demands of the market. As Acemoglu and Robinson point out, however, unions do a lot more than influence the supply and cost of labor. In particular, they have historically played a prominent role in creating and supporting democracy, in limiting the political power of corporations, and in mitigating income inequality.

Narrow policy analyses have repeatedly led economists to push for policies that have had unexpected consequences for the balance of political power. Acemoglu and Robinson cite the push to privatize industries in Russia in the 1990s. The idea was that private ownership, no matter how it came about, would ultimately benefit the entire economy. In practice, a rigged process gave rise to an illegitimate oligarchy and an increase in inequality that set the stage for the ascendance of President Vladimir Putin's authoritarian regime.

Tragic Flaw

More recently, the gospel of economic efficiency helped lay the groundwork for the financial crisis, mostly by encouraging overconfidence in the wonders of financial engineering. Theory-induced dreams of market discipline provided justification for stripping away entirely sensible regulations, such as barriers between commercial and investment banking, and for avoiding oversight of the booming trade in derivatives. One result was an extremely wealthy financial lobby that is still working hard to block reform.

In all these cases, the tragic flaw lies in the heady confidence that comes with a one-size-fits-all theoretical framework. There's a real danger in seeing economics as an objective science from which all values have been stripped. Nelson preferred an older, more modest perspective on economics espoused by Frank Knight, a founder of the University of Chicago's free-market school of thought. Knight expressed the view that truly careful social and economic analysis emphasizes the limits to human knowledge and "the fatuousness of over-sanguine expectations" from economic-policy designs, including those favoring free enterprise.

In short, economists would do well to derive their prescriptions from observations of how the world really works, with a healthy respect for its complexity. Faith is no substitute for informed inquiry.

(Mark Buchanan, a theoretical physicist and the author of "Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics," is a Bloomberg View columnist.)

To contact the writer of this article: Mark Buchanan at [email protected]

To contact the editor responsible for this article: Mark Whitehouse at [email protected]

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What to Do When the Invisible Hand Stops Working By Mark Buchanan

Jun 5, 2013Bloomberg

Economists rave about the power of the market to deploy productive resources better than any central planner possibly could. A mysterious process, which Adam Smith called the "invisible hand," guides countless individuals with conflicting aims to somehow coordinate into a remarkably effective economic organization. Usually.

But as the British economist John Maynard Keynes famously argued, markets can also fall into dysfunction. A crisis can set off a downward spiral: Spending declines, companies fail, people lose jobs, spending declines further. Much of the wonderful coordination disappears, as if the invisible hand were injured.

None of this is controversial. But if you ask how best to cure an afflicted economy, you get vicious and sometimes hysterical argument, typically polarized along political lines. Should markets be left alone, because the invisible hand is self-healing and intervention can only make matters worse? Or does an economy, like a real living thing, sometimes need direct medical (or governmental) intervention?

Resolving the debate is difficult, largely because we know surprisingly little about how the invisible hand actually achieves such precise economic coordination. Even more surprising, few economists over the past 30 years have been focusing on this area of ignorance.

Perfect Rationality

If that sounds hard to believe, consider the "state-of-the-art" mathematical models currently used by economists. They ditch all the complexity of the real economy in favor of a peculiar scheme in which one ideal household and one ideal firm meet and optimize their behavior with perfect rationality. Adam Smith would be mystified -- I think even horrified. Such "rational expectations" models can be tweaked to back up just about any story you like, so it is little wonder that the vicious arguments over policy persist.

Happily, there is hope. A few economists have been trying to go deeper by exploring the actual coordinating mechanisms of the invisible hand, how they emerge and also how they can break down.

One notable example is a line of research initiated about a decade ago by Robert Clower and Peter Howitt. They noted that useful economic coordination comes about over time as people interact, discovering where to find the goods they like as well as the companies they trust and find useful. Businesses get started after people learn about one another's needs and wants. In other words, there's a necessary and usually messy growth history behind the familiar structures -- firms, shops, and other intermediaries -- that provide the coordination for a functioning economy.

To get a sense of how the process works, Clower and Howitt set up a computer simulation. They let lots of virtual people interact with one another, following fairly simple rules to trade among themselves while seeking their desired goods. People finding many potential trading partners for certain goods could choose to set up a specialist firm trading that good, profiting while also making it easier for others to find that good. Over time, a vast web of useful firms covering all goods emerged, without any central planning, to solve the coordination problem of getting goods to the people who wanted them. Something else happened, too: One of the goods in the economy came to be valued universally by all as a convenient medium of exchange. The market discovered money all on its own.

Unlike traditional economic models, Clower and Howitt's way of looking at an economy respects Adam Smith's core heroic insight: that coordination emerges in a wholly natural way, from the interactions of ordinary people (For more on this fascinating research, see my blog). It can also offer insight into practical policy matters, including those that so interested Keynes.

Valuable Infrastructure

In recent work with Quamrul Ashraf and Boris Gershman, for example, Howitt finds an important effect of financial crises that rational-expectations models miss: the hard-to-reverse failure of firms. The disappearance of firms destroys valuable coordinating infrastructure, making economic life more challenging for others. As other firms lose key sources of income, supplies and customers, they might also go bankrupt, furthering the destruction.

Afterward, the recovery of an economy won't be only a matter of restoring confidence, letting prices and wages adjust, or keeping interest rates low. Recovery requires the time-consuming rebirth of entire networks of firms. Although the research doesn't model that process explicitly, it's pretty clear that government action could easily help, by providing individuals with unemployment benefits until they find a new job, or by intervening to keep crucial firms alive (remember the U.S. automaker bailouts of 2009).

The work of Howitt and colleagues is only a beginning, but a huge step in the right direction. The unfortunate reality is that most economic theory today still rests on analyses of extremely intelligent people acting in unrealistic situations. We need to explore the way people of ordinary intelligence manage in the face of an incredibly complex world. Until we can really understand the coordination mechanisms that help us do it, policy making will remain a dark art.

(Mark Buchanan, a theoretical physicist and the author of "The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You," is a Bloomberg View columnist. The opinions expressed are his own.)

To contact the writer of this article: Mark Buchanan at [email protected]

To contact the editor responsible for this article: Mark Whitehouse at

[Jul 09, 2013] "James Tobin's Hirsch Lecture"

Rajiv Sethi discusses James Tobin's "four distinct conceptions of financial market efficiency," particularly his notion of functional efficiency"

James Tobin's Hirsch Lecture, by Rajiv Sethi: James Tobin's Fred Hirsch Memorial Lecture "On the Efficiency of the Financial System" was originally published in a 1984 issue of the Lloyds Bank Review, and republished three years later in a collection of his writings. Willem Buiter discussed the essay at some length about a year ago in a provocative post dealing with the regulation of derivatives. Both the original essay and Buiter's discussion of it remain well worth reading today as guides to the broad principles that ought to underlie financial market reform.

In his essay, Tobin considers four distinct conceptions of financial market efficiency:

Efficiency has several different meanings: first, a market is 'efficient' if it is on average impossible to gain from trading on the basis of generally available public information... Efficiency in this meaning I call information arbitrage efficiency.

A second and deeper meaning is the following: a market in a financial asset is efficient if if its valuations reflect accurately the future payments to which the asset gives title... I call this concept fundamental valuation efficiency.

Third, a system of financial markets is efficient if it enables economic agents to insure for themselves deliveries of goods and services in all future contingencies, either by surrendering some of their own resources now or by contracting to deliver them in specified future contingencies... I call efficiency in this Arrow-Debreu sense full insurance efficiency.

The fourth concept relates more concretely to the economic functions of the financial industries... These include: the pooling of risks and their allocation to those most able and willing to bear them... the facilitation of transactions by providing mechanisms and networks of payments; the mobilization of saving for investments in physical and human capital... and the allocation of saving to to their more socially productive uses. I call efficiency in these respects functional efficiency.

The first two criteria correspond, respectively, to weak and strong versions of the efficient markets hypothesis. Tobin argues that the weak form is generally satisfied on the grounds that "actively managed portfolios, allowance made for transactions costs, do not beat the market." He notes, however that efficiency in the second (strong form) sense is "by no means implied" by this, and that "market speculation multiplies several fold the underlying fundamental variability of dividends and earnings."

My own view of the matter (expressed in an earlier post) is that such a neat separation of these two concepts of efficiency is too limiting: endogenous variations in the composition of trading strategies result in alternating periods of high and low volatility. Nevertheless, as an approximate view of market efficiency over long horizons, I feel that Tobin's characterization is about right.

Full insurance efficiency requires complete markets in state contingent claims. This is a theoretical ideal that is impossible to attain in practice for a variety of reasons: the real resource costs of contracting, the thinness of potential markets for exotic contingent claims, and the difficulty of dispute resolution. Nevertheless, Tobin argues for the introduction of new assets that insure against major contingencies such as inflation, and securities of this kind have indeed been introduced since his essay was published.

Finally, Tobin turns to functional efficiency, and this is where he expresses greatest concern:

What is clear that very little of the work done by the securities industry, as gauged by the volume of market activity, has to do with the financing of real investment in any very direct way. Likewise, those markets have very little to do, in aggregate, with the translation of the saving of households into corporate business investment. That process occurs mainly outside the market, as retention of earnings gradually and irregularly augments the value of equity shares...

I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. I suspect that the immense power of the computer is being harnessed to this 'paper economy', not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges. For this reason perhaps, high technology has so far yielded disappointing results in economy-wide productivity. I fear that, as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost of facilitation nth-degree speculation which is short sighted and inefficient...

Arrow and Debreu did not have continuous sequential trading in mind; when that occurs, as Keynes noted, it attracts short-horizon speculators and middlemen, and distorts or dilutes the influence of fundamentals on prices. I suspect that Keynes was right to suggest that we should provide greater deterrents to transient holdings of financial instruments and larger rewards for long-term investors.

Recall that these passages were published in 1984; the financial sector has since been transformed beyond recognition. Buiter argues that Tobin's concerns about functional efficiency are more valid today than they have ever been, and is particularly concerned with derivatives contacts involving directional bets by both parties to the transaction:

[Since] derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution. Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game.

The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults. Defaults, insolvency and bankruptcy are key components of a market economy based on property rights. There involve more than a redistribution of property rights (both income and control rights). They also destroy real resources. The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved. There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners. But there is such a thing as insolvency for losers, if the losses are large enough.

The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple. The party purchasing the insurance should be able to demonstrate an insurable interest. [Credit Default Swaps] could only be bought and sold in combination with a matching amount of the underlying security.

The debate over naked credit default swaps is contentious and continues to rage. While market liquidity and stability have been central themes in this debate to date, it might be useful also to view the issue through the lens of functional efficiency. More generally, we ought to be asking whether Tobin was right to be concerned about the size of the financial sector in his day, and whether its dramatic growth over the couple of decades since then has been functional or dysfunctional on balance.


"I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity."

The key question here, is not whether this has happened, it seems beyond question that this fear has been realized, the real question is why it is profitable to do this.

ken melvin said in reply to reason...

Diverting these resources back to investment in productive capacity, utilities, ... would be the payoff of good regulation, no?

[Jun 07, 2013] 'The Great Persuasion Reinventing Free Markets Since the Depression'

No it's not the end, but this an end of the beginning. Neoliberalism entered Zombie stage after 2008.
Economist's View

The end of an era?:

Persuasion, Great and Intimate, by David Warsh: ...The Great Persuasion: Reinventing Free Markets Since the Depression by Angus Burgin, of Johns Hopkins University ... is the latest of a lengthening shelf of books by intellectual historians that seek to explain the election of Ronald Reagan in 1980 in terms of the influence of ideas or money or both. To most of those writing the narrative of American politics in the 1970s, the enthusiasm for markets and reduced government that accompanied "the Reagan revolution" (or, earlier, the deregulation of transportation, under Jimmy Carter, or finance, under Richard Nixon and Gerald Ford), seemed to come out of nowhere. They were expecting, per Keynes and Schumpeter, "the end of laissez-faire."
Burgin's argument is that a group of market advocates formed in the late 1930s, around a discussion of Walter Lippmann's The Good Society, then took flight after World War II as the Mont Pelerin Society, and subsequently influenced the evolution of postwar economic and political thought. That thought isn't new, but Burgin's is the by far the best account of the organization's history. The MPS was the brainchild of Austrian economist and social philosopher Friedrich von Hayek, then in the process of relocating from London to Chicago. He intended the organization to be "something halfway between a scholarly association and a political society." Thirty nine persons attended its first meeting, in April 1947, at a mountain hotel near Vevey, Switzerland, on the north shore of Lake Geneva, not far from Lausanne.
Among them were economists (Hayek, Lionel Robbins, Maurice Allais, Fritz Machlup, Ludwig von Mises, Frank Knight, Milton Friedman, George Stigler, Aaron Director); philosophers (Karl Popper, Michael Polanyi, Bertrand de Jouvenal); journalists (Henry Hazlitt, John Davenport); and activists (Leonard Read and representatives of the Volker Fund, the Kansas City, Mo., foundation that bankrolled the Americans' participation) – a regular Who's Who of young men (only one woman, British historian Veronica Wedgewood, was included). They would become influential theorists of the turn towards markets.
Burgin, a historian, shows that from the beginning the group comprised two factions, European traditionalists and American upstarts. The Europeans were concerned with the difficulty of reconciling capitalism with social traditions that had evolved over the centuries. The Americans were not. Eventually, Burgin writes, Milton Friedman got the upper hand and brought in "a more strident version" of market fundamentalism. His predecessors' work, Burgin writes, had been "ingrained with a sense of caution at the knife's edge of catastrophe. Friedman's was infused with Cold War dualisms…. Friedman's philosophical models brooked no concessions to communism, and the America of his time found a ready audience for a philosophy that did not allow itself to be measured in degrees."
For all his fascination with Friedman, Burgin does not pay much attention to developments in economics itself. Robert Solow, of the Massachusetts Institute of Technology, has written that Burgin tends to endow the MPS with more significance than it ever really has, whether within the economics profession or in the world at large." And surely Burgin stints the debates that gave rise to the Mont Pelerin Society. He doesn't mention the "calculation debate" about the technical possibility of planning that had preoccupied the Austrians economists since Germany's surprisingly successful administration of its national economy during World War I; nor the controversy over the New Deal's National Industrial Recovery Act of 1933, which was the background for the Lippmann book; nor the various crises of peacetime planning that were unfolding in Europe as the group first met.
Moreover, as a historian of ideas, Burgin ignores various more purely experiential means of persuasion by which faith in markets was renewed in the 1960s,'70s and '80s. There was the success of Toyota, for example, in improving standards of automotive quality. Then, too, the Cultural Revolution in China and the Prague Spring of 1968 had powerful effects on views of political economy, in both East and West; so did the US war in Vietnam. Populism, meaning the durable sectional rivalries within the US itself (Midwest vs. the Coasts, South vs. North) played a role as well. So did rivalries between the United States and Europe.
For my money, Burgin's real find (apparently for his, too, since his book ends with an account of it) is a 1988 essay by Milton and Rose Friedman (his economist wife and collaborator) tucked away in a Hoover Institution volume, Thinking About America: The United States in the 1990s. In "The Tide in the Affairs of Men," they discerned a tendency of powerful social movements to begin as works of opinion, spread eventually to the conduct of policy, then generate (often) their own reversal, only to be succeeded by another tide. The Friedmans discerned three such movements in the past 250 years – a laissez-faire or Adam Smith tide, beginning in 1776 and lasting until around 1883 in Britain and the United States (with policy lagging: 1820-1900 in Britain, 1840-1930 in the US); a Welfare State or Fabian tide, beginning around 1883 and lasting until 1950 in Britain and 1970 in the US (policy tide 1900-1978 in Britain, 1930-1980 in the US); and a resurgence of free markets or Hayek tide, beginning around 1950 in Britain and 1980 in the US, whose opinion phase was "approaching middle age" and whose policy phase twenty-five years ago was "still in its infancy."
This is standard cycle theory, familiar to readers of Ralph Waldo Emerson, Henry Adams, Arthur Schlesinger Sr. and Jr, Albert Hirschman and a host of others, unexceptional except insofar as it portends, even in the Friedmans' view, not exactly the end of laissez-faire, but the beginning of some new tide of emphasis on the social. Burgin doesn't make much of it except to note that, at the height of the financial crisis, in the autumn of 2008, "commentators on both sides of the political aisle declared that a long era in American political history was drawing to a close." ...

Barkley Rosser:

The most important of the "European traditionalist" at that first MPS meeting is not mentioned here, Walter Eucken, who would die in 1950. He invented "Ordo-Liberalism" in 1937, which would become the inspiration for the "social market economy" (sozialmarktwirtschaften) that would dominate the policies of the West German economy throughout its wirtschaftswunder, or postwar "Economic Miracle," with Ludwig Erhard particularly influenced by him and implementing policies with his influence in mind.

Second Best :

Milton Friedman once said there is a fundamental conflict between economic freedom and political freedom, that the freedom of the latter to suppress the former will always prevail and therefore must be restrained with eternal vigilance.

It did turn out that way, but in reverse order of what he meant. The economic freedom he had in mind in terms of maximum economic welfare for all was actually suppressed for maximum welfare for the few.

All those foxes guarding the henhouses just couldn't stand up to the onslaught of corporate lobbyists.


If the original question is the "Reagan revolution" the answer is much simpler. The United States Supreme Court decisions on one man one vote destroyed the typical political control of local corporations in the states. This forced a national political coalition of corporations that was enunciated by the Powell Memorandum to the U.S. Chamber of Commerce to coordinate this coalition. The Powell Memorandum emphasized the growing threat of democratic social movements such as the autosafety efforts of Ralph Nader and the environmental movement.

The Republican "Southern Strategy" reflected this national corporate effort to channel political funds to low population states where they could overwhelm local efforts. Ronald Reagan was dominantly a creation of the Powell Memorandum efforts, he became a national spokesman for this pro-corporate movement and then implemented the "Southern Strategy".

The creation of a national corporate economic coalition funding local political activity fell under the influence of the international rise of multinational corporations which sought to elude political restraints imposed by rising democratic movements such as environmental and consumer safety laws. That, in turn, created the need to reinterpret "Laissez Faire" to mean a pro-corporate deregulation. And, of course, the reinterpretation of Hayek et al in this vein.

Thus the simple answer is that the underlying effort is a thin political skin over the multinational corporate effort to eliminate legal restrictions on their ability to operate on the basis of profits unconstrained by concerns about workers and environmental issues.

Darryl FKA Ron:

In "The Tide in the Affairs of Men," they discerned a tendency of powerful social movements to begin as works of opinion, spread eventually to the conduct of policy, then generate (often) their own reversal, only to be succeeded by another tide.

[Please let's not conflate market economics as a powerful social movement such as civil rights. The conflicted views of Joe Schumpeter regarding capitalism as valiant entrepeneurs innovating juxtaposed against the efficiency of innovation by monopoly seeking uber corporations somehow interlocking into a creative destruction that in the end would evolve into a system of capitalism so evil that it would be overthrown is the dream, or nightmare, that we are living.

For Schumpeter it was both the dream and the nightmare. That's what conflicted means. The thoughts of the economic elite never changed. They needed no new idea. They were just trying to get the old one back in motion. The policy shift from this idea started as soon as FDR lay cold and dead and its first major victory was the tax reform of 1954, which was a clever act of tax the rich stealth by Republicans to rescind the dividends tax credit making the return to capital via capital gains incentive the transformational force in enterprise.

Democrats took over Congress after 1954, but who were they to go against raising taxes on the rich if that is what Republicans wanted? It looked great while growth potential was unbound by virtually limitless resources and rapid population growth. But it facilitated the consolidation of corporate enterprises large enough to rule every aspect of public life that they deemed useful. Then every kind of incremental deregulation and liberlization of finance and assurance for the value of currency for capital's muscle would follow. ]

Charles Peterson said in reply to Darryl FKA Ron...

Thanks for the bit about the tax reform of 1954.

But you could probably find rollbacks from the New Deal vision of Roosevelt as early as 1945. The one that stands out to me is the Taft Hartley act of 1947. I also wonder whether if FDR had lived longer, the Cold War could have been avoided and instead of the endless overt and covert wars we could have had the Four Freedoms. So another suspect is the National Security Act of 1947, which created the military industrial complex as we know it, and the endless pursuit of world control through military dominance.

These disgruntled aristocrats and petit bourgeois who started MPS were angry both at democracy and unions. Friedman blamed the business failures of his parents on unions.


The shift toward neoliberalism occurred in the 1970s because businesses and the super-rich began a process of political self-organization in the early 1970s that enabled them to pool their wealth and influence to achieve dominant political power and to capture administration.

Money pouring into lobbying firms, political campaigns, and ideological think tanks created the organizational muscle which mimics the Bolsheviks organizational muscle. And Repugs got a bunch of Trotskyite turncoats such as James Burnham, who knew the political technology of bolshevism from the first hands, were probably helpful in polishing this edifice. All that gave the Republicans a formidable institutional advantage since 1980s.

Carter and Clinton sold Democratic Party to the same forces.

This rise of special interests politics has been at the expense of the middle class. In this sense already in 1994 the USA became very unhealthy society although the crisis of 200 was still six years ahead. Collapse of the USSR and subsequent looting of the territory by Clinton administration slowed down this process, but now it's by-and-large over (with the USA failing to prevent reelection of Putin) and "latin-americanization" of the USA is again in full force.

There are no sizable countervailing forces on the horizon, although the level of public debt might be an implicit limiting factor for neoliberalism. It will be interesting to see how and by what political forces neoliberal regime in the USA ends. Some people suggest that the USA might eventually disintegrate along the lines of Civil War alliances. I think much depends how "peak oil" crisis unfolds. And will the wars with terrorism continue to give the USA elite the required level of the national unity and meaning. Rise of separatist movements in Texas, Alaska and other states is pretty indicative here.

[Apr 29, 2012] Stiglitz - Politics Is At the Root of the Problem

Where Stiglitz refers to 'free markets' here, he means the 'efficient markets hypothesis.' That is, if markets are left entirely to their own devices they will manage themselves, honestly and efficiently.

Government and regulation are the problem, and they distort markets. Therefore if you 'free' markets from the influence of imperfect supervision, the natural efficiency of the market will prevail.

This model of the markets assumes that most market participants, people, are naturally good and almost perfectly rational, that information disperses equally among those participants, and that fraud becomes quickly known to all and is shunned, so that no participant will be encouraged to engage in it.

One of the things that will be reconsidered in the aftermath of this crisis, besides the perennial tendency of academic theories to act as handmaidens to thugs and gangsterism, is how to maintain a market based economy with effective regulation, so that when the unscrupulous come to tear down the protections erected by previous generations, to lure the foolish and gullible with their siren songs of progress and freedom, they might be seen for what they really are: the old familiar frauds come back to rob again.

I am a strong believer in a market based economy, where the rules encourage fairness and transparency, and decision making is broadly dispersed amongst a large number of well-informed participants. Monopolies, corruption and fraud are inimical to such a system.

An excess of planning and regulation, on the other hand, leads to a concentration of power in few hands, which is a form of monopoly or cartel which is the same abuse that occurs with too little transparency and regulation.

It takes hard work and an alert public to maintain the balance of justice, and it is hardly natural. For the affairs of all men do not naturally tend to virtue, alas, but from a minority of the lawless there is the tendency to selfish and short term thinking, and entropy from temptation, and the concentration of power in unworthy hands.

Such is the tendency of the world as it is, not naturally good, but imperfect and fallen. And this is not only the theme, but the force of history, the recorded actions of people, the continuing struggle between moderation and excess, between good and evil. Without it, history would be merely the progression of happiness and contentment, and that is not the condition of this world, but of the next.

Cross Posted from The European

"Politics Is at the Root of the Problem"

by Joseph Stiglitz

Austerity policies are driving us towards a double-dip recession, warns US economist Joseph Stiglitz. He sat down with Martin Eiermann to discuss new economic thinking and the influence of money in politics.

The European: Four years after the beginning of the financial crisis, are you encouraged by the ways in which economists have tried to make sense of it, and by the ways in which those insights have been taken up by policy makers?

Stiglitz: Let me break this down in a slightly different way. Academic economists played a big role in causing the crisis. Their models were overly simplified, distorted, and left out the most important aspects. Those faulty models then encouraged policy-makers to believe that the markets would solve all the problems. Before the crisis, if I had been a narrow-minded economist, I would have been very pleased to see that academics had a big impact on policy. But unfortunately that was bad for the world. After the crisis, you would have hoped that the academic profession had changed and that policy-making had changed with it and would become more skeptical and cautious. You would have expected that after all the wrong predictions of the past, politics would have demanded from academics a rethinking of their theories. I am broadly disappointed on all accounts.

The European: Economists have seen the flaws of their models but have not worked to discard or improve them?

Stiglitz: Within academia, those who believed in free markets before the crisis still do so today. A few people have shifted, and I want to give credit to them for saying: "We were wrong. We underestimated this or that aspect of our models." But for the most part, the response was different. Believers in the free market have not revised their beliefs.

The European: So let's take a longer view. Do you think that the crisis will have an effect on future generations of economists and policy-makers, for example by changing the way that economic basics are taught?

Stiglitz: I think that change is really occurring with the young people. My young students overwhelmingly don't understand how people could have believed in the old models. That is good. But on the other hand, many of them say that if you want to be an economist, you still have to deal with all the old guys who believe in their wrong theories, who teach those theories, and expect you to believe in them as well. So they choose not to go into those branches of economics. But where I have been even more disappointed is American policy-making. Ben Bernanke gives a speech and says something like, there was nothing wrong with economic theory, the problems were a few details in implementation. In fact, there was a lot wrong with economic theory and with the basic policy framework that was derived from theory. If your mindset is that nothing was wrong, you will not demand new models. That's a big disappointment.

The European: There seemed to have been quite a bit of disagreement among Obama's economic advisers about the right course of action. And in Europe, fundamental economic principles like the absolute focus on GDP growth have finally come under attack.

Stiglitz: Some American policy-makers have recognized the danger of "too big to fail," but they are a minority. In Europe, things are a bit better on the rhetorical side. Influential economists like Derek Turner and Mervyn King have recognized that something is wrong. The Vickers Commission has thoughtfully re-examined economic policy. We have nothing like that in the United States. In Germany and France, the financial transactions tax and limits to executive compensation are on the table. Sarkozy says that capitalism hasn't worked, Merkel says that we were saved by the European social model – and they are both conservative politicians! The bankers still don't understand this, which explains why we still see the head of the European Central Bank, Mario Draghi, arguing that we have to give up the welfare system at a time when Merkel says the exact opposite: That the social model kept us going when the central banks failed to do their regulatory job and used politics to change the nature of our societies.

The European: How have your own convictions been affected by the crisis?

Stiglitz: I don't think that there has been a fundamental change in my thinking. The crisis has reinforced certain things I said before and shown me how important they are. In 2003, I wrote about the risk of interdependence, where the collapse of one bank can bring about the collapse of other banks and increase the fragility of the banking system. I thought it was important, but the idea wasn't picked up at the time. The same year we looked at agency problems in finance. Now we recognize just how important those issues are. I argued that the real issue in monetary economics is about credit, not money supply. Now everybody recognizes that the collapse of the credit system brought down the banks. (I don't agree, the collapse of the credit system was a symptom not a cause. It was the fraudulent paper, and the subsequent insolvency it promoted, that collapsed confidence which is the foundation of credit - Jesse) So the crisis really validated and reinforced several strands of theory that I had explored before. One topic that I now consider much more important than I did previously is the question of adjustment and the role of exchange rate systems like the Euro in preventing economic adjustment. A related issues is the linkage between structural adjustment and macroeconomic activity. The events of the crisis have really induced me to think more about them.

The European: The financial transaction tax seems to have died a political death in Europe. Now, economic policy in Europe seems largely dominated by the logic of austerity, and by forcing other European countries to become more like Germany.

Stiglitz: Austerity itself will almost surely be disastrous. It is leading to a double-dip recession that could be quite serious. It will probably make the Euro crisis worse. The short-term consequences are going to be very bad for Europe. But the broader issue is about the "German model." There are many aspects to it – among them the social model – that allow Germany to weather a very big dip in GDP by offering high levels of social protection. The German model of vocational training is also very successful. But there are other characteristics that are not so good. Germany is an export economy, but that cannot be true for all countries. If some countries have export surpluses, they are forcing other countries to have export deficits. Germany has taken a policy that other countries cannot imitate and tried to apply it to Europe in a way that contributes to Europe's problems. The fact that some aspects of the German model are good does not mean that all aspects can be applied across Europe.

The European: And it does not mean that economic growth satisfied the criteria of social fairness.

Stiglitz: Yes, so there is one other thing we have to take into account: What is happening to most citizens in a country? When you look at America, you have to concede that we have failed. Most Americans today are worse off than they were fifteen years ago. A full-time worker in the US is worse off today than he or she was 44 years ago. That is astounding – half a century of stagnation. The economic system is not delivering. It does not matter whether a few people at the top benefitted tremendously – when the majority of citizens are not better off, the economic system is not working. We also have to ask of the German system whether it has been delivering. I haven't studied all the data, but my impression is no.

The European: What do you say to someone who argues thus: Demographic change and the end of the industrial age have made the welfare state financially unsustainable. We cannot expect to cut down on our debt without fundamentally reducing welfare costs in the long run.

Stiglitz: That is absurd. The question of social protection does not have to do with the structure of production. It has to do with social cohesion or solidarity. That is why I am also very critical of Draghi's argument at the European Central Bank that social protection has to be undone. There are no grounds upon which to base that argument. The countries that are doing very well in Europe are the Scandinavian countries. Denmark is different from Sweden, Sweden is different from Norway – but they all have strong social protection and they are all growing. The argument that the response to the current crisis has to be a lessening of social protection is really an argument by the 1% to say: "We have to grab a bigger share of the pie." But if the majority of people don't benefit from the economic pie, the system is a failure. I don't want to talk about GDP anymore, I want to talk about what is happening to most citizens.

The European: Has the political Left been able to articulate that criticism?

Stiglitz: Paul Krugman has been very strong on articulating criticism of the austerity arguments. The broader attack has been made, but I am not sure whether it has been fully heard. The critical question right now is how we grade economic systems. It hasn't been fully articulated yet but I think we will win this one. Even the Right is beginning to agree that GDP is not a good measure of economic progress. The notion of the welfare of most citizens is almost a no-brainer. (Median is the message. - Jesse)

The European: It seems to me that much of the discussion is still about statistical measurements – if we're not measuring GDP, we're measuring something else, like happiness or income differences. But is there an element to these discussions that cannot be put in numerical terms – something about the values we implicitly bake into our economic system?

Stiglitz: In the long run, we ought to have those ethical discussions. But I am beginning from a much narrower base. We know that income doesn't reflect many things we care about. But even with an imperfect indicator such as income, we should care about what happens to most citizens. It's nice that Bill Gates is doing well. But if all the money went to Bill Gates, the system could not be graded as successful.

The European: If the political Left hasn't been able to fully articulate that idea, has civil society been able to fill the gap?

Stiglitz: Yes, the Occupy movement has been very successful in bringing those ideas to the forefront of political discussion. I wrote an article for Vanity Fair in 2011 – "Of the 1%, by the 1%, for the 1%" – that really resonated with a lot of people because it spoke to our worries. Protests like the ones at Occupy Wall Street are only successful when they pick up on these shared concerns. There was one newspaper article that described the rough police tactics in Oakland. They interviewed many people, including police officers, who said: "I agree with the protesters." If you ask about the message, the overwhelming response has been supportive, and the big concern has been that the Occupy movement hasn't been effective enough in getting that message across.

The European: How do we move from talking about economic inequality to tangible change? As you said earlier, the theoretical recognition of economic problems has often not been translated into policy.

Stiglitz: If my forecast about the consequences of austerity is correct, you will see a new round of protest movements. We had a crisis in 2008. We are now in the fifth year of crisis, and we haven't solved it. There's not even a light at the end of the tunnel. When we come to that conclusion, the discourse will change.

The European: The situation needs to be really bad before it will get better?

Stiglitz: Yes, I fear.

The European: You recently wrote about the "irreversible decay" of the American Midwest. Is this crisis a sign that the US has begun an irreversible economic decline, even while we still regard the country as a potent political player?

Stiglitz: We are facing a very difficult transition from manufacturing to a service economy. We have failed to manage that transition smoothly. If we don't correct that mistake, we will pay a very high price. Already, the average American is suffering from the failed transition. My concern is that we have set in motion an adverse economics and an adverse politics. A lot of American inequality is caused by rent-seeking: Monopolies, military spending, procurement, extractive industries, drugs. We have some economic sectors that are very good, but we also have a lot of parasites. The hopeful view is that the economy can grow if we rid ourselves of the parasites and focus on the productive sectors. But in any disease there is always the risk that the parasites will devour the healthy body parts. The jury is still out on that.

The European: Have we at least understood the disease well enough to prescribe the correct therapy? Especially with regard to policy-making and the Euro crisis, there seems to be a lot of shooting into the dark.

Stiglitz: I think the problem is not a lack of understanding by dispassionate social scientists. We know the basic dilemma, and we know the effect of campaign contributions on policy-makers. So we are facing a vicious circle: Because money matters in politics, that leads to outcomes in which money matters in society, which increases the role of money in politics. You have more gerrymandering and more disillusionment with parliamentary politics.

The European: Has politics become too focused on outcomes, and is it not sensitive enough to the processes that lead to those outcomes? The bedrock of democracy seems to hinge on the avenues for participation, not on the effectiveness of particular policies.

Stiglitz: Let me put it this way: Some people criticize by saying that we have become too focused on inequality and are not concerned enough about opportunity. But in the United States, we are also the country with the biggest inequality of opportunity. Most Americans understand that fraud political processes play in fraud outcomes. But we don't know how to break into that system. Our Supreme Court was appointed by moneyed interests and – not surprisingly – concluded that moneyed interests had unrestricted influence on politics. In the short run, we are exacerbating the influence of money, with negative consequences for the economy and for society.

The European: Where is change rooted? In parliament? In academia? In the streets?

Stiglitz: You look in the streets and a little bit in academia as well. When I say that the major thrust of the economics profession has disappointed me, I need to qualify that statement. There have been groups that push new economic thinking and challenge the old models.

The European: You have written that the challenge is to respond to bad ideas not with rejection but with better ideas. Where is the longest and strongest lever to bring new economic thinking into the realm of policy?

Stiglitz: The diagnosis is that politics is at the root of the problem: That is where the rules of the game are made, that is where we decide on policies that favor the rich and that have allowed the financial sector to amass vast economic and political power. The first step has to be political reform: Change campaign finance laws. Make it easier for people to vote – in Australia, they even have compulsory voting. Address the problem of gerrymandering. Gerrymandering makes it so that your vote doesn't count. If it does not count, you are leaving it to moneyed interests to push their own agenda. Change the filibuster, which turned from a barely used congressional tactic into a regular feature of politics. It disempowers Americans. Even if you have a majority vote, you cannot win.

The European: We're looking at six months of presidential campaigning. The role of money has been embraced by both parties. Campaign finance reform seems rather unlikely.

Stiglitz: Even the Republicans have become more aware of the power of money by seeing how it influenced and distorted the primaries. The outcomes are not what the Republican party establishment had hoped for. The disaster is becoming clear – but that will not lead to immediate remedies. Those who become elected depend on that money. It will require a strong third party or civil society to do something about this.

[Nov 17, 2011] The Anatomy of Influence - The Chronicle Review - By Evan R. Goldstein

But for Kahneman and Tversky, it was self-evident that people are neither fully rational nor completely selfish. Their "Prospect Theory: an Analysis of Decision Under Risk," published in Econometrica, exposed flaws in utility theory by pointing out how it fails to capture the way people actually behave: We are easily influenced by frames and anchors; we're overconfident; we fear losses more than we value gains. Prospect theory, they argued in 29 equation-packed pages, provides a more psychologically realistic model of economic behavior. (The name itself, "prospect theory," is meaningless. Kahneman and Tversky wanted something distinctive and easy to remember.)
November 8, 2011 | The Chronicle of Higher Education

In 1971, Daniel Kahneman and Amos Tversky, psychology professors at the Hebrew University of Jerusalem at the time, began a sabbatical year at the Oregon Research Institute. The two Israelis, both in their 30s, seemed like a study in contrasts; where Tversky, a decorated paratrooper with shrapnel lodged in his body, was optimistic and analytical, Kahneman was pessimistic and intuitive. But they shared a sense of humor, and an interest in the psychology of mistakes.

That year they ran dozens of experiments. In one, they built a wheel marked 0 to 100, but rigged it to stop on only 10 or 65. After each spin, the subject wrote down the number and was then asked to guess the percentage of countries in the United Nations that are African. On average, those who spun a 10 guessed 25 percent, while those who spun a 65 guessed 45 percent.

The number on the wheel, though arbitrary, unconsciously swayed people's predictions-hence the phenomenon is known as anchoring. It happens everywhere. For instance, a sale on cans of tuna that limits each customer to 12 causes the average shopper to buy twice as many cans (seven) than if there were no limit. People also anchor on ideas, sometimes with serious consequences. Recent studies indicate that physicians can fixate on an initial but ultimately misleading symptom, jump to conclusions, and fail to make an accurate diagnosis.

Kahneman and Tversky became connoisseurs of such cognitive biases, meticulously cataloging the ways in which human thinking is flawed.

Beneath the laboratory curiosities lurked an explosive idea. In the 1970s-and still today, though to a lesser extent-two beliefs held sway in the social sciences. First, that people are generally rational and have sound judgment. Second, that when they depart from rationality, it's a temporary aberration, resulting from emotions like fear, hatred, and love. Kahneman and Tversky's research suggested an entirely different view: that it is the very way we think-our use of what they called heuristics, or mental shortcuts-that leads us astray.

In 1974 they published their findings in Science. "In general," they wrote, "these heuristics are quite useful, but sometimes they lead to severe and systematic errors." That might not sound like the opening shot of a revolution, but as Mark Kelman, a professor of law at Stanford University, puts it: "This was reconceptualize-the-world-type stuff."

Five years later, Kahneman and Tversky did it again, this time upending conventional wisdom about economic behavior. Assumptions about rationality and selfish profit-seeking are built into utility theory, the dominant model in economics, which holds that people will always act in their own best interests. But for Kahneman and Tversky, it was self-evident that people are neither fully rational nor completely selfish. Their "Prospect Theory: an Analysis of Decision Under Risk," published in Econometrica, exposed flaws in utility theory by pointing out how it fails to capture the way people actually behave: We are easily influenced by frames and anchors; we're overconfident; we fear losses more than we value gains. Prospect theory, they argued in 29 equation-packed pages, provides a more psychologically realistic model of economic behavior. (The name itself, "prospect theory," is meaningless. Kahneman and Tversky wanted something distinctive and easy to remember.)

"Going back to Adam Smith, everyone knew that the idea that people operate optimally is a simplification," says Eric Wanner, president of the Russell Sage Foundation and an early enthusiast of Kahneman and Tversky's work. "But until prospect theory, nobody had pinned down the psychology well enough to do anything about it." Richard Thaler, a professor of economics at the University of Chicago, has an earthier explanation of prospect theory's impact: "Rationality was f***ed."

Perhaps, but it didn't feel that way to most people at the time. Kahneman and Tversky (who died in 1996) had early converts among some junior professors and insurgent types, but their thinking was at first far from the mainstream. Today, however, their ideas have rippled across the scholarly landscape, from economics to engineering, medicine to environmental studies. Their Science and Econometrica papers are among the two most cited in all of social science. According to the Thomson Reuters Web of Science, Kahneman has appeared or been cited in scholarly journals more than 28,312 times since 1979. In 2002 he won the Nobel in economic science for "having integrated insights from psychological research into economic science."

Kahneman's career tells the story of how an idea can germinate, find far-flung disciples, and eventually reshape entire disciplines. Among scholars who do citation analysis, he is an anomaly. "When you look at how many areas of social science he's put his fingers in, it's just ridiculous," says Jevin West, a postdoctoral researcher at the University of Washington, who has helped develop an algorithm for tracing the spread of ideas among disciplines. "Very rarely do you see someone with that amount of influence."

But intellectual influence is tricky to define. Is it a matter of citations? Awards? Prestigious professorships? Book sales? A seat at Charlie Rose's table? West suggests something else, something more compelling: "Kahneman's career shows that intellectual influence is the ability to dissolve disciplinary boundaries."

You don't glean much about how he did that from his new memoir, Thinking, Fast and Slow (Farrar, Straus and Giroux). The book's scope is wide-Kahneman, 77, revisits his entire body of scholarship, including the research on judgment and bias he did with Tversky, as well as his later work on happiness-but his focus is on the science, not himself. (Kahneman was unable to comment for this article, because of an arrangement with another publication.) For a clearer sense of his stature, turn to the blurbs. "Among the most influential psychologists in history," says Steven Pinker. "One of the greatest psychologists and deepest thinkers of our time," says Daniel Gilbert. Nassim Nicholas Taleb declares Thinking, Fast and Slow "a landmark book in social thought, in the same league as Adam Smith's The Wealth of Nations."

That's not book-flacking hyperbole. (OK, maybe a little.) Ask around and you hear pretty much the same thing. "Kahneman is the most influential psychologist since Sigmund Freud," says Christopher Chabris, a professor of psychology at Union College, in New York. "No one else has had such a broad impact on so many fields."

Born in Tel Aviv in 1934, the son of Lithuanian Jews, Kahneman spent his boyhood in Paris, where the family prospered until Germany invaded, in 1940. Precocious and math-minded, the 6-year-old decided to sketch a graph of the family's fortune: The curve dipped into negative territory.

Jews in France were placed under curfew and required to wear a Star of David. One evening, when Kahneman was no more than 7, he accidentally stayed late at a friend's house. Before starting the few blocks' walk home, he turned his sweater inside out. An SS soldier approached. "I was terrified that he would notice the star inside my sweater," Kah­neman recalled years later. Instead, the black-uniformed Nazi gave him a hug and showed him a photograph of his own son. The cognitive dissonance made a great impression on Kahneman: How was this soldier simultaneously capable of great cruelty and great affection?

After Kahneman's father was arrested in a roundup of Jews-his employer, a chemical company, somehow negotiated his release-the family fled, first to the Riviera and then to the center of France. In 1944, Kahneman's father died from untreated diabetes. The rest of the family survived the war and returned to Palestine. In an interview a few years ago, Kahneman was asked about his wartime experience. He said simply, "I was luckier than most of the children of my generation in that place in the world."

At Hebrew University, Kahneman studied psychology and math, earning a bachelor's degree in two years. In 1955, he joined the psychological-research unit of the Israeli military. Just 21, he found himself the best-trained psychologist in the young army. He was assigned to assess the psychological fitness and leadership abilities of new recruits. Mostly he watched as soldiers completed group challenges like trying to cross a six-foot-high wall using nothing but a log that couldn't touch either the ground or the wall. Kahneman made note of who took charge and who was a quitter, and was confident in his evaluations.

That confidence was misplaced. Every few months, a commander would report to him about each soldier's actual performance. It was always the same story: Kahneman's evaluation had been about as accurate as a blind guess. He noticed something else as well: He was incapable of acknowledging the full extent of his own ignorance. He didn't doubt the evidence, but he remained confident in his predictions.

Decades later, Kahneman coined a phrase for this cognitive fallacy-the illusion of validity-and applied it to the psychology of Wall Street. Fifty years of research is conclusive, he argues in Thinking, Fast and Slow: Picking stocks is a game of luck, not skill. And yet the illusion of expertise persists in the financial world-and not only there. We are all masters of self-deception, he suggests, blithely ignorant of our own ignorance.

By the mid-60s, Kahneman had joined the faculty at Hebrew University. One day Amos Tversky, a colleague, argued in a guest lecture in Kahneman's class that people are generally good intuitive statisticians. Kahneman was skeptical, having already been sensitized to his own cognitive limitations. Their debate was lively, and they decided to collaborate on a study of intuition and expertise.

Their first paper was published in Psychological Bulletin in 1971, shortly before they arrived in Oregon. It confirmed what Kahneman had suspected: Even the brains of professional statisticians are not well suited to think statistically. To determine the lead author, he and Tversky flipped a coin. Thereafter they alternated. Over the next 12 years, their research forever changed the way people think about thinking.

"When I met Danny and Amos, neither of them knew any economics," says Richard Thaler. "They couldn't have passed Econ 101." Thaler, sharp-witted and talkative, is seated in his glass-walled corner office at the University of Chicago's Booth School of Business. He props his feet on the cluttered desk, clasps his hands behind his head, and takes me back to 1976.

Thaler was then an untenured assistant professor at the University of Rochester with an unusual hobby: He collected examples of people behaving at odds with utility theory. For instance, he had a wine-collecting colleague who paid $35 for a bottle but refused to sell it for less than $100. Utility theory couldn't explain the large disparity between those prices. Thaler called these cases anomalies and tacked a list of them to his office wall.

One day a package arrived from an acquaintance. Inside were several papers, including Kahneman and Tversky's 1974 Science article on heuristics and biases. Thaler was enthralled. He tracked down an early draft of their essay on prospect theory-in which a key idea is that losses are more acutely felt than gains. Put another way: The pain of giving up a bottle of wine you own and value can be greater than the pleasure of getting an equally good bottle.

For Thaler, it was an aha! moment. "I was no longer the only crazy person in the world. There were at least two other equally crazy people," he says, grinning broadly. "Even more, they were well regarded in their field, which I was not." Kahneman and Tversky were then at the Center for Advanced Studies at Stanford University. In 1977, Thaler went to Palo Alto and stayed for 15 months. Behavioral economics had its origin story.

The once-marginal field is now booming. Consider that the top five economics journals rejected Thaler's first paper on anomalous behavior (it was finally published in 1980 by the Journal of Economic Behavior and Organization). Today he is rumored to be on the shortlist for his own Nobel. What accounts for this sea change? How did an idea-integrating psychology into economics-become a movement?

Part of the answer can be traced to Eric Wanner. Back in the mid-1970s, he edited Harvard University Press's series on cognitive science. Kahneman and Tversky were on the advisory board, and Wanner heard the buzz about prospect theory. In 1982 he left the press to join the Alfred P. Sloan Foundation, where he tried to bring economists and psychologists together to research the market implications of nonrational decision making. Kahneman and Tversky were at first skeptical, convinced that interdisciplinary work couldn't be coerced. They suggested instead that Wanner get behind the few economists then willing to listen. Sloan's first grant in that area, in 1983, paid for Thaler to spend a sabbatical year with Kahneman, who was then at the University of British Columbia. "That's when behavioral economics really crystallized in my mind," Thaler says.

A few years later, Wanner became president of the Russell Sage Foundation, which since 1986 has put $8.3-million into behavioral economics. "These are not princely sums," Wanner says, but the money has been well spent. In 1994 the foundation established a biannual summer camp for budding behavioral economists. The two-week workshop for some 30 advanced graduate students and junior faculty was Kahneman's idea. Among the graduates are several leading lights of the field, including David Laibson and Sendhil Mullainathan, of Harvard, and Terrance Odean, of the University of California at Berkeley. (Mullainathan, who received a MacArthur Foundation "genius award" in 2002, was recently appointed to lead the new Consumer Financial Protection Bureau's Office of Research.) "Dollar for dollar, says Colin Camerer, a professor of economics at the California Institute of Technology, "it's the best social-science investment any foundation has ever made."

As Kahneman and Tversky's ideas hopped from discipline to discipline-by the early 1980s, prospect theory had spilled over into medicine, law, and political science-the pattern repeated itself: An enterprising, unorthodox scholar from outside of psychology would fall into their orbit and extend their ideas in new directions. The story of how this happened in medicine is representative.

Donald Redelmeier began his residency at the Stanford University Medical Center in the 80s and became a student of Tversky's, who had joined the university's faculty in 1978. "The brightest person I ever met," Redelmeier says by phone from his office at the University of Toronto, where he is a physician and researcher. In a number of papers he wrote independently with Kahneman and Tversky, Redelmeier-called the "leading debunker of preconceived notions in the medical world" by The New York Times-explored doctor-and-patient decision making and the psychology of pain. He even put to rest the belief that arthritis symptoms are exacerbated by inclement weather. (Redelmeier and Tversky chalked that myth up to people's tendency to look for patterns even where none exist.)

"Danny and Amos didn't always see the medical connections, but they had a tremendous receptivity to people outside their domain of expertise," says Redelmeier. "When they spoke about decision sciences, I was all ears; when I spoke about medicine, they shut up and listened."

Framing-the way information is presented-is the most salient example of how a cognitive bias identified by Kahneman and Tversky can affect medical decision making. In a classic study done by Tversky and colleagues at Harvard Medical School, physicians were given two options to treat a patient with cancer: surgery or radiation. The five-year survival rate favored surgery, but the short-term risks were higher. Half the doctors in the study were told that the one-month survival rate was 90 percent, while the other half were told that there was a 10-percent mortality rate in the first month. The odds were the same, of course, but the doctors responses' were markedly different. Those told the survival rate were much more likely to choose surgery (84 percent) than those who were given the mortality rate (50 percent).

Among the medical experts who have taken note of such findings is Jerome Groopman, an oncologist at Harvard Medical School and author, with Pamela Hartzband, of Your Medical Mind: How to Decide What Is Right for You (Penguin Press, 2011). "Rational-decision analysis is so far from a doctor's reality," he says, adding that the typical consultation lasts only eight to 10 minutes. In that time, doctors must rely on intuition and pattern recognition-this symptom suggests that ailment-to reach a diagnosis. About 80 percent of the time, he says, intuition gets it right. But in the other cases, the patient is misdiagnosed or the diagnosis is delayed.

Groopman believes that heuristics and biases are often to blame. "Intuition is powerful and necessary," he says, "but if you just rely on that, you're going to get it wrong." According to Hartzband, that message is getting through to her students. "I routinely hear them using terms like anchoring," she says, adding that Kahneman and Tversky "have definitely percolated through the ranks."

Four decades after he and Tversky first cleared the way for a new understanding of the mind, Kahneman and his ideas have branched off in a dizzying array of directions. How to explain his influence? Most everyone agrees that his scholarship-especially the work with Tversky from 1971 to 1983-is just exceptionally good. Moreover, their insights are relatively easy to digest and pack a lot of explanatory power. And because they shine a light on the very stuff of thought, their ideas are relevant to just about everything.

Political scientists use prospect theory to model foreign-policy decision making. Some international-relations scholars argue that cognitive biases favor hawkish policies, making wars more likely to begin and more difficult to end. (Kahneman shares that view.) At Columbia University, an interdisciplinary group of economists, psychologists, and anthropologists is building on Kahneman's ideas about risk perception to better understand apathy about climate change. Kahneman's services are also, not surprisingly, in demand on Wall Street. Guggenheim Partners, a New York-based global financial-services firm that manages more than $125-billion in assets, has recently advertised a Kahneman-designed "proprietary approach" to help "high-net-worth investors understand their specific attitudes toward risk."

It may be in the policy world where Kahneman's ideas have gained the most recent attention and may have the most impact. In the late 1990s, a movement in behavioral law and economics emerged to challenge the assumption in conventional law and economics that judges, jurors, criminals, and consumers are rational. That school of thought, which emerged in the 70s and is most closely associated with Richard Posner, is seen as a bulwark of free-market libertarianism. If people make good choices, the thinking goes, government need only get out of their way. Critics were at a disadvantage, says Thaler. They had misgivings and arguments, but no competing theory of economic behavior. "Then Kahneman and Tversky came along," he says. "People who felt like they were being bullied now had something to hit back with."

Much of this hitting back has been done by Kah­neman's friend and collaborator Cass R. Sunstein, the Harvard Law professor who now serves as head of the White House Office of Information and Regulatory Affairs. In 1998, Sunstein and Thaler, along with Christine Jolls, of Yale Law School, published a highly influential article-"A Behavioral Approach to Law and Economics"-in the Stanford Law Review. They called on legal scholars to adopt a more realistic view of human nature. In 2008, Sunstein and Thaler built on those ideas in Nudge: Improving Decisions About Health, Wealth, and Happiness (Yale University Press), which drew from Kahneman and Tversky to design noncoercive policies that encourage people to save more, eat better, and become smarter investors.

For example, 401(k) programs are generally opt-in, meaning that the onus to join is on the employee. Many of us want to, and doing so is certainly in our self-interest, but we're human: We procrastinate, we forget. Sunstein and Thaler proposed switching 401(k) programs to automatic enrollment. Studies show how doing so increases employee participation. Moreover, because there is still an opt-out, people aren't forced to join against their will. Kahneman calls Nudge the "bible of behavioral economics." Interest in these ideas has spread across the Atlantic. The British government has established something called a Behavioural Insight Team to bring principles from behavioral economics to bear on public policy. (Thaler is an adviser.)

It now seems inevitable that Kah­neman, who made his reputation by ignoring or defying conventional wisdom, is about to be anointed the intellectual guru of our economically irrational times. For proof, look no further than the newsstand. In the December issue of Vanity Fair, Michael Lewis profiles Kahneman, who is described on the cover as the "brilliant but quirky professor who made Moneyball possible." Rumor has it that the article is a preview of Lewis's sure-to-be best-selling next book. Will Aaron Sorkin write the movie script? Will Brad Pitt star? Will Kahneman fall victim to his own illusion of expertise?

That's unlikely. Near the end of Thinking, Fast and Slow, he insists that his deep understanding of bias and blunder has not made him immune to either failing. "Except for some effects that I attribute mostly to age, my intuitive thinking is just as prone to overconfidence, extreme predictions, and the planning fallacy"-making excessively optimistic estimates of how long it will take to complete a project-"as it was before I made a study of these issues," he writes.

But Kahneman, it seems, has indeed learned something about the limits of intuitive thinking. After all, what could be more counterintuitive than a humble guru?

Evan R. Goldstein is managing editor of The Chronicle Review.

ellenhunt :

Another reason to respect T&K's work is that together they drove a stake through the heart of the Ayn Rand frootloops. Ayn Rand's novels of purified cold-hearted self-interest were literally based on a sociopath who murdered a 12 year old girl for his own entertainment. This is literally true. Her journals prove her fetid obsession with his sociopathy and her schoolgirl crush on this creep. Her own words convict her, showing how John Galt was based on this child-torturing thrill-killer monstrosity. Ayn Rand's work has as much to do with economics as snuff-film pornography has to do with child-rearing.

I must share with you this bit from today's news (excerpted from Huff-Po) regarding Ayn Rand's fecal-splatter she painted upon our world. I salute the unsung typesetter who managed this wonderful bit of monkey-wrenching from inside of the vicious machine of Rand-drivel that plagues our world.

================================================================== Atlas Productions LLC execs apologize for the error with a series of frameworthy quotes:

From CEO Harmon Kaslow:

"As we all well know, the ideas brought to life in Atlas Shrugged are entirely antithetical to the idea of 'self-sacrifice' as a virtue. Atlas is quite literally a story about the dangers of self-sacrifice. The error was an unfortunate one and fans of Ayn Rand and Atlas have every right to be upset."

And more, from Communications Director Scott DeSapio:

"It's embarrassing for sure and of course, regardless of how or why it happened, we're all feeling responsible right now. You can imagine how mortified we all were when we saw the DVD but, it was simply too late - the product was already on shelves all over the Country. It was certainly no surprise when the incredulous emails ensued. The irony is inescapable." ===================================================================

Today T&K can be cited against the brain-eating Rand as proof that her fundamental thesis is wrong. It is not the only citable work, but it is a good one. Flag

[Oct 17, 2010] How Supermodels Are like Toxic Assets by Ashley Mears

July 12, 2010 |

Coco Rocha in Bill Blass by Peter Som February 2008, Photographed by Ed Kavishe for Fashion Wire Press.jpg

(Photo: Coco Rocha in Bill Blass by Peter Som February 2008, Photographed by Ed Kavishe for Fashion Wire Press, and is licensed under creative commons.)

In 2002, a tall and skinny 14-year old girl competed in a dance contest in Vancouver, Canada. There she encountered a modeling agent, who asked her to consider going out for modeling jobs. Today, the 22-year-old Coco Rocha is celebrated as a "supermodel" (however little of its glamazon power the term retains these days), appearing on covers of Vogue and i-D magazines, on catwalks from Marc Jacobs to Prada, and as the star face for Dior, H&M, and Chanel. You might not recognize her name, but the chances are you've seen Coco Rocha in the past few years.

Coco is what economists would call a winner in a "winner-take all market," prevalent in culture industries like art and music, where a handful of people reap very lucrative and visible rewards while the bulk of contestants barely scrape by meager livings before they fade into more stable and far less glamorous careers. The presence of such spectacular winners like Coco Rocha raises a great sociological question: how, among the thousands of wannabe models worldwide, is any one 14 year-old able to rise from the pack? What makes Coco Rocha more valuable than the thousands of similar contestants? How, in other words, do winners happen?

The secrets to Coco's success, and the dozens of girls that have come before and will surely come after her, have much less to do with Coco the person (or the body) than with the social context of an unstable market. There is very little intrinsic value in Coco's physique that would set her apart from any number of other similarly-built teens-when dealing with symbolic goods like "beauty" and "fashionability," we would be hard pressed to identify objective measures of worth inherent in the good itself. Rather, social processes are at work in the fashion modeling market to bequeath cultural value onto Coco. The social world of fashion markets reveals how market actors think collectively to make decisions in the face of uncertainty. And this social side of markets, it turns out, is key to understanding how investors could trade securities backed with "toxic" subprime mortgage assets leading us into the 2009 financial crisis.


When trying to figure out how winners happen in the modeling industry, the first thing to know is that nobody knows. This was one of the most striking things I discovered over the course of researching fashion. Clients-designers, photographers, and stylists-don't know what makes one model a better choice than another. And how would they? It's an inherently uncertain task, hinging upon aesthetic preference, unknown consumer demand, and quick turnover-fashion is, after all, by definition change.

Consider the Fashion Week catwalks. There are thousands of models worldwide that vie for a chance to appear in the shows of New York, London, Milan, and Paris, and nearly all of them meet a high bar of tall, slim, and beautiful. As many as 200 models may walk through a casting director's door in a single day during show season, and typically the shows have just 15 – 40 slots to fill. That's a lot of models to sort through.

How do the clients know which models to choose for their fashion shows? Plucking the right face from the flock to fit a particular designer's look of the season is, as Prada casting director Russell Marsh told me, like finding a needle in a haystack. Russell peruses hundreds of images of women and men for potential spots in the Prada and Miu Miu runway shows and campaigns; he's a key "Mover, Shaker and Style-Maker" according to the London Independent. When I put the question to him-why this model as opposed to that one?-he threw his hands up in the air, and excitedly pointed around his studio, "Why did I decide to buy this chair and sofa? You know, for me, it ticks the box. You know, it's an internal thing!"

Like dozes of fashion producers I spoke with, Russell doesn't really know what it is about a kid like Coco Rocha that excites him. He "just knows" if a model is right for him, and further, he "knows it when he sees it." This instantaneous knowledge is what sociologist Patrik Aspers calls "contextual knowledge" that creative producers tap into as they broker otherwise "fuzzy" values like beauty and edginess. It's also what sociologist Michel Abolafia has called "gut feeling" in his study of Wall Street traders-on the trading floor, brokers have a kind of 6th sense for what's hot and cold.

But while fashionistas express this 6th sense as an internal thing, they feel it together. Here we have a paradox: Despite an abundant labor supply and uncertain criteria, there is enormous inequality in who gets to participate in Fashion Week. With my colleague, social networks expert Frédéric Godart, I studied the show reports from Spring 2007 and found that designers used a total of 677 fashion models worldwide for their shows. Coco Rocha was among just 60 other women in the entire modeling universe to walk in over 20 shows; in fact, she walked in a whopping 55 shows. In contrast, the overwhelming bulk of models, 75% in fact, were used in just 5 shows.

So our plot thickens: What's at the center of this collective "gut feeling" that happens to land on Coco, ratcheting up her popularity and hence, her economic value? The answer holds parallel lessons for how traders in finance markets were able to assign so much inflated value to relatively worthless mortgage assets now known as "toxic assets."

Coco could herself be considered toxic, depending on who you ask, and crucially, when. To the average American consumer, Coco isn't exactly good-looking. She has what industry insiders call an "edgy" look: pale and thin, with long brown hair hanging over a small face with a sharp small mouth and big almond eyes. She certainly is strikingly interesting, but a New York casting director of 14 years explained his initial reaction when he first saw her for show castings back in 2005: "Like Coco, urgh!" Making a sour face, he continued, "Ooh, like she came in and I was like, in my head I was like, 'What trailer park did she come from?'" (This might sound particularly cruel, but rest assured it's a pretty routine way for people in the industry to talk about bodies as a car mechanic might review an engine.)

A year after this casting, Coco graced the cover of Italian Vogue shot by powerhouse photographer Steven Meisel, and when Spring runway season concluded, she boasted a resume of 55 shows from Marc Jacobs to Chanel. By the time the next show season rolled around, when Coco made her way back to the initially skeptical casting director, he desperately wanted to book her.

"I can't just book any girl I want," he explained. "After I see all the girls, you know, I call the agents up and I say these are the girls that I would like for this show. And they don't normally give me girls right away. The first thing they ask you is, "Well who else is in the show?" … They want to know who else you've got. So I always have to get that one girl. If I can get, I guess this season was Coco." At this he rolls his eyes, and continues, "You know as soon as I got Coco in the show, it was like, okay now I'll book whoever I want."

Today, this casting director still cannot see what it is about Coco that makes her a winner. "But now," he explained, "it doesn't matter. It doesn't matter what I think now. Like she is, you know, it right now." As in the fable of "The Emperor's New Clothes," even if one does not believe in the legitimacy of a social order, one obeys the conventions of a social order because one believes that other people find it legitimate and will obey, a classic condition of legitimacy noted by Max Weber. Quite possibly, one may not be able grasp why a model stands out as a winner, but the label legitimates itself as other tastemakers imitate their high-status peers.

Imitation, however, is a funny thing. It's not so simple as mere mimicry of established players, because in fact, established players are just the best imitators. That is, a successful and powerful fashion client like Russell Marsh also has to know what to imitate, and crucially, the right moment. To do this, they need a little help. I found both formal and informal means of sharing information in the fashion market. Informally, producers talk. They hang out throughout the week at lunches, dinners, parties-at one point I studied booking agents in New York who had a regular karaoke party with clients and models. They talk constantly, facebooking, texting, and drinking; they even date each other. They share social and cultural space, and they pick up on the gossip, or "the buzz," this way. Naturally, social ties are important for producers to figure out what's fashionable, since there is so much uncertainty and ambiguity in their work. Lots of industries work this way: publishing, film, art, and even, sociologists have found, financial investing.

The fashion modeling market also has a formal mechanism in place, known as the "option," to ensure all tastemakers get in on the action. An option is an agreement between client and agent that enables the client to place a hold on the model's future availability. Like options trading in finance markets, an option gives the buyer the right, but not the obligation, to make a purchase. In the modeling market, it enables clients to place a hold on the model's time, but unlike finance options trading, model options come free of cost; they are a professional courtesy to clients, and also a way for agents to manage models' hectic schedules.

While the actual runway casting may take just minutes, the work of optioning models begins weeks before Fashion Week, when agencies send clients "show packages," akin to a press kit, announcing every model available for hire. Each agency can have 20 – 50 models up for the shows, given that there are at least 12 high fashion agencies in NYC alone, we're already talking 600 model cards vying for clients' attention! It's a familiar site in the months of February and September to see stacks and stacks of these cards lining the walls of casting directors' offices.

In addition to circulating model cards, this pre-Fashion Week ritual begins the important work of circulating buzz. Options serve the symbolic purpose of "signaling" the model's popularity to all other clients. During castings, clients are likely to ask models, "Which shows are you optioned for," thereby letting them know their competitors' tastes. Modeling agents drum up buzz using options as selling points too, as in, "Russell Marsh just optioned Coco Rocha for Prada!" To most fashion designers' ears, such words sound like warm honey; they greatly reduce the anxiety of having to sort Coco from 599 other striking teenagers.

These formal and informal mechanisms of gossip result in a classic cumulative advantage effect in which successful goods accrue more success (also known as "the rich get richer" phenomenon, or by Biblical reference, the Matthew Effect). Hence, a model with several show options is deemed to be in high demand, or "hot," compared to the model with no options. The opposite is also true. Thus, small differences in quality snowball into large differences in popularity-this is how, among a pool of nearly identical Sashas, Dashas, Mashas and Natashas, fashionistas can pick out a supermodel of the moment such as Sasha Pivovarova.

In the language of economic sociology, options are performative; they create what they putatively just describe. In other words, the models have agency (that's market models we're talking about, not the fashion models, heaven's no!). Options enable investors to anticipate other investors' actions, which spurs herding behavior, where actors decide to disregard their own information (i.e., "That Coco Rocha, urgh!") and imitate instead the decisions taken by others before them (but Russell Marsh optioned her).

In behavioral economics, Coco Rocha's success is a case of an information cascade. Faced with imperfect information, individuals make a binary choice to act (to choose or not to choose Coco) by observing the actions of their predecessors without regard to their own information. In such situations, a few early key individuals end up having a disproportionately large effect, such that small differences in initial conditions create large differences later in the cascade. We see such effects in fields ranging from consumer fads (think Atkins-everyone knows a meat-and-cheese diet isn't healthy for you!), science (like global warming), and technology (VHS beat BETA in the video market, though BETA was a superior machine).

Herding and cascades are rather problematic to financial markets; they leads investors to artificially bid up asset values, thereby leading to bubbles and eventual crashes, even if investors knew better all along, which, it turns out in the housing market, they largely did. But because investors, like fashionistas, react to each other as well as to the aggregate traces of fellow investors' actions (captured well in signaling instruments like options), they exacerbate systemic risk. Essentially, valuing financial goods is a matter of trying to be in fashion, which is a gamble.

In fact, the economist John Maynard Keynes likened finance markets to casinos, in that both are based in speculation. To illustrate, Keynes drew on newspaper beauty contests from the 1930s, where readers were asked to rate the contestants, but with a catch. The prize would go to the reader that could guess the highest ranked winner. So readers would rate not what they themselves thought was personally beautiful, but what they thought other readers would find beautiful. The sociologist would add that beauty is always in the eye of the socially-dominant beholder, but as a metaphor for financial markets, it should worry us, as it worried Keynes: Finance assets accrue profits not according to their actual worth, which, at the height of the housing boom we know now was vastly inflated; rather, their worth is generated in how speculators perceive what other speculators will perceive. A finance market, like a fashion market, consists of speculators chasing each other's tails in disregard for what things are really worth.

But perhaps most worrisome in the fallout of the economic crisis is our ongoing commitment to an ethos of individualism to make sense of it all. We chalk the crash up to a few bad apples and "greedy" executives gone astray-not far off, by the way, from individualist rhetoric in the fashion press celebrating the genius new beauty of Coco. Without a view of the market as a social body-composed of individuals acting in concert with each other, aided by financial models, and bound together by conventions to help them anticipate one another's actions-we can't see how participants act together. Yet their collectively attuned steps can inflate or deflate the value of assets, thus building economic values from cultural ones. Don't take Fashion Week at face value; the catwalk delivers an important sociological lesson for free market enthusiasts.

Posted by Robin Varghese at 01:00 AM | Permalink



This is a great piece. I didn't know about Keynes using the example of a newspaper beauty contest. Thanks for such a thoughtful and thought-provoking essay!

Posted by: Maeve Adams | Jul 12, 2010 9:18:42 AM


When financiers created their doomed portfolios with deeply hidden toxic assets they were very well aware of what they were doing. They were hoping to offload them to some uninformed over-optimistic dummies - and they were often pleasantly surprised.

Are the careers of 'unusual' fashion models somehow the same? Clearly not – because their attributes are very much on show, for anyone to make up their own mind.

There's no buried uber-nastiness that the punters will only discover later when it's too late. Is there?

Posted by: Martin g | Jul 12, 2010 1:03:18 PM

Martin, there might be a parallel of mutually-reinforcing valuations (of mortgage-based securities or of modelling service). But I generally agree.

Posted by: Sagredo | Jul 13, 2010 4:24:55 AM

While I think Martin is quite right to question just how close the parallel really is in the case of mortgage-backed securities, there are certainly herding effects elsewhere in the market. Behavioral economists remains new and under appreciated.

Great article, thanks!

Posted by: Cyrus Hall | Jul 13, 2010 8:31:33 AM

I was informed by this article, right up until the discussion about information cascades.

An information cascade involves a bunch of people being wrong - there doesn't seem to be anything for these people to be wrong about.

The discussion about the social convention being created by options, in part, is very interesting. But it lacks the observations about misdirection and outright deception which virtually all of these performative markets contain.

Very interesting stuff, though.

Posted by: michael webster | Jul 13, 2010 10:10:30 AM

Coco looks like any other teenager you would find in a mall. At last, fashion designers are choosing average women for their models.

Posted by: J.Hawkins | Jul 13, 2010 12:45:21 PM

@J. Hawkins:

Are they choosing average women, or, on average, are teenagers starting to look like the models?

Posted by: E. Lyons | Jul 14, 2010 12:13:44 PM

The image of Coco Rocha was taken by Peter Som and released under the Creative Commons Attribution 3.0 license. I think you found it on Wikipedia. Please could you include the license and attribution. You could even include a link to the image on Wikimedia Commons.

Posted by: Edward Betts | Jul 14, 2010 12:34:23 PM

@J. Hawkins:

Finally we have equality! Now the next step is to replace all our scientists and leaders with average people. Anyone that went to an Ivy League school must be immediately fired and replaced with someone that went to community college.

Posted by: elitist | Jul 14, 2010 12:45:19 PM

this is a nice piece. I completely agree with you,

Posted by: Sachin | Jul 14, 2010 1:03:44 PM

This post underwhelmed me with its loose logic.

Also, why is there a picture of Daul Kim?

Posted by: Anonymous | Jul 14, 2010 4:12:02 PM

What logic? You have to sex up stories about economics somehow. Even if it's just Coco Rocha.

Posted by: J.Hawkins | Jul 14, 2010 4:20:04 PM

Interesting take on the mechanisms of the fashion industry.

But you are off base with your comparison to mortgage assets. Many of those assets were not being traded by pit traders, and there was no "gut" valuation going on. It was highly formalized.

Second, information cascades occur do to bound rationality and not behavioral economics. The distinction is pretty important. Pure bayesian agents will cascade.

Posted by: Dan in Euroland | Jul 14, 2010 6:39:37 PM

As a fashion blogger who has gone to Fashion Week in the big shows and as a Wharton student, I must say this is one of the best pieces I've read in a long time. The parallels are striking and the insights rich.

Thanks so much!

Posted by: Tony Wang | Jul 16, 2010 7:41:55 PM

Books John Cassidy's How Markets Fail

"Between the collapse of communism and the outbreak of the subprime crisis, an understandable and justified respect for market forces mutated into a rigid and unquestioning devotion to a particular, and blatantly unrealistic, adaptation of Adam Smith's invisible hand."

Economist John Maynard Keynes had a weakness for rhetorical flourishes. At the end of his classic The General Theory of Employment, Interest, and Money, he wrote: "Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist." To author John Cassidy, it's a quote that applies to the practical decision-makers of our own time-and that explains the roots of our own Great Recession.

In his ambitious How Markets Fail: The Logic of Economic Calamities, Cassidy, an economics writer for The New Yorker, offers a powerful argument that the current generation of investors and policymakers has been manacled by what he calls the "utopian" free-market school of economics. In an effort to debunk that "ideology," which he sees as holding sway in academia and among policymakers in recent decades, Cassidy marshals a deep understanding of economic intellectual history, deftly explaining the principal ideas of such towering figures as Adam Smith, Friedrich von Hayek, Léon Walras, Kenneth Arrow, Milton Friedman, and Robert Lucas. This long view allows him to place in context the free marketers' notion that self-interest and competition "equals nirvana." In the author's words: "Between the collapse of communism and the outbreak of the subprime crisis, an understandable and justified respect for market forces mutated into a rigid and unquestioning devotion to a particular, and blatantly unrealistic, adaptation of Adam Smith's invisible hand." And it was this faith, he goes on to say, that led Alan Greenspan, among others, to turn a blind eye to what was happening in the real world of money and business.

Cassidy has his intellectual heroes, too. They are the advocates of what he calls "reality-based economics"-grappling with market failures, disaster myopia, speculative frenzies, and other economic complexities. John Maynard Keynes, the great scholar of economic-crisis management, is one such thinker. So are the experimental psychologists Amos Tversky and Daniel Kahneman, the mathematician Benoit Mandelbrot, and Hyman Minsky, the expert on financial manias. "Reality-based economics ... affords the concept of market failure a central position, recognizing the roles that human interdependence and rational irrationality play in creating it," writes Cassidy. "If further calamities are to be avoided, policymakers need to make a big mental shift and embrace this eminently practical philosophy."

How Markets Fail is a nuanced book. That's a major attraction in an era when shrill commentators bicker crudely about government vs. markets and liberty vs. socialism. Even the portrait of Greenspan, perhaps the closest figure to a villain in Cassidy's account, is drawn with a measure of empathy. Yet this book can provoke angry questions in the mind of the reader. Why did so many smart economists, including Robert Lucas and Eugene Fama, refrain from protesting as their ideas were hijacked and abused by demagogic politicians and messianic think tanks? The scholars knew the exceptions, the qualifications, and the heroic assumptions that lay behind their market models. Why, then, didn't they take issue with the op-ed and cable-TV table-pounders who twisted their thinking?

Cassidy agrees with free-market advocates that the market performs wonders, but he believes its reach is limited. In that spirit, he favors greater government regulation of the financial-services industry. Although he doesn't dwell much on practical ideas for reform, he argues that it's necessary to tame Wall Streetplus or minus now that financiers have learned they can privatize profits during good times and socialize losses in bad. He admires the changes that came out of the Great Depression, such as the Glass-Steagall Act, which separated banking from investment banking. Even if current legislators aren't willing to go that far, banks must be required to keep more capital on hand and be given limits on how much debt they can accumulate, he says. He considers the proposed Financial Product Safety Commission a sensible idea. "The proper role of the financial sector is to support innovation and enterprise elsewhere in the economy," he writes. "But during the past 20 years or so, it has grown into Frankenstein's monster, lumbering around and causing chaos."

The author doesn't offer the reader any juicy bits of gossip. There aren't any vivid recreations of tense negotiations over an investment bank's future. Yet he brings ideas alive. More important, the reader comes away persuaded that reality-based economics can play a critical role in what the 18th century British conservative Edmund Burke called "one of the finest problems in legislation, namely, to determine what the state ought to take upon itself to direct by the public wisdom, and what it ought to leave, with as little interference as possible, to individual exertion."

Let's hope the legislators in Washington share this principled view of their role. Cassidy makes a compelling case that a return to hands-off economics would be a disaster.

[Dec 30, 2009] Kodak, Bill Gates and efficient markets

"The market could stay wrong for a very long time. Maybe as long as some blinkered academics could continue to believe in strong versions of the efficient market hypothesis."
Bronte Capital

I am just back from my summer holidays on the New South Wales South Coast. To my (mostly) Northern Hemisphere readers I should boast about warm water, perfect waves, beaches in national parks with only one or two pairs of footprints on them and no people, fish that seem to suicide on your lines, etc – but that would just be boring.

In the middle of every day – when the heat became too much and the surf had waterlogged me I read. On my kindle of course. And some books which I had never read I read happily made easy mostly by the kindle's large font options. One of those books was Alice Schroder's too long but otherwise excellent biography of Warren Buffett. There was plenty there – I just want to share a single throw-away observation.

Warren Buffett has a group of his best investing friends get together once a year. He originally called it the Graham group in honor of his mentor Ben Graham who presented at the first annual meeting in 1968. By 1991 the group had expanded somewhat to include not only the original fabulous stock pickers but some business luminaries who could help enlighten the group on the nitty-gritty of their industries. One regular attendee was Bill Gates of Microsoft fame. From here I will quote Alice Schroder:

After a while Buffett asked everyone to pick their favourite stock.

What about Kodak? asked Bill Ruane. He looked back at Gates to see what he would say.

"Kodak is toast," said Gates.

Nobody else in the Buffett Group knew that the internet and digital technology would make film cameras toast. In 1991, even Kodak didn't know it was toast.

Gates was right of course – and since 1991 Kodak has been a terrible stock – and I would have counted Bill Gate's comments as "knowledge" in as much as a statement about markets and technology could be knowledge. But it would be an awful long time before that "knowledge" would be reflected in stock prices. Here is a graph of the stock price since 1 Jan 1990.

If you had taken Gates to heart in 1991 and shorted the stock then for almost ten years you looked like toast. If you sold the stock because of something Bill Gates said then you looked silly for six or more years unless you purchased something better.

Indeed if you had the "knowledge" probably the best thing to do with it was to use it just to avoid the photography sector altogether. That would mean you might outperform the market – but that outperformance was slight. [If avoiding that sort of catastrophe was your mechanism of making money you probably needed an enormous amount of "knowledge".]

Anyway there is little question that if you understood the implications of digital photography in 1991 you were – at least on that item – the smartest guy in almost any room. And it did not help you make (much) money.

The market could stay wrong for a very long time. Maybe as long as some blinkered academics could continue to believe in strong versions of the efficient market hypothesis.

Efficient Markets or Herd Mentality? The Future of Economic Forecasting

November 11, 2009 | Knowledge@Wharton

Ever wonder why you succumbed, yet again, to advertising hype or deceptive packaging and overpaid for a product? Or bought securities that you know were overvalued when the herd instinct was just too strong to resist?

Such irrationality is the focus of behavioral economists, who appear to be gaining greater credibility in macroeconomic circles since the housing bubble of 2008 and the ensuing global financial meltdown. They are also at the center of an age-old debate recently reignited by columnist and Nobel laureate Paul Krugman in a September 6 New York Times Magazine article titled, "How Did Economists Get It So Wrong?," which fires a salvo at the assumption underlying neoclassical economics -- namely, that free markets are inherently rational and efficient.

Krugman's article heaps scorn on so-called "freshwater economists" -- as typified by the University of Chicago economics faculty, whose ideas have dominated government policymaking since the early 1980s. In contrast, "saltwater economics" exhibits more openness to the ideas promulgated in the 1930s by Britain's John Maynard Keynes -- that free markets often behave inefficiently, are self-destructive and at times need corrective policy actions such as government stimulus spending. Rather than ascribing perfect rationality to markets, these economists say people and institutions often behave irrationally and often in ways contrary to their own interests.

While the debate between the freshwater and saltwater viewpoints in macroeconomics may sound academic, it has a significant impact far outside the ivory towers of universities. First, companies rely on macroeconomic forecasting in their strategic planning and budgeting and for gaining insight about customers and competitors. And macroeconomic theory underlies much of government policymaking. Since the late 1970s, for example, the U.S. government's deregulation of airlines, banking, utilities and communications grew out of a tacit belief in market efficiency and rationality. The Obama administration may be the first to seriously challenge efficient market assumptions since the Reagan era of the 1980s, amid its attempt to restrain executive compensation and set up a new consumer protection agency to govern credit and debit card practices.

The debate isn't limited to the U.S., either. This year's Nobel Prize in economics was awarded to Elinor Ostrom of Indiana University, a political scientist, and Oliver E. Williamson of the University of California, Berkeley, an expert in conflict resolution, striking many economists as an international rebuke of the rigidly mathematical, rational-market models. "It is part of the merging of the social sciences," Yale University economist Robert Shiller told The New York Times, echoing elements of Krugman's argument. "Economics has been too isolated, and these awards are a sign of the greater enlightenment going around. We were too stuck on efficient markets, and it was derailing our thinking."

Repositioning the Field

There is no shortage of opinion on either side of the argument, including a lengthy blog by University of Chicago professor John Cochrane, who was one of Krugman's most conspicuous targets. Cochrane's blog asserts: "The case for free markets never was that markets are perfect... [but that] government control of markets, especially asset markets, has always been much worse.... Krugman at bottom is arguing that the government should massively intervene...."

Much of the debate will indeed be played out in the public policy arena. The rational behavior framework, dominant for the past 30 years, dictates one set of public policy conclusions -- the wisdom of further deregulation, for example, coupled with fiscal restraint on the part of governments. But a new framework influenced by behavioral economics might dictate others -- tighter regulation, say, in addition to continued stimulus spending and different taxation. "There is much to recommend what the neoclassicists have been doing for 30 years," says Wharton business and public policy professor Jeremy Tobacman. "But you have to be sensible and apply some intuition."

Robert Stambaugh, a Wharton finance professor, cautions that the rational markets point of view is just a model, "and like any model, it's wrong -- because all abstractions are deficient to some degree. The greater question is, so what?" It could be that behavioral economics will be used more now to remedy the neoclassical model's flaws because it offers rich new insights into human patterns of irrationality. Even so, Stambaugh doubts it will replace the rational behavior model altogether. "It may be that relying on market-based solutions is a bad idea and leads to all sorts of terrible things, but it's like that saying about democracy -- 'the worst imaginable form of government except for all the others.' And if beating up on the rational market view of the world becomes a way of justifying a greater degree of government intervention or some theory of non-market solutions, I think we need to be suspicious."

According to Wharton finance professor Jeremy Siegel, the freshwater market view of macroeconomics has dominated academic thinking and government policymaking in recent decades in part because behavioral economists haven't been able to produce the same degree of analytical rigor as the rational economists have. Now that may be changing. Siegel sees the field of macroeconomic forecasting repositioning itself, with attempts at understanding how people form expectations and how periods of economic stability breed over-optimism and encourage high debt levels. "We may be moving toward a more behavioral, Keynesian way of viewing economic crises, and that would be a healthy change," he says.

Rational vs. Irrational?

The basic elements of the freshwater/saltwater debate are straightforward. The freshwater markets viewpoint rests strongly on the efficient markets hypothesis, or EMH, as propounded by the University of Chicago's Eugene Fama in the 1970s and later bolstered by Chicago's best-known neoclassicist, Milton Friedman. EMH argues that in any free market, competition among investors and entrepreneurs invariably drives prices to their correct levels. EMH does not assume rationality on the part of each player, merely on the part of markets as a whole. Therefore, the rationalists argue, free markets always make unbiased forecasts, even if they prove incorrect. EMH does not say the market price is always right, merely that it reflects all known information at any given moment.

Like a natural science, freshwater economics lends itself to complex, often elegant mathematical modeling. The freshwater view is that consumers, offered an array of choices, will select the one that is best for them -- a straightforward assertion that can be neatly expressed in mathematical formulae.

In contrast, many assertions made in behavioral economics are more challenging to express mathematically. "Behavioralists" argue that consumers don't always act in their own interests, especially when they fail to understand the choices on offer or succumb to irrational impulses involving those choices. For example, employers in the U.S. had been frustrated by the low participation of employees in company savings plans, despite the benefits the plans could offer the vast majority of workers. Employee participation jumped significantly when the government permitted companies to make savings plan enrollment automatic unless an employee checked a box to opt out of it. In other words, the government policy helped companies combat an employee's negative impulse -- but such impulses are inherently vague and difficult to define.

Unlike in freshwater economics, behavioral economics focuses primarily on the bounds of rationality. Behavioral economists assert that markets are often "informationally inefficient," with much of the inefficiency stemming from patterns of irrational behavior that cognitive psychology can document and measure. In an article titled "Behavioral Finance," published in the Pacific-Basin Finance Journal, Jay R. Ritter from the University of Florida notes that such patterns include:

So, does the recent economic crisis mean victory for behavioralists at the freshwater school's expense? Yes and no, according to a sampling of Wharton faculty. "It has been a crisis for the entire economics field," says operations and information professor Katherine Milkman, who specializes in behavioral decision making. Macroeconomics failed to predict last year's historic meltdown, but equally, microeconomic precepts have long been the basis for aligning executive incentives with the interests of companies and their shareholders. Milkman argues that the misalignment of interests was a major cause of last year's turmoil, but so was the immense complexity of mortgage derivatives and other financial instruments. "The assumption that we can perfectly anticipate future outcomes of highly complex systems is absurd," she says.

While agreeing that macroeconomic forecasting has relied heavily on the rational behavior model in recent decades, Milkman does not believe that dependence was entirely misplaced. "In any field, it's important to solve the biggest problems first," she notes -- and viewing people as optimal decision makers was the right way to begin. At the same time, she sees the recent failure of economic forecasting as having brought about a sea change. "Now, economics has gone from viewing humans as perfectly rational and consistent to saying, 'People are inconsistent and flawed in making their decisions, but we can analyze the inconsistencies and factor them into a new model.'"

A Call to Arms

Justin Wolfers, a Wharton professor of business and public policy, concurs that the downturn drew attention to important flaws, not just in the efficient markets model, but also more generally in macroeconomists' understanding of the marketplace. "The fact that there could be large-scale banking panics, that there was a shadow banking system that the regulators didn't have a lot to say about -- these elements have not been a large part of macroeconomic theorizing over the past two decades," he notes. However, the field of macroeconomics won't necessarily radically alter its course as a result. True, says Wolfers, "there is widespread public anger directed at macroeconomists right now, but there is also widespread anger at the meteorologists every time it rains."

According to Wolfers, "Most of the successes of economic policy of the last two decades remain intact. For example, economic theory is now widely accepted as a starting point for analyses of law, sociology, psychology and all sorts of social issues." Nonetheless, he argues, macroeconomics needs to become both more data-driven and more empirical, with greater emphasis on how consumers and investors behave and make decisions. Public disillusionment with macroeconomic forecasting, he adds, should be a "call to arms" for all economists. "It's clear that the downturn entailed important issues that all economists should be thinking about and that each subfield of economics -- not just macro -- has something to contribute."

Why Economists Failed to Predict the Financial Crisis

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."


Economists have largely become cheerleaders to support the crummy securities their employers sold and data point predictors and revisors of estimates on un-influential series of data. They have fallen lock step in with one another competing to predict the output of widgets in Timbuktoo or where ever and of course its global significance. As they left university they left their critical ability behind. Why? Because their employers want team players who think outside the box. At least that's what the job ad says. In reality the nonsense they spouted such as 'end to boom bust cycles' only indicated their hubris and poverty of knowledge of economic history, rendering any strategic input they have largely useless. But should we confine criticism to privately employed economists? No! Hands up the Central Banks who were blithely tightening interest rates while sailing into this storm, crushing aggregate demand to boot - not every one all at once please!

Greg C

Michael, are you implying that the central bankers of the world should have been loosening, rather than tightening, even in 2005 and 2006?


It's not only economist who are being disconnected from the real world. Same applies to many finance and possibly other professionals. Besides profit and greed considerations, I believe people from the Wall Street, who developed all these mortgage based CDOs and similar securities, have little understanding how the real estate market and the economy in general works. Most probably, these finance professionals are just sitting in front of computers and play with different models and numbers. Then they come up with some highly profitable and low risk (based purely on computer statistical models with little connection to the reality) securities, have S&P and Moody's rate these papers as AAA, and sell to the banks, funds, and investors that mostly follow strict rules like "buy AAA securities only".

This reminds me of the Soviet Union (or any planned economy for that matter). People in Moscow were making plans on what kind of shops should be operated in some remote locations without deep (or maybe little) knowledge of these regions, relying primarily on statistics. Obviously, making complex economic decisions that are detached from the reality led ultimately to the demise of the USSR. Similarly, investment bankers, economists, and other professionals who rely heavily on statistics and have little working knowledge of the subject will have difficulty in producing correct decisions in the long-run.

I agree that training in certain professions should be revised considerably. Mintzberg has a great book: "Managers Not MBAs". There, he discusses the major issues in the educational system focusing primarily on preparing MBAs. A key point from this book, for me at least, is that managers (and others in the business world) should be close to the customers and have constant interaction with the clients and reality in order to come up with the products and make decision that will provide the most value to the society.

K Subramanian

There were several factors which blinded economists. The most important was the smugness among many of them that economics had become a science comparable to Physics or Chemistry. If only they had read the last chapter of the BIS Annual Report for 2007, they would have become saner.

Its morganitic marriage with mathematics was its undoing - it added an air of certainty and extra elegance to the pretention that Economics was indeed a science. Lastly, in an era of computers and modelling, it was not only a fashion but a way of making big money to adopt "models" in day to day banking.. It is no use blaming it on the incentive structrue.

Regulatory who should have been more circumspect, ignored the warnings of Governor Gramlich, and were worhipping the 'innovations.' Bankers got the wrong mesage from the lTCM episode - they were confident that the Fed would bail them out if there were a crisis.


Why are we blaming Economists. The blame should go to all stakeholders of the economy. Any one who has little understanding of the economic activities and keep track of those data can feel that some thing was wrong with our economy in 2007. It was too much irrational optimism. Change was taking place but we did not want to notice it- story of frog in a jar. I was really feeling unconfortable with all economic indicators / data for two years culmnating in December 2007.

Yes the causes are too much dependence on Efficient Market theory, mathematical models forgeting the facts that models would generate output based on our assumptions - suiting us and finally credit creation by bank and non-banking industries.

But again our memories are weak so far finance markets go. There were many such financial / economic crises in the past but we forget them fast or don't want to heed them. Therefore in my opinion we will continue to expereince such irrational exuberance from time to tome due to animal spirits we human beings have.

K Subramanian

Unfortunately, we have to blame the economists as they have become standard bearers. It is not suggested that they should not play any role. Rather, it is the plea that they should do it with moderation and realism. They should not be carried away by ideologies (read, markets), fads and catchwords. In retrospect, it is surprsing that for nearly two decades they worshipped monetarism and lost all touch with real economy and the relationship between money and real economy. We are paying a heavy price indeed, considering the trillions of dollars going down the drain.


The con was in 5 years ago when 'finance professionals' constructed bonus lead transactions, overlaying 90 odd years of default experience across known Rating Agengy statistical models to produce paper with an 'average Rating' of AAA and a credit history of 15 years. This junk was foisted on a the gullible world. Not even close inspection was needed to reveal seriously flawed underlying portfolios.

I mean in considering an ordinary CDO (corporate bonds) would a sane money manager equally weight a AAA with a BB-? No wonder Moodys profits are down, structuctured securities are their most profitable area.

As to risk management, when all use the same risk model, all run to the exit when the risk book tells them to as the Michael above accurately observes.

Nick Choukair

Adding what has been written above is basically the politics has a main roll to the cause mainly to hamper the new administration and allot of the causes has been dumped underneath the reality carpet.

Ray Randall

In general, most of us think the anomaly will not happen. We ignore either ignore or overplay keen observations of the obvious.

Todd Hawkins

Create a mathmatical/statistical model that measures GREED at different levels (i.e. consumer, gov't, bussiness, Wall St) and you'll see the bubbles forming. I'm amused by this rationality of markets argument, outright GREED leading to over-confidence got all of us into this boat. Now FEAR is bringing us back to Earth.


That economists failed to predict the current financial crisis has not gone unnoticed by the public and has implications for the profession's image and standing in the community. For example, see Let's Rescind The Nobel Prize For Economics

Maurice Cardinal

You nailed it Todd.


Many of the other arguments here remind me of sports fans debating why an athlete zigged when he should have zagged.

The ground is wet because it's raining.

It's greed. Pure, plain and simple.

BTW, not everyone burned up in the crash. Some of us recognized the greed factor and bailed well before the plane hit the ground.


Part 1

There are more lessons than you mention in the Long-Term Capital Management (LTCM) fiasco: lessons not learned and repeated in the current financial crisis.

(1) Slack Regulation/Deception and the start of LTCM

John Meriwether, a bond trader, ran a very successful arbitrage group at Salomon Brothers. One of his traders confessed to making a false bid on treasuries. Meriwether reported it, but no disciplinary action was taken. Turned out the bonder trader had lied. It was not a one-time deviation. Meriwether took the heat and was fired. He started LTCM.

Lesson: Compliance and risk management not a priority at Salomon. (Had it been a priority LTCM would not have happened.)

Part 2

(2) 25% bonuses on Profits

The enormous success of the arbitrage group at Salomon emboldened Meriwether to demand a new form of compensation: 15% share of profits for his traders. When he started LTCM, this practice increased to 25% -- all over and above management fees. Apparently 20% is now routine.

Lessons: (a) The temptation for huge risks with other people's money when the rewards are outrageous by any normal standards of decency. (***) (b) It is the fiduciary duty for portfolio managers to maximize profits for their clients. That goal, then, should be inherent in fund management. Pocketing any percentage of the profits is completely counter to that fiduciary duty. Their compensation should come out of their management fees.

Part 3

(3) Arrogance, Academia and Theoretical Mathematical Models

The founders of Long-Term Captal Management included Myron Scholes and Robert C. Merton, who along with Fischer Black, invented the Black-Scholes fairy option pricing model. Other elite included David Mullins, once a vice chairman of the Board of Governors of the Federal Reserve System, and Eric Rosenfeld from MIT and Harvard. Myron Scholes boasted they would make money by being a vacuum sucking up nickels that no one else could see. (*) LTCM's strategy was arbitrage and relative value convergence trading – hedging systematic risk to zero, using computer and theoretical models.

Lesson: Academic models, theories and assumptions fail miserably in the real world. Academic arrogance has no place on Wall Street.

Part 4

(4) Prerequisite for Change

To change, improve and move forward, we have to first acknowledge what is wrong. I have just watched a video of Eric Rosenfeld lecturing students at MIT about LTCM. (**) In my view, his arrogant, unrepetant and delusionary view of the events is staggering -- and there he is lecturing the next generation of Wall Street.

Lesson: The government, greed, easy credit, low interest rates, housing bubble, risky derivatives, etc. have been paraded before us as the culprits of the current financial crisis. We need to add universities and teaching methods to the mix.

By the way, you say: "But exotic derivatives devised in recent years, including securities built upon pools of mortgages, turned out to be poorly understood." What do you mean by "recent years"? Mortgage backed securities have been around for over 30 years.

(***) Small portion of LTCM's investments included the partners' capital.


The academic models are based on fairly restrictive assumptions as stated before. When there is human interference returns will obey a Weibull pdf in many cases. The normality assumption breaks down. How much research has been done in this field?

How is volatility measured, over a period of 5 days, 10 days or whatever the analyst chooses?!.

John Henry

Wharton does not need to include 'regulation' in its business curriculum. It would be far more intelligent to acknowledge that free-market capitalism and central banking cannot and never have co-existed. The irrational mortgage-backed securities were a tool used by the financial industry to implement US Federal policy that everybody (without regard to individual worth) should own a home. The Federal Reserve system and the banking industry were just cogs in the machine, dutifully implementing Congressional blather. We are experiencing a failure of socialism (Keynesian economics is tool of socialism), not a failure of the free market system. If there is a central bank, there is no free market system. The idea that free-market capitalism and central banking can co-exist is a Keynsian-induced delusion; the recent past (and more to come in 2010) is the death of that delusion.


The first clue to anyone understanding economics was the deal President Clinton and his Justice Department made with banks to award house loans to the poor in order to increase "minority" home ownership. We had the government using the money of other people for low income housing which is not unusual but in this case they used the money of our bank system. How does a bank loan money to a poor person? They don't check the borrower's data on the loan application.

Anyone paying attention at the time Clinton and his bankster pals devised this plan, knew it was insane and dangerous for the financial health of the banks and a fraud for investors who bought the loans. If the banks were willing to enter into this irresponsible agreement with their investors' money you have to ask yourself, what else are the shysters doing to wreck the banking system? What leglislation was involved to enrich the banksters was involved in the deal with the politicians? Take a guess. (continued)


Corrupting the banks worked out well for Clinton and Bush who both ran on their great record of getting minorities into "home ownership." It worked for the limo liberal banksters making them look like generous gift givers to the worthy cause of making minorities "rich" by getting them into the hot market (they did not mention the bad loan deals). To liberals and "compassion conservatives" business is politics and politics is business.

Why would not the University economists toss their cookies over this fascist corruption of the banking system. Are they going to be the Democrat Party smeared racists trying to keep minorities out of home "ownership"? Hell no. The the "smart" people in America are unified corrupt cowards. (continued)

There were a few Republicans sounding the alarm in the House and eventually Bush raised an alarm. They were shouted down by Democrats (Barney Frank and the Congressional Black tribal caucus) as racists.


As you said: "It's not just that they missed it, they positively denied that it would happen,"

So true.
But I think the issue is larger than just that economists failed to see the importance of banking.

One is a theological notion, touted by Adam Smith, that the markets are governed by the "invisible hand". Although Smith's important and insightful work was deservedly highly influential, (and nevertheless can even be read and understood by ordinary persons--unlike most present day academic economic writing.) The "invisible hand" has unconsciously become part of the theological basis of academic economics. Thus it is assumed that (1)economies will naturally find an outcome in equilibrium with least imposition of any rules and (2) Whenever people follow their own self interest, this will result in the best macroeconomic outcome.

The second difficulty is the artificial abstraction imposed by the mathematical formalism imposed in the name of precision. This gives answers which can be highly precise, but where unfortunately the reality has been abstracted to the point where the real problems are obscured because they can't be easily modeled..


I say it's greed with laziness.

US had stopped innovating on tangible engineering for a few decades and was busy finding ways to make money reproduce by itself.

E.L. Beck

When I returned for my master's, I immediately recognized that very little useful knowledge would be gained from my economic classes, though I was required to take them. After years of being in business, there was a complete disconnect between economics and the real world. Nothing will change until the field of economics dumps this insane obsession with an idealized, mathematically elegant theoretical base, and starts studying what is, rather than what plugs in to differential equations. I love math, but our mathematics is not complex enough to accurately predict human behavior in all its irrational glory.


What about teaching the economics of crime aka 'real world experience'. Every economist should have an internship on Wall Street and not be so naive like Greenspan that thought corporate executives were trustworthy. Let all economists drink the kool aid hide behind the discombobulated math models aka 'the black box'. I recently took a PHD class in econometrics and once I saw what was inside the black box I laughed. Just keep adding filters upon filters and that will spit out the magic number. I agree economics must return to it's roots as a social science and begin looking at behavior rather than black box models of kool aid drinkers.

The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street (Hardcover)

Markets are mainly efficient in separation of fools and their money...
A Failed Scientific Revolution, October 24, 2009 By R. Albin (Ann Arbor, Michigan United States) - See all my reviews

This 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
By Richard Gibson "Rick Gibson" (Woodland Hills, CA) - See all my reviews
Amazon Verified Purchase(What's this?)

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
By Stephen Perrenod (singapore) - See all my reviews
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 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.

Another Victim Of The Financial Crisis ... - JOI Articles by David Blitzer

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 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.

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

Time to Bang My Head Against the Wall Some More (Pre-Elementary Monetary Economics Department) - J. Bradford DeLong's Grasping Reality with All Eight Tentacles

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...

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Brad DeLong on January 26, 2009 at 03:37 PM in Economics, Economics: Federal Reserve, Economics: Finance | Permalink

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Memory said...

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.

Reply January 26, 2009 at 04:31 PM

Aza said...

Cochrane's paper upsets me, mostly because he's a professor of finance, and he should know what he 's talking about. It's a well-worded, long article describing something that is, in a word, misunderstood.

Yours is a good example of banking.

Reply January 26, 2009 at 04:40 PM

Commenterlein said...

I just read Cochrane's nonsense and immediately thought, why don't I check whether Brad has already reacted. And, as usual, you didn't disappoint.

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.

Reply January 26, 2009 at 04:52 PM

George said...

What if a whole bunch of us were to each email a copy of your post to him? Would that help?

Or would that just be a case of us virtually pounding your head against his wall?

Reply January 26, 2009 at 04:55 PM

notsure said...

Here is what is confusing to me about all this.

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?

Reply January 26, 2009 at 05:04 PM

notsure said...

Sorry, I should have typed

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.

Reply January 26, 2009 at 05:11 PM

ogmb said...

"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."

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.

Reply January 26, 2009 at 05:37 PM

MattYoung said...

"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."

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.

Reply January 26, 2009 at 05:49 PM

notsure said...

OMGB you are confused.

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.

Reply January 26, 2009 at 06:06 PM

Gerard MacDonell said...

Cochrane should be more ambitious. His work actually shows that no spending ever has any effect on aggregate demand.

Reply January 26, 2009 at 06:42 PM

Nick Rowe said...

Brad: Read further down Cochrane's paper. He explicitly talks about fiscal policy changing the velocity of circulation.

Reply January 26, 2009 at 06:47 PM

SvN said...

I would have thought that John Cochrane was trying to describe reality.

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.

Reply January 26, 2009 at 06:50 PM

mike said...

I think this is brilliant. Thank you Brad, you're a true public servant.

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.

Reply January 26, 2009 at 06:50 PM

Nick Rowe said...

"In this analysis, fiscal stimulus a roundabout way of avoiding monetary policy. If money demand increases dramatically but money supply does not, we get a recession and deflation. If we want to hold two months of purchases as money rather than one months's worth, and if the government does not increase the money supply, then the price of goods and services must fall until the money we do have covers two months of expenditure." That's a change in the velocity of circulation.

Reply January 26, 2009 at 06:58 PM

ogmb said...

"At the beginning of the period, capital is fixed."

Says who?

Reply January 26, 2009 at 07:01 PM

Robert Bell said...

What happens if I take one step back to where Carol has $500 in cash that she hasn't loaned out yet, and she has the choice of loaning to Beverly or buying a t-bill?

Reply January 26, 2009 at 07:05 PM

anonymous said...

A dollar spent by the government is a dollar spent. As opposed to, you know, what we have now.

Reply January 26, 2009 at 07:12 PM

Rob said...

No Nick it isn't.

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.

Reply January 26, 2009 at 07:25 PM

JC said...

Not disagreeing with the analysis, but a few questions as it applies to stimulus in general:

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?

Reply January 26, 2009 at 08:06 PM

JKH said...

"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."


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.

Reply January 26, 2009 at 08:40 PM

saveusobama said...

Carol has $500 that she wants to spend improving her McMansion. She pays Alice and Beverly $1000 each to build a deck on her house because she figures the house will be worth at least $2000 more next year because of the booming market. Market crashes; house value plummets. Carol walks away from house. The bank eats the mortgage. Alice and Beverly shrug and say the deck building job was good while it lasted. All vote democratic and push for higher unemployment benefits.

Reply January 26, 2009 at 08:46 PM

New Policy said...

As a current student at Berkeley (and a former student of BDL), I am sorry to discover that Cochrane earned a PhD in our prestigious economics department. Can these degrees be rescinded? How about a new campus policy--whenever an honorary degree is given out, how about we must rescind the degree of a former student. That would certainly control degree inflation, increasing the value of the degrees that have been both earned and kept.

Reply January 26, 2009 at 08:51 PM

JWV said...

A lot of people appear to be getting lost in the example, then coming up with variants that have nothing to do with its point. I think the point is that money does not cease to exist simply because it has been spent or invested. It continues to circulate, unless the most recent person to get it hoards it. I'd have thought this would be obvious to just about everybody, but I guess it isn't.

Reply January 26, 2009 at 10:38 PM

Nick Rowe said...

Rob @7.25 Yes it is a change in velocity. When Cochrane says " If we want to hold two months of purchases as money rather than one months's worth" he's talking about a change in the desired velocity of circulation from 12 to 6 times per year.

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.

Reply January 26, 2009 at 11:58 PM

Luis Enrique said...

So the idea is that government intervention can engineer an increase in the velocity of money - accelerate the circulation of money and increase economic activity.

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)?

Reply January 27, 2009 at 01:59 AM

wkwillis said...

You might do better giving an example where a new house is built instead of just adding a porch and a home equity loan advance.
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?

Reply January 27, 2009 at 02:43 AM

Luis Enrique said...

I needed the words 'long run' in front of supply curve in my last para above.

Reply January 27, 2009 at 02:56 AM

Robert Bell said...

Maybe I'm misreading it, but I believe Dr. Cochrane's argument is that prior to lending to Beverly, there is a single decision point in time for Carol where her cash can only be used once:
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?

Reply January 27, 2009 at 03:58 AM

A said...

Isn't the "end of story" in the first scenario rather arbitrary?

Reply January 27, 2009 at 04:11 AM

El del 0.33% said...

Cochrane assumes constant velocity but you assume constant interest rates.

In your small economy, you multiply velocity by four without changes in interest rate.

Reply January 27, 2009 at 04:24 AM

mere mortal said...

I do want to pound my head against the wall.

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?

Reply January 27, 2009 at 05:51 AM

Mike Rosenberg said...

You could loan Cochrane $5000 so he could enroll in college and take Econ 101.

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.... :)

Reply January 27, 2009 at 07:03 AM

Rob said...

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.

Reply January 27, 2009 at 07:14 AM

PQuincy said...

It sure is a good thing that economics is an empirical objective science -- as people from Chicago and of a similar ilk keep telling us...

Reply January 27, 2009 at 07:51 AM

Ken said...

"We don't normally think of governments as being able to engineer an increase in productivity"

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?

Reply January 27, 2009 at 08:04 AM

stefan said...

Just skimming Cochrane, isn't he just using a standard cash-in-advance model with a Leontief technology and the assumption of a constant money stock and an equilibrium in which the cash-in-advance constraint binds? Which seems like a bit of an extreme model for the situation at hand.

Reply January 27, 2009 at 08:15 AM

BB said...

I would imagine that it gets old having to explain simple ECO 101 concepts to Johnny-Come-Lately Conservative types who can't tell a multiplier from their assholes.

Reply January 27, 2009 at 08:24 AM

Luis Enrique said...


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.

Reply January 27, 2009 at 08:37 AM

Anderson said...

What about that lazy slut, Deborah?

Is she writing John Cochrane's column about how what Alice, Beverly, and Carol are doing cannot possibly be happening?

Reply January 27, 2009 at 08:53 AM

geoff said...

"A" at 4:11 on January 27: You're the winner!! Of course that's correct. I'd call it an elementary economics mistake, but that would be juvenile. Brad: What happens to the $500 after Carol gets it? Does she stuff it under her mattress, or does she perhaps do something else with it? Does it matter for long or medium run economic growth whether the transfer from A to C occurs before or after the deck is built, etc.? I'd wager not, but I'd love to hear why you think otherwise.

Reply January 27, 2009 at 09:09 AM

Dhimmisoftheworldunite said...

Professor DeLong,

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.


Sam Conner

Reply January 27, 2009 at 09:24 AM

stefan said...

To follow up a bit, this whole debate illustrates how bad models of money and credit are in macro models. Money in the utility function or cash-in-advance models don't get at the actual transaction and credit opportunities or constraints agents face, nor does the standard neo-keynesian model with or without money. The counter argument DeLong makes here just doesn't make sense in almost all (all?) models of money and credit in the literature, since they rule out exactly these sorts of bargains and transactions by assumption.

Reply January 27, 2009 at 10:11 AM

Neil B ☺ said...

I'm an amateur (with help from bro-in-law K. Rock at Chicago), but I thought I knew that extending credit (in the monetary system we actually have) meant in effect an increase in the "money supply" - true?

[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.

Reply January 27, 2009 at 10:26 AM

jfxgillis said...

Meanwhile, Deborah lives under Beverly's deck eating the scraps leftover from the meals cooked by Carol for Alice.

Reply January 27, 2009 at 11:09 AM

Robert Bell said...

stefan: "Just skimming Cochrane, isn't he just using a standard cash-in-advance model with a Leontief technology and the assumption of a constant money stock and an equilibrium in which the cash-in-advance constraint binds? Which seems like a bit of an extreme model for the situation at hand. "

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.

Reply January 27, 2009 at 11:38 AM

Ken said...

Luis Enrique wrote: "Yes the provision public goods etc. can increase productivity, and governments do raise productivity in lots of ways."

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.)

Reply January 27, 2009 at 12:26 PM

rock the casbah said...

PQuincy | January 27, 2009 at 07:51 AM - you provide wonderful examples of the fundamental problem with Brad's story - capital allocation. People trapped in monetary analysis never account for opportunity costs and the lack of a market feedback loop when government monopolizes resource allocation. How much better would our Interstate system be today if Eisenhower used a private ownership model - that was being actively pursued by many States before it was ultimately squashed by the Federal government????

Reply January 28, 2009 at 04:31 AM

Ken said...

"The trouble is the government taxes and borrowing defunds the private sector sucking up funds that would have been lent and spent..."

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.

Reply January 28, 2009 at 07:35 Andrey said...

Rock the casbah @4:31: It would probably be similar to our private health care system - cost more per person and deliver less per person than virtually any other first-world nation.

Reply January 28, 2009 at 03:54 PM

L Angeles said...

Deborah is not needed in the story, though.

[Oct 13, 2009] Ostrom & Williamson Win "Ironic" Nobel in Economics By Barry Ritholtz

October 12th, 2009 | The Big Picture

The 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.


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.

[Sep 1, 2009] More On Economic Reasoning

August 11, 2009 | Thoughts On Economics
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 And Our Macroeconomic Policymakers By Simon Johnson

The Baseline Scenario

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'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.
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.
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.

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)

"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!

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……
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…

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

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

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

"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.

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


Otto: Apes don't read history.
Wanda: Yes they do, Otto, they just don't understand it.
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

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.

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.

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.


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.

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!

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.

"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?

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.

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.

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?

Yakkis, you underestimate human stupidity
There is this wonderful type of stupidity where you accidentally become rich beyond anyone's wildest dreams.

because 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)

I find your words strangely comforting, as if I too could achieve the American dream.
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…
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?
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

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.
…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.
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???


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.

"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."

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?

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.

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 -

"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):

  1. 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.
  2. 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.

How Much Does the Financial Sector Cost?

The Baseline Scenario

with 35 comments

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

Magic and the myth of the rational market By Keir Martin

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

[Aug 23, 2009] The Limits of Arbitrage

The Baseline Scenario

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

  1. EMH is all nonsense. Soros explained it best: markets have thinking participants who are always biased. His track record makes it clear you can beat the market, which is not about 'value' but about psychology.

    Of course, you can lose too, which makes playing with your own money somewhat dangerous.

Why 'efficient' markets go haywire - MSN Money by Jim Jubak

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?

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.

[Jul 20, 2009] Ketchup and the housing bubble - Paul Krugman Blog -

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 17, 2009] Economics What went wrong with economics The Economist

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 7, 2009] In defence of EMH by Neil Hume

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.

  1. PiotrC Jul 6 21:20

    The idea of fully efficient market is inherently contradictory. In order to remove market inefficiencies we must have traders who are motivated to exploit them. But if the market is perfectly efficient there is no possibility to make excess profits. While efficiency might be true at first order, it cannot be true at second order: There must be on-going violations of efficiency that are sufficiency large to keep traders motivated. The misconception of efficient market is even obvious now than ever before, because it was the intervention of the authorities that prevented financial market from the total meltdown, not the market themselves. Indeed non-equilibrium nature of the markets is especially visible in the sharp price movements occurring at the booms and (especially) crashes which are accompanied with massive price jumps.

  2. ! Report

    DavidG Jul 6 21:03

    The efficient markets hypothesis is not wrong, just oversold. Like Value-At-Risk, it's true most of the time, but probably not true when you need it the most. This body of thought is great for daily risk management, but not useful for estimating losses in market dislocations.
  3. ! Report

    Ginger Yellow Jul 6 15:53

    "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 "

    That's a very, very weak version of the EMH, though, to the extent that it's almost a tautology. For the EMH to have any explanatory power, it has to incorporate some variation of the idea that markets price in all available information as a result of the sorts of arbitrage described above, not just obvious ones. I mean, even a stupid central planner can spot obvious opportunities.

  4. ! Report

    Carlomagno Jul 6 15:48

    He's trying to have his cake and eat it too. Doesn't make sense.

[Jul 4, 2009] Woefully Misleading Piece on Value at Risk in New York Times

naked capitalism
Anonymous said...
I always thought that the EMH is exactly that the market is a discounting mechanism. A classic MBA Finance problem is: Company X announced that their earnings dropped by 5%, yet the market value of the firm rose by 10%. How is that consistent with the semi-strong version of the EMH?

The answer is 'Because the market expected that the earnings would drop by 15%, so a 5% drop is good news, causing the price to rise.'

I am not defending the EMH here or arguing that it is true in reality, but instead saying I don't understand how the discounting mechanism point is inconsistent with the EMH. So I am confused, not arguing. Maybe I just don't know what you mean by the discounting mechanism.

[Jul 4, 2009] Deprogramming the cult of the Efficient Market

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.

Posted by Steve Hsu at 1:10 PM 10 comments Links to this post

Labels: behavioral economics, economics, efficient markets, expert prediction, finance

The Myth of the Rational Market By Barry Ritholtz

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.


"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.


Poking Holes in a Theory on Markets
NYT, June 5, 2009

Talking Business - Poking Holes in a Theory on Markets - By JOE NOCERA

June 5, 2009

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 The Myth of the Rational Market- A History of Risk ...

Pointing Fingers by JUSTIN FOX

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.

Refuted economic doctrines #1: The efficient markets hypothesis

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!

28 Responses to "Refuted economic doctrines #1: The efficient markets hypothesis"

  1. costa Says:
    January 2nd, 2009 at 11:41 am

    Nice Post John.

    The EMH never really recovered from the collapse of Long Term Capital Management in the late 90's staffed by some of the modern portfolio theory academics. In fact the writing was on the wall back in the 1987 market crash where portfolio insurance (using black and scholes replicating strategies) contributed to a market meltdown.

    I think it also shows why Eugene Fama has yet to win a nobel prize. But your last sentence is a bit of a leap of faith from EMH to mixed economy. As a general statement - yes, but I think we can agree not too much or perhaps too little. This is the art of a modern mixed economy.

    I think the various financial crises since deregulation enables competing views like behavioural finance, Minsky and even good old Keynes to make a comeback from the likes of Friedman and Schumpeter. I guess it is a good case of mean reversion in Economic theory!

  2. Joseph Clark Says:
    January 2nd, 2009 at 1:28 pm

    I can't see how this kind of empirical "refutation" of EMH has any practical value. If you misrepresent EMH as a scientific theory then you can't fail to refute it. There will always be some price that does not adjust correctly – for any number of reasons. The fact that anybody is able to earn high wages or profits for any length of time is itself sufficient to disprove that prices are always efficient.

    So what? What makes EMH interesting and useful is its implication that inefficient prices provide opportunities for profit; how quickly or perfectly they adjust to these opportunities is a separate empirical issue. The standard argument that EMH is "falsified" so markets don't work and capitalism is bad (or similar) completely misses the point.

  3. Michael of Summer Hill Says:

    January 2nd, 2009 at 1:30 pm

    John, recent events suggest 'subsidies' will be part of the government's fiscal armoury necessary to maintain economic growth and/or prop up businesses which are in dire straits. Take for example Russia, the government there has pledged over $200bn this financial year to prop up some 1,500 flagging companies which account for 85% of Russia's GDP. For this very reason I have to agree with you that a 'mixed economy' seems to be more plausible than any other economic system.

  4. P.M.Lawrence Says:
    January 2nd, 2009 at 2:17 pm

    "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."

    That's a non sequitur, based on a hidden assumption about the wisdom of state direction in state run areas. It is entirely plausible that the central planning side would also fail, possibly through different causes - and 20th century experience bears this out too (Five Year Plans, anybody? The Groundnut Scheme?). As to whether humbler central planning within a mixed economy worked out better, that's still an open question bearing in mind claims that today's problems were partly driven from that side of things and merely showed up on the private side. I do think it could work - if everybody (central planners included) knew what they were doing, which is another way of doubting it. Failing that, muddling along with some intellectual humility on all sides seems the best bet. Someone once modernised the three laws of thermodynamics as "you can't win, you can't even break even, and you can't get out of the game".

  5. Jim Birch Says:
    January 2nd, 2009 at 2:34 pm

    Is there any theoretical justification for the EMH that doesn't sound like it came off the back of a corn flakes packet? As far as I can see it's pure religion: another simple "sounds-good" explanation for something that's actually more complicated than the human brain can handle. It's possibly even a case of a "why the sun comes up every day" superstition that allows you to sleep at night, ie, we're all engaged in this activity so it just can't be crazy.

    Mathematically, EMH says that even though any individual choice may be whacky the (dollar) weighted average choice must somehow be correct. It doesn't follow, does it?

  6. Sinclair Davidson Says:
    January 2nd, 2009 at 2:55 pm

    Classic evidence on the EMH here.

    More evidence here.

  7. gerard Says:
    January 2nd, 2009 at 2:59 pm

    Steve Keen had what I thought was a very good discussion of the EMH in his Debunking Economics book.

  8. Brendan Says:
    January 2nd, 2009 at 3:23 pm

    PM Lawrence. To illustrate the failure of mixed economies, can you come up with better counter examples than "Five Year Plans, … The Groundnut Scheme"? Otherwise I think you should be less dismissive of JQ's premise.

  9. Brendan Says:
    January 2nd, 2009 at 3:31 pm

    PM Lawrence, my apologies for thinking you were arguing the examples above were meant to be about a mixed economy- I misread your comment and now see they were not but part of some other thread about the wisdom of central planning.

  10. P.M.Lawrence Says:
    January 2nd, 2009 at 4:57 pm

    I gave the counterexamples to purer central planning cases since the failures there clearly relate to the central planning, thus showing that planning per se also fails. I then pointed out that mixed approaches may well have failures stemming from that that show up on the private side. Inherently, that would be a lot harder to trace.

  11. jquiggin Says:
    January 2nd, 2009 at 5:18 pm

    Sinclair, thanks for the refs. The Fama article is useful and stands up surprisingly well after 40 years. I'd agree with his conclusion that weak form efficiency is well supported, strong form implausible and semi-strong important but much harder to test. Still, I'm looking for something more recent than 1969.

  12. jquiggin Says:
    January 2nd, 2009 at 5:26 pm

    PML, the frequency with which I've seen references to the Ground Nut Scheme (a failed exercise in development assistance 60 years ago) leads me to suspect that there can't be many such extreme failures. Interestingly, Wikipedia gives a see also to a private sector comparator

    But if there is one lesson that ought to have been learned back at Sydney Cove is that governments and agriculture don't mix very well.

  13. Sinclair Davidson Says:
    January 2nd, 2009 at 6:22 pm

    There is a 1991 follow up piece (by Fama) in the Journal of Finance - December issue (log in would be required for non-uni users) there is a ungated version at SSRN but its down for maintainence over new year.

  14. Brendan Says:
    January 2nd, 2009 at 6:32 pm

    #10 "thus showing that planning per se also fails" … that's drawing a fairly long bow - but then why not go a bit further and say all planning is bound to fail?

  15. Peter Wood Says:
    January 2nd, 2009 at 6:46 pm

    Evidence that news and volume play a minor role in stock price jumps here.

    Evidence that financial analysts show pronounced herding behaviour is here. According to the abstract - "These results add to the list of arguments suggesting that the tenets of Efficient Market Theory are untenable."

  16. mp Says:
    January 2nd, 2009 at 7:01 pm

    #12 - you can question the degree of the failure, but other examples of govt failure could include WA Inc, the Pyramid Building Society (which had an almost explicit govt guarantee), the Christmas Island Spaceport and the Queensland Magnesium plant.

    On a related point:
    It is clearly a non sequitur to argue that market failure means government intervention will result in a welfare improvement.
    I for one agree that financial markets are clearly imperfect, but governments are far worse at allocating capital.

  17. rog Says:
    January 2nd, 2009 at 7:03 pm

    Whilst attributing blame for an event to a hypothesis, in this case the GFC to the EMH, is easy it doesn't go to the root cause of the GFC.

    The cause of the GFC is government.

  18. Alanna Says:
    January 2nd, 2009 at 7:08 pm

    How so Rog? The cause of the GFC is government? Please elaborate. I rather thought it was lack of government myself.

  19. Peter Wood Says:
    January 2nd, 2009 at 7:46 pm

    rog, it does not make sense to talk about the 'root cause' of the GFC. Markets are have complex networked relationships with feedbacks. For complex systems such as these it is difficult to talk about causality, and even more difficult to talk about something as complex as the GFC having a single 'root cause'.

    For example, if governments regulate markets poorly, and this leads to some wild fluctuations, does this mean that government is the cause, or something in the market is the cause? Maybe you could say that government is the cause because if government didn't exist, the GFC wouldn't happen. BUt I suspect that if government didn't exist, the global financial market wouldn't either.

  20. Alanna Says:
    January 2nd, 2009 at 8:06 pm

    I think mostly everyone would acknowledge government failures in supporting markets that were essentially unviable in the past, or supporting markets for their own political self interest by the quite common porkbarrelling. No one would surely suggest that governments are free of human imperfections. The inadequacies of governments are not under dispute by me - yet what I do dispute (and strongly) is the notion that markets do not fail (or that the markets are free of human imperfections either) and that markets are superior in all aspects to any form of government intervention or planning. We swing from one extreme to another without recognising that governments and markets are not, and should not be considered adversaries. They should progress in an orderly and complementary fashion like shoes and socks. The purpose of government intervention and planning is to assist the smooth functioning of markets which is desirable. Intervention when it is required to protect competition or infrastructure and no intervention when no intervention promotes genuine competition and entrepreneurial abilities. By this I don't mean promotion of the entrepreneurial abilities of only the largest (and already established / concentrated / monopolistic) firms. The encouragement of smaller entrepreneurs is much needed and has been somewhat lacking (what unnecessary time does a BAS take to a builder starting out??). There has been far too much government kow towing to firms with the financial wherewithall to lobby hard, and not nearly enough assistance given to small businesses.

  21. kitchenslut Says:
    January 2nd, 2009 at 8:15 pm

    I think its good to see some acknowledged concensus here on the weak form of the EMH as its a theory which has always been poorly presented and abused in the media ie: it means the market is always correct …. which it doesn't at all.

    This has also been used as a reason to use index funds however my perception is that this would have also led you into the biggest bubbles ie Nasdaq 2000. There is a reference above to analysts herding being a refutation of EMH which I would have thought is no refutation at all and may in fact be confirmation from another perspective?

    Not sure how the Dimenmsional Funds are travelling these days but as far as I know were associated with Fama (quoted above) and I used to regard these as "EMH with a brain"?

  22. Marginal Notes Says:
    January 2nd, 2009 at 8:33 pm

    Presumably the EMH is meant to apply to rural land values as well, but casual observation suggests that rural property values pretty much factor in a long-term projection of the current price for the commodity in question, especially on a rising market - witness the boom in sugar land values in Queensland in the 1990s. Since the most optimistic (least far-sighted?) bidder makes the purchase, how can the 'market' be rational? It is bound to overshoot.

  23. rog Says:
    January 2nd, 2009 at 8:53 pm

    As EMH is a hypothesis it has yet to be properly tested.

  24. rog Says:
    January 2nd, 2009 at 9:13 pm >

    There has been no failure of the market - it has efficiently priced the risk as it became known. As govts increase their intervention we can be assured of greater price movements - govts are not known for their efficiency.

  25. d4winds Says:
    January 3rd, 2009 at 12:22 am >

    (1) a pure "animal spirits" explanation of stock market fluctuations (inclusive perhaps but not necessarily requisite of "herding") with no or an extremely tenuous relationship between the real economic value of capital resources and stock prices can be consistent with semistrong or weak EMH.
    (2) EMH efficiency is a pure TRADING efficiency argument, that is necessary for but by no means sufficient for economic efficiency in capital allocation.
    (3) The jump from EMH to allocative efficiency of markets ("..they're better than any other possible capital allocation method…") is not prima facie false, owing to (2), but neither is it justified, owing to (1).

  26. Will Says:
    January 3rd, 2009 at 1:59 am

    Perhaps the problem is not with our ability to determine prices but the whole idea that the secondary market prices of financial assets are important or even relevant. Is the EMH something we should even care about?

    Financial assets represent the right to receive a series of cash flows over some extended period of time, and which are ultimately generated by some real productive enterprise. Maybe the financial system would be in better shape today if it was recognized that the relevant test of an investor is how the actual long term cash flow compares with it's original expectations.

    This is quite different from investment performance based on the secondary market price of financial assets, which is a second order property of the assets affected by many factors other than just the underlying real productive enterprise.

    To say that short-termism is bad is not simply a slogan; financial assets like shares and bonds are long term, and it is ultimately wrong for short term investors to be buying them if they can't hold them for the long term. In other words, why should short term investors expect that someone else will always be willing to buy them out of their long term investments? Ponzi, anyone?

    If you have a short term investment horizon, as many people do, then we have banks to intermediate deposits into long term loans, through the magic of the law of large numbers (average deposit inflows and outflows should be relatively constant over the long term) and the presence of a lender of last resort.

  27. Carl Futia Says:
    January 3rd, 2009 at 3:10 am

    If you substitute the words "no free lunch" for "efficient markets" you typically find much more public acceptance of the hypothesis. After all, it's main prediction is that markets rarely make EXPLOITABLE mistakes, i.e. mistakes that can be recognized as such when they occur and that can be exploited via some investment strategy that is spelled out in advance.

    As far as I can tell this prediction has enormous empirical support.

    The hypothesis that public officials can outguess the financial markets because they know more about the future course of the economy has exactly zero evidence to support it.

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