Bookblogging: After the EMH, what next?

by John Quiggin on August 4, 2009

Writing a critique of the Efficient Markets Hypothesis in terms rigorous enough to stand up to scrutiny, but comprehensible to the average reader hasn’t been easy, and I still have a lot more work to do. But thanks to the help I’ve had from commenters here and at my blog, and from other readers, I hope to make a go of it. Now comes the hard bit: suggesting some alternatives, both in theory and policy. I’m not by any means satisfied with this draft. In particular, I need to go back and get a better linkage to the question “if the market price for assets is not the “right” price, what is?”. But, I thought I’d do better getting some help and criticisms now, rather than trying for some more polish first.

What next?


Realistic theories of financial markets 


The theoretical analysis underlying the EMH shows that perfectly rational investors, operating in perfectly efficient financial markets, will produce the best possible estimate of the future value of any asset. The catastrophic failure of the EMH in reality suggests the need to re-examine not only the theoretical premises of individual rationality and market efficiency and the whole concept of “best possible estimate”.


The first of these tasks is well under way. For the past twenty-five years or so, economists have been seeking to replace assumptions of perfect rationality with more realistic models of how individuals make choices under uncertainty and over time. Much of this work goes under the banner of ‘behavioral economics’ or ‘behavioral finance’ (in true academic fashion, there is some dispute about the ownership of this term, with some economists trying to tie it to a specific research program, and others preferring a broader view that encompasses any work based on actual behavior rather than a priori rationality assumptions). 


Many of the crucial ideas of behavioral economics are derived from the work of psychologist Daniel Kahneman and his longtime collaborator, the late Amos Tversky. In 2002, Kahneman became the first, and so far only psychologist to be awarded the Nobel prize in economics, while Tversky, almost uniquely in the history of the award, received a posthumous mention. Among other crucial ideas, Kahneman and Tversky showed that people have difficulty in handling probability judgements and, in particular, tend to overweight certain kinds of low-probability events, such as the chance of winning the lottery or dying in an airplane crash. 


Moreover, while people are mostly risk-averse, they tend to “chase losses”, taking additional risks in the hope of recouping losses from an original reference point. Far from being the reliable calculating machines assumed in the standard theory, people rely on ‘heuristics’ such as ‘availability’, which means that they tend to overestimate the probability of events of which examples are readily available. 


Another collaborator of Kahneman and Tversky, Richard Thaler has focused on how people make decisions over time. The standard model requires people to value future flows of income using a moderate, constant discount rate, such as the rate of interest on bonds. So, if the annual rate of interest on bonds is 5 per cent, a sum of $100 invested now will be worth $105 in a year’s time and (because of compound interest) about $110.25 in two years’ time. Turning this argument around, a sum of $105 received in a year’s time, or $110.25 in two years’ time, should be worth $100 today.


Observing what people actually do in day-to-day decisions reveals a quite different pattern, called hyperbolic discounting. People greatly prefer to receive benefits immediately rather than, say, in a year’s time. They are similarly keen to defer costs from the present into the relatively near future, even when facing high interest costs for doing so. But if asked to choose between a benefit (or cost) in one year’s time, and a larger benefit or cost in two year’s time, they are fairly patient. 




Unawareness


Unawareness


The study of behavioral economics shows that people often fail to follow the precepts of rational decision making. And the economics of asymmetric information literature gives reasons why even when participants in financial markets are entirely rational, market outcomes may not be efficient. But there is a more fundamental challenge which economists are only now beginning to address. This is the fact that, since the number of possible contingencies that may affect economic outcomes is effectively infinite, no decisionmaker, no matter how well-informed and sophisticated, can possibly take them all into account.


This point has arisen in popular discussion, for example with Donald Rumsfeld’s famous observation ‘There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.’ Although Rumsfeld was much derided for this statement, is both valid and important. The real problem was that, having made the point, Rumsfeld did not consider that, since launching a war exposes a nation to a host of ‘unknown unknowns’, decisions to do so should be made with extreme caution.


In the financial literature, writer and investor Nassim Taleb has popularised the term ‘black swans’ to describe such unforeseen contingencies. For Europeans, the proposition that “all swans are white” was confirmed by all experience. It seems unlikely that Europeans ever contemplated the possibility of a black swan, until they came to Australia and found them. Fortunately, there was not a large financial system built on the whiteness of swans. However, history is full of examples of careful planning brought undone by unconsidered possibilities.


It is not hard to point out that we are regularly surprised by ‘unknown unknowns’ and ‘black swans’. A much harder problem is to describe a system of reasoning and decisionmaking that takes account of events that are, by definition, unforeseen by those reasoning and making decisions. Economists, philosophers and decision theorists have been wrestling with this problem for a long time, and at last seem to be making some progress. It turns out that it is possible to develop formal models of bounded rationality in which decisionmakers are unaware of some possibilities and unable to fully articulate and communicate all the possibilities of which they are aware.


The implications are profound. One is that in environments where surprises are likely to be unfavorable, it makes sense to apply a precautionary principle to decisionmaking, preferring simple and easily understood choices to those that are complex and poorly understood, even when the complex option appears to offer greater net benefits. A similar point relates to contracts. In joint work with Simon Grant and Jeff Kline, I have shown that contracts between boundedly rational parties always involve some element of ambiguity. For this reason, simple contracts with terms that are understood by both parties may be preferred to the complex arrangements indicated as optimal by standard economic theory.










Trust and crises


But individual deviations from rationality aren’t the only problem. In perfectly efficient markets, even a small number of of hardnosed and rational speculators would be enough to ensure the outcomes predicted by EMH theory. Such speculators could take advantage of the irrational behavior of the majority of investors, turning them into “money pumps”. As Keynes observed though, successful speculation depends on the market getting things right, not just eventually, but before the speculators run out of money. A realistic theory of financial markets must  explain how bubbles can persist long enough to deter speculators from betting on a return to market equilibrium.


We also need a deeper understanding of financial collapses like the current crisis. Although the textbooks represent financial markets as involving impersonal exchanges of precisely defined assets, the actual operation of the system relies crucially on trust and more generally, on understanding the amount of trust that should be placed in particular kinds of promises. In the last few decades, economists have spent a lot of time studying trust, and particularly the problem of when one party to a contract should trust the other to tell the truth and keep faith. This problem has been analysed  in terms of asymmetric information (when one party knows something the other does not, and both parties know this). But the problems go deeper than this, to situations where it is impossible to calculate all the possible outcomes, and individuals must decide whether to rely on the judgement and good faith of others.


Trust breaks down in crises. All institutions, both public and private, rely to some extent on trust, and when trust breaks down it is often hard to rebuild. In the crisis of the 1970s, the failure of governments to deliver on their commitments to manage the economy and maintain full employment led to a loss of public trust, which was transferred (more or less by default) to markets and particularly financial markets. This loss of trust made it difficult, if not impossible, to implement policies that might have made a difference, such as agreements to stabilise wages. By the time such agreements were feasible, in the 1980s, the balance of economic power had already shifted to financial markets.


Even more than governments (which have, after all, the direct power of the state behind them) financial markets depend on trust. The central financial institution of modern capitalism is the fractional reserve banking system, whereby banks lend out most of the money that is deposited with them, keeping only a fraction to meet calls for withdrawals. In an unregulated system, a failure of trust in a given institutions leads to a ‘run on the bank’ as depositors scramble to get money out while they can.


Systems of deposit insurance and bank guarantees now ensure that depositors’ trust in banks is backed up by their trust in the ability of governments to protect them in the event of default. But other kinds of trust in the financial system are not so easily maintained. Banks are sustainable if and only if they can accurately assess the willingness and ability of borrowers to repay their debts. In normal conditions, this is not an exceptionally difficult task. Banks can look at standard measures of ability to repay, credit histories and so on to distinguish good risks from bad and, in any case, the first group are in the overwhelming majority. 


But in a crisis all this breaks down. Formerly reliable formulas cease to work as borrowers realise they are better off walking away from their debts (through bankruptcy or foreclosure) than struggling to repay them and failing anyway. At this point, trust can only be restored through personal knowledge of particular borrowers, the kind that is built up through a long business relationship. But it is precisely in a crisis that such business relationships break down. Banks fail and their assets are taken over by others with no knowledge of the customers beyond what they can glean from formal records and remaining employees. In a complex and interlinked system like that built up over recent decades, the failures can cascade until the entire system ceases to function beyond a minimal level.


Financial regulation


The global financial crisis has been, above all, a failure of models of financial regulation based on the EMH.The approach to financial regulation developed in response to the Depression was highly restrictive. Financial institutions were confined to a limited range of services, and financial innovation was limited. Financial institutions seeking to create new assets had to satisfy regulators that these assets could be fitted into the existing regulatory framework, or else wait until a new set of regulatory structures was developed.


Financial deregulation in the 1970s put an end to these constraints. The term ‘deregulation’ is something of a misnomer, since no system in which the public is the ultimate guarantor can be regarded as unregulated. Rather a system of regulation focused on protecting the public and stabilising the economy was replaced by one in which the primary concern was to facilitate innovation and to manage risk in the most ‘light-handed’ possible fashion. The EMH played a crucial role in designing these regulatory systems, which went through a variety of forms before their final embodiment in the Basel Accords issued by the Basel Committee on Banking Supervision, which is made of up senior representatives of bank supervisory authorities and central banks from the G-10 countries.


The Basel Accords attempted to assess the riskiness of banks’ holdings using a combination of market prices and ratings from private agencies (such as Moody’s and Standard & Poors). According to the EMH, market values of classes of risky assets are the best possible estimate of their value. While the EMH does not have direct implications for the interpretation of agency ratings, the fact that such ratings are sought by bond issuers, implies, according to the EMH that the ratings contain valuable and reliable information, since they would otherwise be ignored.


Until 2007, the Basel system had never had to deal with a serious financial crisis in the developed world. It failed catastrophically at its first test. Not only did many banks fail, but the measures of capital adequacy required under the Basel system proved all but useless in assessing which banks were at risk. 


Radical changes in financial sector regulation have already taken place as a result of the financial crisis. Guarantees of bank deposits have been introduced or greatly expanded in all major economies. Partial or complete nationalisation of failing institutions, with the resulting assumption of risk by the public, has been widespread.


However, these policies have been introduced as emergency measures, with the implicit (and sometimes explicit) premise that they will be ended when normal (pre-crisis) conditions are restored. his premise is untenable. By the time the crisis is over, the financial sector will be radically transformed, and will require a radically different mode of regulation.


The starting point for a stable regulatory regime must be a reversal of the burden of proof in relation to financial innovation. The prevailing rule has been to allow, and indeed encourage, financial innovations unless they can be shown to represent a threat to financial stability. Given an unlimited public guarantee for the liabilities of these institutions such a rule is a guaranteed, and proven, recipe for disaster, offering huge rewards to any innovation that increases both risks (ultimately borne by the public) and returns (captured by the innovators).


What is needed is a system of ‘narrow banking’ where with a clearly defined set of institutions (such as banks and insurance companies) offering a set of well-tested financial instruments with explicit public guarantees for clients, and a public guarantee of solvency, with nationalisation as a last-resort option. Financial innovations must be treated with caution, and allowed only on the basis of a clear understanding of their effects on systemic risk.


It is important not to suppress the activity of those willing to take risks with their own capital. As Adam Smith observed, (CH X, Part I)


The chance of gain is by every man more or less overvalued, and the chance of loss is by most men undervalued, and by scarce any man, who is in tolerable health and spirits, valued more than it is worth.


Smith argues that this characteristic over-optimism is crucial in promoting investment and enterprise. Later writers such as Keynes described attitudes to risk in terms of ‘animal spirits’, and noted, in the light of experience, the occurrence of periodic panics and depressions, in which animal spirits could not be roused. But even so, there is a clear need to allow scope for those with an optimistic view to chance their arm, while ensuring that the costs of the inevitable failures are borne by those concerned in the speculative investment and not by the community as a whole.


Stabilising financial markets does not mean that it is necessary to prohibit risky investments, or even to prevent speculators from developing and trading in risky new financial assets. What is crucial is that these operations should not threaten the stability of the system as a whole. Publicly regulated (and guaranteed) banks and other financial institutions  should be prohibited from engaging in speculative trade on their own account and from extending any form of credit to institutions engaged in such speculation, as they did with LTCM and its successors. Governments should commit themselves not to allow any bailout if speculators get into trouble, again as occurred with LTCM. After that speculators can safely be left to sink or swim. 


The starting point for a stable regulatory regime must be a reversal of the burden of proof in relation to financial innovation. The prevailing rule has been to allow, and indeed encourage, financial innovations unless they can be shown to represent a threat to financial stability. Given an unlimited public guarantee for the liabilities of these institutions such a rule is a guaranteed, and proven, recipe for disaster, offering huge rewards to any innovation that increases both risks (ultimately borne by the public) and returns (captured by the innovators).


Post-crisis financial regulation must begin with a clearly defined set of institutions (such as banks and insurance companies) offering a set of well-tested financial instruments with explicit public guarantees for clients, and a public guarantee of solvency, with nationalisation as a last-resort option. Financial innovations must be treated with caution, and allowed only on the basis of a clear understanding of their effects on systemic risk.


In this context, it is crucial to maintain sharp boundaries between publicly guaranteed institutions and unprotected financial institutions such as hedge funds, finance companies, stockbroking firms and mutual funds. Institutions in the latter category must not be allowed to present a threat of systemic failure that might precipitate a public sector rescue, whether direct (as in the recent crisis) or indirect (as in the 1998 bailout of Long Term Capital Management). A number of measures are required to ensure this.


First, ownership links between protected and unprotected financial institutions must be absolutely prohibited, to avoid the risk that failure of an unregulated subsidiary will necessitate a rescue of the parent, or that an unregulated parent could seek to expose a bank subsidiary to excessive risk. Long before the current crisis, these dangers were illustrated by Australian experience with bank-owned finance companies, most notably the rescue, by the Reserve Bank, of the Bank of Adelaide in the 1970s.


Second, banks should not market unregulated financial products such as share investments and hedge funds.


Third, the provision of bank credit to unregulated financial enterprises should be limited to levels that ensure that even large-scale failure in this sector cannot threaten the solvency of the regulated system.




The state and the market


The EMH implies that governments can never outperform (well-informed) financial markets in making investment decisions. The failure of the EMH does not imply the converse claim that governments will always do better. Rather, the evidence suggests at 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).


This inference from capital market outcomes is consistent with the general experience of the 20th century, and particularly the decades after World War II. In these decades, governments took a central role in the development of a wide range of infrastructure services including transport and telecommunications networks, and the provision of electricity, gas and water. These investments were not, in general, motivated by doctrinaire socialism, but by a belief that the development of market economy would be promoted by the reliable supply of infrastructure services.


The rise of economic liberalism saw a substantial, though far from complete, shift of responsibility to the private sector. Reform of electricity, telecommunications and other infrastructure services … The results have been mixed, to put it as charitably as possible. In some cases need some examples, reliance on private capital has led to new and innovative investment strategies. In others, such as electricity transmission in the US, failure to take account of the public good character of infrastructure has led to inadequate investment by all parties, and to a gradual deterioration in the quality of the network. In still other cases, as in the creation of supposedly competitive electricity markets in California, financial engineering and market manipulation have produced catastrophic failures.


The experience of the 20th century suggests that a mixed economy will outperform both central planning and laissez faire. The economic doctrines derived from the EMH seemed to contradict that suggestion. It is now clear,however, that it is the EMH and not the mixed economy that has failed the test of experience.

{ 24 comments }

1

The Raven 08.04.09 at 5:41 am

“What is might a be a form of social democracy for our purposes?” I think is one reading of the question. Unfortunately, I don’t think a single answer can be given. The answer is necessarily contingent. As if this were not enough–I’ve been citing Converse lately–not only is the economic form in question, so is the political form. Not only are unclear on what financial institutions are needed, we do not know how to direct a government to find out what those might be, and shape finance to those goals.

I suspect that a financial system dominated by a heavily regulated central banking system is likely to be oppressively conservative: one which will tend to entrench power. On the other hand, we have seen the results of the lack of regulation. Faugh to financial “creativity!” For every truly creative idea, there are 1,000 scams. Perhaps…what we need is a system with a conservative core, a speculative margin, and, also on the margin, a component just gives some significant, amount of money away? At random, even, or at least on an idiosyncratic basis for goals like scientific research, art, or who knows? And the US Federal estate tax seems to me a very good idea, to prevent entrenched, heritable wealth.

2

Billikin 08.04.09 at 7:21 am

A friend of mine likes to say that the purpose of a court trial is to reach a decision. He is not being terribly cynical when he say that. What he means is that, though we might wish for truth to be revealed and justice to be done, we also need for decisions to be reached to provide a basis for moving on, even if those decisions are imperfect. Similarly, we may say that the purpose of a market is to make trades. We may wish for the price to be right, but we also need trades, even if the prices are not correct.

Generally speaking, as far as some good is concerned, there is every reason to think that different people will value it differently. Earlier I have suggested that the median value among the members of a society or community might be considered the right price in a representative sense. But there is nothing about supply and demand, along with affordability and whatever other factors may apply, to suggest that the market price will converge on that value, or on any particular value. (OC, there are some things for which a correct value may be estimated from public information, and the price should be near that value.)

In the general case, if there is no correct value to which the price converges, can we make any prediction about future prices? Well, we can, can’t we? Assuming that current factors of individual evaluation, supply and demand, affordability and any other relevant factors remain the same, the price should remain approximately the same. (If the current price lies between two individual values, so should the subsequent price. In a large community, the difference between individual values should be small, so that the difference between successive prices should be small, as well.) In the normal course of affairs these factors change slowly and unpredictably, so that the current price should be the best predictor of future prices.

To say that we have not invoked efficiency at all. Does it have anything to do with the idea that the current price is the best predictor of future prices? Yes, it does. If a market inefficiency is known, then there is an opportunity for arbitrage, and the next price will change accordingly. Thus a known market inefficiency means that the current price will not be the best predictor of future prices.

Now, for an asset with a known value, the best predictor of future prices is that value. However, if the current price differs significantly from that value, that future can be distant. The next price will usually be close to the current price, but the chance of a large change is not insignificant.

To return to my main point, for a market in a good that does not have a known value towards which prices may be expected to converge, and if there are no opportunities for arbitrage, does it make sense to speak of market efficiency at all?

3

Tim Worstall 08.04.09 at 11:16 am

If this were me (which it isn’t of course):

“Formerly reliable formulas cease to work as borrowers realise they are better off walking away from their debts (through bankruptcy or foreclosure)”

I would add the Russian option: shooting one’s banker. It was a surprisingly common option in the 90s…..

“The failure of the EMH does not imply the converse claim that governments will always do better.”

It doesn’t even imply that governments will *ever* do better. There may be all sorts of reasons why govt will do, might do, could do, better, but the failure or not of the EMH isn’t one of them. For one reason that markets might fail is not proof that govt is better…..

“In others, such as electricity transmission in the US, failure to take account of the public good character of infrastructure has led to inadequate investment by all parties,”

D2 once argued (as I recall his argument anyway, I’m not necessarily the most reliable of sources though) that water, as a natural monopoly, should be govt owned for only govt would recognise the public good character and thus provide the socially optimal amount of investment. And since privatisation (and regulation of course) investment in water in the UK has risen dramatically. Which means that either private companies are investing more than the socially optimal amount or that govt was investing less than it. The latter sounds a little more believable quite frankly.

“It turns out that it is possible to develop formal models of bounded rationality in which decisionmakers are unaware of some possibilities and unable to fully articulate and communicate all the possibilities of which they are aware.”

Which comes back to govt v. markets. I’m not sure I understand why having decisions made by that smaller group in govt as opposed to the larger group out in the market means that there will be fewer possibilities which people are unaware of.

4

Billikin 08.04.09 at 3:57 pm

Tim Worstall: “Which comes back to govt v. markets. I’m not sure I understand why having decisions made by that smaller group in govt as opposed to the larger group out in the market means that there will be fewer possibilities which people are unaware of.”

In the case of monopoly, which you refer to in the case of water, the smaller group is not gov’t, but the monopolists. The gov’t at least has the general welfare in mind.

5

Tim Worstall 08.04.09 at 6:15 pm

Yes, but as you will also note from the example I gave of water, the govt was spending less than the private companies are. So govt wasn’t in fact taking care of the general welfare even if it supposedly had it in mind.

6

John Quiggin 08.04.09 at 10:22 pm

Tim, you might recall at the time that the Thatcher government had a policy target (the Public Sector Borrowing Requirement) that effectiveley prohibited substantial public investment in water. At the same time, the EU was demanding that Britain bring its water supply system and water quality up to scratch, and also pro-privatisation (those terrible Eurosocialists again!).

So, if you need more investment and the public sector is prohibited from providing it, privatisation is a good idea. But this doesn’t look like a promising basis for a general argument.

In any case, you’ll have a chance to comment further on this, as there will be a whole chapter on privatisation.

7

Tim Worstall 08.05.09 at 8:19 am

Sure: I’m aware of why it happened. Just trying to make the point that while government could (might, may, is capable of) take into account the wider social interest there’s rather less evidence that they actually do……

8

dsquared 08.05.09 at 12:52 pm

just to note that (yes, I am still whipping this deceased horse) when one looks at all the current furor over “high frequency trading”, it’s relevant to Fama’s weak-form EMH, as by definition an HFT system is one that uses information about past price and volume histories to execute profitable trades, ie a technical analysis machine. (there’s also an issue with respect to flash orders and the like about Fama’s implicit assumption that all information about the history of securities prices is public information, but most HFT systems don’t rely on flash orders).

9

JE 08.06.09 at 12:07 am

Be sure to take a look at, and take into account in your work, Richard Thayer’s article or op-ed in yesterday’s FT (August 3rd) (might be the 4th) and the work cited therein.

10

Richard H. Serlin 08.06.09 at 3:14 am

“In perfectly efficient markets, even a small number of of hardnosed and rational speculators would be enough to ensure the outcomes predicted by EMH theory. Such speculators could take advantage of the irrational behavior of the majority of investors, turning them into “money pumps”. As Keynes observed though, successful speculation depends on the market getting things right, not just eventually, but before the speculators run out of money.”

I think it’s important to add that in addition to running out of money, there are other easy counters to the savvy marginal investors EMH argument. A key is the issue that prices can be grossly inefficient in their implied risk-adjusted returns, without there being risk-free “money pump” opportunities (pure textbook arbitrage). This leads to a point I made in a 2006 Economists’ Voice letter, “Informed Investors Have Limited Ability to Push Prices to Efficiency”:

One reason…which I have not seen yet in the literature, at least explicitly, is that a smart rational investor is limited in how much of a mispriced stock he will purchase or sell by how undiversified his portfolio will become. For example, suppose IBM is currently selling for $100, but its efficient, or rational informed, price is $110. It must be remembered that the rational informed price is what the stock is worth to the investor when added in the appropriate proportion to his properly diversified portfolio of other assets. Such a savvy investor will purchase more IBM as it only costs $100, but as soon as he purchases more IBM, IBM becomes worth less to him per share, because it becomes increasingly risky to put so much of his money in the IBM basket. By the time this investor has purchased enough IBM that it constitutes 20 percent of his portfolio, the stock may have become so risky that it’s worth less than $100 to him for an additional share. At that point he may have only purchased enough IBM stock to push the price to $100.02, far short of its efficient market price of $110. Thus, if the rational and informed investors do not hold or control enough—a large enough proportion of the wealth invested in the market—they may not be able to come close to pushing prices to the efficient level.

11

John Quiggin 08.06.09 at 4:21 am

A nice point Richard. I guess there’s a dynamic story where the well-informed investors become rich enough to push things closer to equilibrium over time, but it may well be vulnerable to the same kind of criticism.

12

Tracy W 08.06.09 at 7:46 am

In the crisis of the 1970s, the failure of governments to deliver on their commitments to manage the economy and maintain full employment led to a loss of public trust, which was transferred (more or less by default) to markets and particularly financial markets.

If this was true then how come Margaret Thatcher, Ronald Reagan, and Roger Douglas were met with such opposition to their reforms? I lived through the 1980s and 1990s reforms in NZ, I recall them being very controversial. And for the UK, didn’t over 300 economists sign a letter saying that Margaret Thatcher’s policies were wrong? This idea that public trust was transferred to markets doesn’t match with my memories of this period.

By the time such agreements were feasible, in the 1980s, the balance of economic power had already shifted to financial markets.

What does this statement mean? For a start, what metric are you using to measure where the balance of economic power is at any point of time?

The global financial crisis has been, above all, a failure of models of financial regulation based on the EMH. …
. The EMH played a crucial role in designing these regulatory systems, which went through a variety of forms before their final embodiment in the Basel Accords ….

You don’t cite any specific reference for this role of the EMH. And if I look at the Basel Committee, I can’t see any support for the idea. For example, the Core Principles for Effective Banking Supervision, September 2007. http://www.bis.org/publ/bcbs30a.htm, doesn’t mention the efficient markets hypothesis anywhere and instead has statements like:

An essential part of any supervisory system is the evaluation of a bank’s policies, practices and procedures related to the granting of loans and making of investments and the ongoing management of the loan and investment portfolios.

(page 7 of the pdf)

This does not sound to me like Basel II was based on the EMH.

Furthermore, I googled Basel and “efficient markets hypothesis”. The first page returned two articles by you, one by the “New Left Review”, some chapter headings or course outlines for financial market courses or books, which cover both EMH and Basel II because both of them have to do with financial markets, and some articles which have Basel in them by accident (eg something to do with the University of Basel, or the blog’s called “The Baseline scenario”). Where are the papers by the developors of Basel where they talk about the EMH?

According to the EMH, market values of classes of risky assets are the best possible estimate of their value.

I didn’t know that EMH said anything at all about “classes of risky assets”. The strong form of the EMH says that you can’t beat the market even with all private and public knowledge, nothing in there about classes of risky assets or about how you would assign assets to classes of risk. After all, with stock market prices, all you have is a time series of prices. Those prices will be affected not only by beliefs about the future riskiness of the underlying product, but also by beliefs about the future average return of the underlying product. Perhaps my knowledge of mathematics was failing me, but I thought that if you only have the product of two numbers its impossible to work out what the original two numbers were. So even if the strong form of the EMH is true, how could you work out, using only market prices, how risky an asset is?

While the EMH does not have direct implications for the interpretation of agency ratings, the fact that such ratings are sought by bond issuers, implies, according to the EMH that the ratings contain valuable and reliable information, since they would otherwise be ignored.

Two points:
1. Actually all you need to assume is profit-seeking firms to get the implication that ratings contain valuable information. Moody’s has been around since 1909, and Standards & Poors since 1860, so they have thus survived two World Wars and the Great Depression. This inclines economists to say that there must be some value in rating agencies, independently of whether or not you can beat the market using public or private information. Of course the fact that something has been useful for a long time does not mean that it will always be useful in the future (eg horses were used in transport a lot longer than 150 years).

2. All that profit-seeking implies that the ratings are valuable, which is not necessarily the same as reliable. And reliable is not the same as infalliable.

The starting point for a stable regulatory regime must be a reversal of the burden of proof in relation to financial innovation.

You are aware that this rule means that no financial innovation will ever be permitted again, as it’s impossible to prove that something poses no risk?

And, while we’re at it, how about monetary innovation? If financial innovation is to be banned unless it can be proved to pose no risks, why shouldn’t we ban monetary innovation on the same basis? Keynesian economics is still an innovation, can you prove that it poses no risks?

I do agree with you that if we are going to insist on guaranteeing banks then taxpayers’ downside risk should be limited.

The EMH implies that governments can never outperform (well-informed) financial markets in making investment decisions.

Whatever the EMH may say, the case for reform and privitisation was not based on the EMH, but on theories like public choice theory and other theories coming from insitutional economics. To quote:

Officials, most notably within the Treasury, were also intensively following developments in microeconomic theories concerning public choice, market competition and governance: contracting issues including property rights, asymmetric information and transaction costs and institutional economics more generally.

page 7 of the pdf, page 1863 of the Journal of Economic Literature, Vol XXXIV (December 1996). http://people.stfx.ca/x2004/x2004ceg/Econ/Economic%20Reform%20in%20New%20Zealand.pdf
This paper was written by Lewis Evans, Arthur Grimes, Bryce Wilkinson and David Teece, and should be right on what NZ officials were thinking at the time, as Bryce Wilkinson was one of those officials at the New Zealand Treasury.

I don’t have Richard Prebble’s book about the 1980s NZ Labour government “I’ve Been Thinking” to hand, so I can’t quote from it, but from memory he attributes privitisation to a desire to control government costs, and the poor quality of service provision, I don’t recall anything in there about EMH.

On the other side, I had always understood that the main argument for government provision of services like telecommunications, water systems, electricity networks, etc, was that they were natural monopolies and thus profit-maximising companies would overcharge for their services, reducing consumer surplus, not that governments could do a better job of forecasting the future.

As for your examples, they’re interesting, to say the least. For a start, US electricity networks are, on the whole, regulated in the rates they can charge by the federal governments and the states (note, the USA is complicated enough that there are lots of exceptions to any general rule. See http://www.raponline.org/Pubs/ELECTRICITYTRANSMISSION.pdf)
So under the circumstances, if US utilities are under-investing in transmission, this is, if anything, an argument against a mixed economy. However, in the interests of fairness I will note that in my experience generally the US electricity people attribute problems with building transmission lines to increasing local opposition to any particular route, something that any economic system would have problems with.

As for California, Enron was able to manipulate the market because of bad rules, for example the system operator didn’t take account of transmission constraints when deciding which power plants to dispatch until the security run after gate closure. So Enron could offer a large plant behind a constrained transmission line at a very low price, the system would accept it, then when they did the security dispatch run realise that they couldn’t balance the power flows and have to run around finding last minute, and naturally expensive, sources of power, driving up wholesale prices. This was a short-term failure, not a long-term investment problem.

Meanwhile forestry companies, in countries where there are reasonable land property rights, appear to cope reasonably well, despite the long-term nature of their investments, and the big oil companies such as Shell and Exxon also make long-term capital investments. (This will probably attract people criticising them for the environmental record, but then many people criticise crop farming practices for their environmental record even though crop farming, operating on an annual basis, is a lot shorter-term than forestry or oil refining).

On the flipside, there are plenty of cases of governments making bad decisions from a long-term view, let’s take a serious long-term problem, if the models are right: global warming. There has been a general lack of action around the developed world on global warming. NZ had a Labour government from 1999 to 2008, and still GHG emissions rose, without any real policies implemented to stop the rise. Europe is only looking like meeting its Kyoto obligations because of the closure of inefficient Communist-era industrial plants in eastern Europe, and the switch to gas for power generation in UK as a result of the North Sea discoveries and conflict over coal supplies, both policies would have happened anyway. Canada – no real policies implemented. Japan – no real policies implemented.

And it’s not just global warming. Government decision-making about deep sea fishing is not promising. Canada let its Atlantic cod fishery collapse because the Canadian government refused to take the short-term costs of job losses despite clear warnings from scientists and a number of fishers themselves. And that was not a particularly risky decision, the idea that there is a maximum to the number of fish that can be caught before the fish species goes extinct is intuitively logical, there is some supporting empirical evidence from 19th century declines in whale fishing and other species’ extinctions, economics has long had a model of this. Furthermore, Canada in the 1980s was not particurlarly badly governed, as countries go. And finally, a similar sort of thing looks likely to happen in European Union waters. (Ironically, Roger Douglas’s Labour Government in the 1980s did manage to reform commercial fisheries to a more sustainable basis, though recreational fishing is still a problem).

Now perhaps you can attribute these failures to the governments elected to power at the relevant time periods. But if people in a variety of OECD countries with different cultural histories often elect governments that don’t make difficult long-term decisions then this implies to me a fundamental problem with relying on democractically-elected governments to make long-term investment decisions (and of course non-democratically elected governments have an even worse track record).

On the whole, the ability of governments to make good long-term decisions is not exactly obvious.

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Tim Wilkinson 08.06.09 at 12:43 pm

The othe Tim W @7: _while government could (might, may, is capable of) take into account the wider social interest there’s rather less evidence that they actually do……_

That’s the problem with voting so-called free-market types into government. You don’t get the benefit. Not that there’s actually anything free-market about the UK water industry. Nor that there’s even the possibility of its being a competitive market, what with it being a natural monopoly providing a unique indispensable human need and all that.

Certainly, water under CCRCV pricing is not a good candidate to fill the gap in In some cases *need some examples*, reliance on private capital has led to new and innovative investment strategies. Apparently some people called Cuthbert & Cuthbert have gone into some detail on that.

I’m assuming of course that ‘[new and] innovative’ was also meant to specify ‘socially beneficial’ or at least ‘not a blatant rip-off’. There might not be many of these, given we’re talking basically about outsourcing the management and financing of of utilities whose capital expenditure requirements are basically pretty obvious and largely determined by some kind of (government service level agreement.

There must (mustn’t there?) be an example somewhere. Maybe in the UK – railways? PFI? Clean power generation? Roads? Well, the privatisation fans out there will produce one soon enough no doubt.

There is a bit of a case for arguing that government regulation means that the EMH can’t really be apllied to privatised utilities at all though (as well as being a bit of a giveaway that privatisation is not a good way of dealing with them – to parody only slightly, every feature of markets is regulated away except profit.)

Tracy W @12: _I didn’t know that EMH said anything at all about “classes of risky assets”._
No, I suppose it doesn’t – in the same sense that the theory of gravity doesn’t say anything about apples.

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Tracy W 08.06.09 at 2:21 pm

Tim Wilkinson: No, I suppose it doesn’t – in the same sense that the theory of gravity doesn’t say anything about apples.

I am not sure of your point. Yes, Newton’s theory of gravity allows you to caculate the force that the Earth’s mass exerts on the apple’s mass and vice-versa, but if you know the force between two objects you can’t, from that alone, work back to figure out the mass of each individual object, let alone if one of them is an apple. Unless of course my knowledge of mathematics is failing me again. Your tone however sounds like you intended this statement as a rebuttal of my comment that EMH doesn’t say anything about “classes of risky assets”. Why did you introduce the analogy? Have I misunderstood your intent?

And what evidence could convince you that some cases of privitisation have worked? (I am not in the mood for a tedious argument where the grounds for success get changed all the time.)

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Richard H. Serlin 08.06.09 at 3:32 pm

“A nice point Richard. I guess there’s a dynamic story where the well-informed investors become rich enough to push things closer to equilibrium over time, but it may well be vulnerable to the same kind of criticism.”

Thanks John, but I would note that the story of the smart investors becoming richer over time and then eventually becoming rich enough to push all prices to the efficient level has severe problems in addition to the one I mentioned.

First, rich investors only live so long. Second, they don’t re-invest all of their wealth in the stock market; a lot gets spent, slowing, or preventing, the growth of their wealth. And, with the tendency of regression to the mean for children, and the fact that wealthy heirs can be much less motivated to work hard and gain skills, their children may not be highly skilled investors. Plus, they may not go into a field anything like investing. Third, the economy may create an equal or greater proportion of new wealth for people in fields other than investing, for example Bill Gates, a computer expert, not an investing expert. How the distribution of wealth in the world evolves depends much less on the amount of excess return of smart investors, than on other factors, just a few of which I’ve mentioned.

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Richard H. Serlin 08.06.09 at 3:48 pm

I should add: The world in general, and on average, has grown, and is growing, more educated and skilled over time, and this will improve the average level of skill of investors in evaluating stock prices and other assets, but as has been painfully well evidenced over the last 10 years, we’re still very far from the perfect efficiency zenith, and it may take many many generations to evolve very close to it, if we ever do. Moreover, along the way there can be decreases in the average level of investing skill, as stock investing has become much more popular among regular people, non professional and expert investors.

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Billikin 08.06.09 at 4:52 pm

Tracy W: ” Of course the fact that something has been useful for a long time does not mean that it will always be useful in the future (eg horses were used in transport a lot longer than 150 years).”

Don’t worry. The horse will make a comeback.

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Richard H. Serlin 08.06.09 at 5:23 pm

Sorry to be taking up so much space, but one more thing I think is important to mention with regard to the great percentage of stock market money that comes from non-expert investors (and will continue to come from them for at least a great while) is the principle-agent problem outlined in Schliefer and Vishney’s 1997 Journal of Finance paper, “The Limits of Arbitrage”: Non-expert investors can and often do hire experts, or people who claim to be experts, through mutual funds, etc. The problem is that if the stocks go down in the short run, the principles don’t know if this is temporary, or not temporary and the agent is just incompetent or mistaken. Principles will thus often pull out their money, and the agent can lose his job and reputation. Likewise, if the agent stays out of a greatly overvalued and dangerous bubble, he may temporarily underperform the market, and may get fired well before the bubble stops going up. This whole thing creates all kinds of serious problems, perverse incentives, and inefficiencies.

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Bruce 08.07.09 at 6:54 am

The theoretical analysis underlying the EMH shows that perfectly rational investors, operating in perfectly efficient financial markets, will produce the best possible estimate of the future value of any asset. The catastrophic failure of the EMH…

When you refer to the “failure of the EMH”, do you mean that it has failed to predict future values as well as other methods? The EMH is not a failure if it does not accurately predict future cash flows, nor is it a failure if there are large swings in asset prices. It is also not a failure if it does not result in most socially desirable outcome, because that it not a claim of the hypothesis.

The only thing the EMH claims is that it is relatively better than other estimates of future value. In order to demonstrate that the EMH is not the best estimate, it is necessary to provide a better estimate.

I am open to the possibility that there can be areas where market players have difficulty making certain bets, such as your example of speculators running out of money before bubbles burst. This may cause price inefficiency, which opens the door to alternatives. However the possibility of better methods of estimation does not demonstrate their existence.

I don’t have a clear picture of the alternative method you are proposing. Do you believe there exist superior models based on behavioural economics? Or are you hoping that such models will be created in the future? Or that the intuition of policy makers will provide a better guide?

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John Quiggin 08.07.09 at 10:06 am

Bruce, I mean that it has been possible for observers to diagnose bubbles and predict their collapse with reasonable accuracy. Such predictions, based on rules such as “if stock prices are way above historical P/E ratios, they will probably fall” constitute an alternative method.

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SusanC 08.07.09 at 11:36 am

I’m not sure that bubbles are a counterexample to EMH.

Suppose, for example, that an asset provides a steady stream of income until some external event happens, after which it provides no further income. (Imagine, for example, we play a game where cookies are taken out of a jar one at a time until we’re told the jar is empty, and at each stage we can bid on the rights to all the cookies that are left in the jar). Further, assume that the probability per unit time of the event occuring is decreasing. At any given time, the crash has either already happened or it hasn’t. Under EMH, the market price of the asset will rise until the external event happens. And yet, this is consistent with the probability of the external event eventually happening being 1.

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John Quiggin 08.07.09 at 12:10 pm

@SusanC I think this illustrates a point I was making in discussion with colleagues. If you can prove that the existence of bubbles is consistent with the EMH, you have the wrong definition of bubbles.

To illustrate in this case, it’s perfectly reasonable for Google’s stock price to rise in response to a more favorable reassessment of its prospects, even though the heat death of the universe will still put an end to the Internet search business someday. Substitute Google dividends for cookies and the example works fine.

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paul 08.07.09 at 4:24 pm

Another problem with hard-nosed speculators and bubbles (in addition to the market staying irrational longer than they stay solvent) is that you really need the speculators to be meta-meta-hardnosed. They need to be convinced that their valuation of the goods in question is the “true” one while at the same time being convinced that they don’t have any other information about prices, such as what the bubble peak might be or when the top of the bubble might be reached. Otherwise an HNS with finite funds will believe that the most profitable behavior is to ride the bubble rather than engaging in any transactions whose information content might mitigate it.

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Billikin 08.08.09 at 6:28 am

Sorry, paul, I do not understand.

paul: “Another problem with hard-nosed speculators and bubbles (in addition to the market staying irrational longer than they stay solvent) is that you really need the speculators to be meta-meta-hardnosed. They need to be convinced that their valuation of the goods in question is the “true” one while at the same time being convinced that they don’t have any other information about prices, such as what the bubble peak might be or when the top of the bubble might be reached.”

I have a little experience here, and I do not think that the speculator has to be convinced of anything except that the market price is wrong and which way it is wrong. I tried to have an estimate of the value to which the price would eventually return, but I certainly did not suffer any delusions about the accuracy of the estimate, which was always changing anyway.

” Otherwise an HNS with finite funds will believe that the most profitable behavior is to ride the bubble rather than engaging in any transactions whose information content might mitigate it.”

IMO, any person who tries to ride the bubble is a gambler, not a speculator. I always hedged, and never used leverage. What do you mean by “most profitable behavior”? If you try to maximize expected profit, rather than expected return on investment, you are headed for the poorhouse, especially if you are betting on bubbles.

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