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.

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.

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.

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?

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

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.

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.)

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.

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.

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.

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.

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.