This is more of a footnote to John’s post on the subject than a substantive contribution, but it struck me that, despite John having made the point otherwise, the debate in comments (here and on Asymmetrical Information still seemed to be based on a few commonly held fallacies about the efficient markets theory;
- that it is basically a neutral, academic theory with few implications for the real world
- that it is basically all about the stock market (to be honest, most of the discussion revolved around the US stock market)
- and that, to quote James Surowiecki, “whether or not markets are perfectly efficient, they’re better than any other capital allocation method that you can think of.
None of these are true.
The really dangerous application of efficient markets theory over its twenty-five year run as the state of the art in economics was its application by the IMF and World Bank to developing countries’ capital account regulations. Whatever one might have picked up on a brief tour through Chicago University, it is historical fact that the efficient market theory was not simply left on the sidelines by academics and occasionally drawn out as a homily against the perils of stock market speculation. Nobody involved in the development of the efficient markets theory ever thought that it ought to be quarantined in this manner. Quite the opposite; the people who put together the statistical evidence (such as it was) for the proposition that stock prices followed a random walk believed and stated that they were gathering evidence for Paul Samuelson’s contention that “Properly Anticipated Speculative Prices Fluctuate Randomly”; ie, that because the observed stock prices followed a random walk, this could be taken as evidence that all the information one might expect to determine those speculative prices, was already reflected in the price.
In other words, it was strongly believed by everyone involved that the efficient markets theory provided what can only be described as an informational free lunch. For the cost of establishing a market in traded securities (which is something that an advanced capitalist society would have to do anyway, in order to provide the convenience to investors of being able to convert their claims on long-term investment projects into liquid funds), we could gain, Ginsu-knives-style, a Delphic oracle that would also give s free information about the future and about cash flows. Belief in the existence of this sort of informational free lunch, by the way, is at the heart of James’s book “The Wisdom of Crowds”, and will also be at the heart of my review essay on it, which I am still procrastinating. Suffice it to say that the use of the phrase “free lunch” is intended to make the reader suspicious as to whether one should uncritically accept such a miraculous and politically convenient (for a number of people) piece of theorising as the efficient markets concept.
Once the world was in the grip of efficient markets as a concept (and the IMF was in the grip of what Joe Stiglitz has memorably called “third-rate students from first-rate universities”, a first-rate university being what Chicago indisputably is), it was hardly surprising that the concept would find itself being applied to the most pressing capital allocation problem of the age; the need to industrialise the Third World. “Development economics” as a sub-field of economic geography rapidly withered on the vine – and who wouldn’t let fruit wither on the vine if they had a free lunch? – as it became conventional wisdom that all one had to do was to open up a country’s capital markets to foreign speculation and sit back and watch. The idea being that markets were efficient, so capital would flow naturally to where it could be best used, in the process providing a better signal to emerging market governments about the correctness of their policy mix than mere humans at the IMF could ever offer. That was the plan.
Well, we all know how that worked out. A “bubble” and “panic” are all rather amusing when they affect funny speculative technology companies with amusing names and young arrogant staff in Aeron chairs. When they affect an entire economy, throwing millions out of work in a country with no functional welfare state, they are rather less of a laugh. And the “emerging markets”(as developing countries were rebranded) proved to be extraordinarily susceptible to booms and crashes. What happened was that when First World interest rates fell, money would flood into a developing country which had become fashionable, vastly in excess of any realistic assessment of the productive investment opportunities there. Because it couldn’t be credibly invested, this surplus money would usually finance a consumption boom, a current account deficit and an appreciation of the exchange rate. After a while, the country would become “uncompetitive” and the money would flood back out again, leaving the economy to deal with a now-unsustainable current account deficit. The only way to deal with this would be to push up the domestic interest rate, which usually had the effect of causing a serious recession. If the country was unlucky, this recession could easily lead to a bank collapse, the proposed solution to which was to “open up the banking sector to foreign capital”. Lather, rinse, repeat.
It’s a tragicomedy which has played itself out across Latin America and Southeast Asia several times. The efficient markets theory was an academic theory which had genuine, massive human consequences, and they were all baleful. Which is why the academics who are still driving stakes into the heart of the efficient markets theory are doing vital work, and why Crooked Timber will, hopefully, continue to put a few digs in ourselves if we see it popping up shoots on the Internet.
Which is the answer to the last point raised in the bulleted list above. In many important cases, there quite clearly is a better alternative method of capital allocation than unfettered free markets. Markets have their place in the development of an economy, but only as part of an overall policy mix which includes careful sequencing of deregulation, oversight of institutional development and which often requires capital controls and other overrides or “circuit-breakers” when free market solutions appear to be delivering a destructive or irrational allocation. And this all requires a little thing known as planning. It’s a difficult problem to solve, to be sure, but no more difficult than brain surgery and not so difficult that Chile, China and Malaysia don’t appear to have done rather better at it than geodemographically similar countries who have left themselves to the tender mercies of unfettered free markets.
{ 68 comments }
Ian Dew-Becker 07.22.04 at 6:26 pm
You never gave a method of capital allocation that is better than free markets. I understand your point about circuit-breakers, gradual deregulation, automatic stabilizers, etc. But all of those things go along with a market system. The free lunch is still there, you just want to filter the information that comes out of it. I guess the only other way to take your post would be that you’re in favor of a completely planned economy, which would be pretty disappointing considering you cite the case of China, a country that has succeded precisely because it opened its markets.
Surowiecki’s point still stands, the market is the thing, its just a matter of protecting from its few cases of irrationality.
dsquared 07.22.04 at 6:32 pm
You never gave a method of capital allocation that is better than free markets.
I thought I did; free markets plus oversight, circuit breakers and planed sequencing is not the same as free markets. It’s what we used to call a “mixed economy”. These things very definitely don’t “go along” with a market system; it’s not so long ago that the IMF would regard them as grounds for turning down loan requests.
China has succeeded precisely because it has opened some of its markets, gradually, on its own terms. That’s not “the wisdom of crowds”; that’s careful planning.
James Surowiecki 07.22.04 at 6:50 pm
I don’t mean to turn this into a discussion of my book, or anticipate Daniel’s forthcoming demolition of my work, but I do think that saying I believe unfettered asset markets to be uncluttered founts of wisdom is a radical misreading of “The Wisdom of Crowds.” When I write that there are stretches “when markets are indisputably ruled by emotion and are systematically wrong,” that they’re “fertile ground for speculation,” and when I quote Keynes — wrongly, as I now know, thanks to John — about markets ability to stay wrong longer than you can stay solvent, I mean what I say. “[F]inancial markets are decidedly imperfect at tapping into collective wisdom, especially relative to other methods of doing so,” is what I wrote in the book, and what I still think now. And I’m hardly opposed, in principle, to the careful sequencing of deregulation or regulation of institutional development (though I think the planners working on these would do well to rely on collective decision-making techniques rather than concentrating power in the hands of one or two decisionmakers).
Having said all that, I don’t think it’ll do to just say that “planning” is necessary “when free market solutions appear to be delivering a destructive or irrational allocation.” We need to know how the planning should be done — I, for instance, would have a lot more confidence in it if it reflected the collective judgment of a diverse, independent crowd of analysts and thinkers rather than being made by an individual — and we need to know what the theoretical justification is for thinking that it will be done better. The examples of China, Malaysia, and Chile are interesting, but hardly definitive. And the record of banks in lending to the Third World — to say nothing of the historical record in the US of speculative bubbles and panics in bank lending — don’t exactly inspire confidence in the ability of a few supposedly well-informed planners (if you think of individual bankers making loans as analogous to planners allocating capital) to consistently make intelligent decisions.
To my mind, the choice has never been between “unfettered free markets” and “free markets plus planning” (which seems to be roughly Daniel’s choice). (The simple fact that currency values are set, in large part, by governmental decisions means that planning is integral to today’s markets.) The job is figuring out the right balance between markets, regulations, and state intervention, and that’s a balance that will be different in different situations. (I don’t, for instance, think the US government should spend much time worrying about how the US stock market values companies.) I think this thing I call the wisdom of crowds can be of use in making all three of those phenomena work better, but the right conditions have to be in place for that to happen.
Finally, figuring out the proper allocation of capital, etc., is much much harder than brain surgery.
James Surowiecki 07.22.04 at 7:07 pm
Daniel, I don’t think you can say with such certainty that “China has succeeded precisely because it has opened some of its markets, gradually, on its own terms.” What’s the control group here? Where’s the other billion-person country, in the one region of the world where many countries have successfully made the leap to healthy development, that took a more unfettered-market approach than China and failed? There isn’t one, so how do we know what, of all the genuinely unique things about China, accounts for its relative success? Hong Kong and Singapore, of course, took a radically different approach to development, and while you may — as I know you do — write them off as historically singular, it’s not clear to me why their singularity is any greater than China’s.
In any case, it all seems to depend on where you put your emphasis. In 2004, China relies less on free markets than the Chicago School would recommend, but far more on free markets than it did pre-1978 or even pre-1990s. Perhaps this is evidence against the wisdom of crowds, but I’ll respectfully disagree.
dsquared 07.22.04 at 7:14 pm
Indonesia.
praktike 07.22.04 at 7:22 pm
Amen.
Another point worth making is that the efficient markets theory has had a rather toxic effect on your average person’s belief that development aid can, in fact, be effective. So not only has it done harm in its application, it has done harm to the very concept of third world development itself.
dsquared 07.22.04 at 7:25 pm
In fact, in general I submit the natural experiment of the 1997-99 Southeast Asian crisis. Countries involved in that crises did better or worse depending on how quickly and how thoroughly they disengaged from the market.
I would also teasingly ask exactly where one might go to find a large crowd of informed, independent analysts to answer the question of whether Malaysia should have capital controls. Everyone in the crowd had an iron in the fire; there was simply nobody whose main concern was the Malaysian economy apart from Ibrahim and Mahathir.
praktike 07.22.04 at 7:27 pm
What about India? It seems like it’s a case worth studying here.
Jonathan Goldberg 07.22.04 at 7:32 pm
Re:
Which is why the academics who are still driving stakes into the heart of the efficient markets theory are doing vital work
would you, for the benefit of the civilians present, cite a few specific examples?
Sebastian Holsclaw 07.22.04 at 7:57 pm
“The efficient markets theory was an academic theory which had genuine, massive human consequences, and they were all baleful. Which is why the academics who are still driving stakes into the heart of the efficient markets theory are doing vital work, and why Crooked Timber will, hopefully, continue to put a few digs in ourselves if we see it popping up shoots on the Internet.”
I have no dog in this economics-theory fight. I will however note the irony of decrying the baleful effects of a particular academic theory while suggesting ‘planning’ as the cure. Will this planning be divorced from baleful academic theory with massive human consequences? I suspect not. Will this ‘planning’ be relatively free from political gamemanship, or will it be done by governments?
Walt Pohl 07.22.04 at 8:03 pm
James: I’ve always thought you were a terrific writer, and I was sorry when you left Slate. But I’m having trouble figuring out what the thesis of your book is. Since no one is suggesting that the US abandon capital markets completely, and since you’ve already conceded Daniel’s main point (capital markets can require government intervention in reaction to crises), I’m not sure what you’re arguing against.
Jason 07.22.04 at 8:18 pm
d2, I don’t quite get what you mean by unfettered. No laws leads to anarchism. Even in largely market-driven countries like the US, the markets talked about are highly regulated. Also, Indonesia is a fairly good illustrative example (2/3 the GDP per capita of China), but they have a number of disadantages China doesn’t have. A less secular, less well integrated population, with religous and racial conflicts. It would seem better to me to compare China and India (although even there, the work and education ethics differ greatly).
James, do you have any other mechanisms in mind for determining public opinion/wisdom (or do we have to buy the book to get your thoughts on this :))?
dsquared 07.22.04 at 8:31 pm
I’m specifically arguing against the proposition that it is not possible for a well-informed individual to know better than the markets whether the market is proposing a capital allocation that makes sense (or more weakly, that this does not happen often enough to be worth making the basis of policy). I believe that this proposition is false, and that blind faith in the belief that it is true has been extremely damaging.
abb1 07.22.04 at 8:33 pm
I am not an economist, but I thought this has been known since the great depression: unregulated market is destined to limp along in a boom-to-bust cycle. If there is no regulatory intervention at all, then, eventually, you’ll see a huge bubble (overproduction) followed by such severe depression that it’ll wipe out the system. I mean, isn’t this common knowledge?
Carlos 07.22.04 at 8:45 pm
… Indonesia as a control group to China in the post-1978 period? Doug M’s on vacation, but hell, even I can think of six different reasons why that makes no sense at all.
McDuff 07.22.04 at 8:53 pm
“Even in largely market-driven countries like the US, the markets talked about are highly regulated.”
This is, indeed, correct. However, the Washington Consensus is considerably more ‘liberal’ as regards the implementation of capital controls in third world countries. The USA and the EU would reject the IMF’s proscriptions for their own economies, yet economies with less muscle are often held to the knifepoint of debt and forced to implement these destructive policies.
The West does not lead by example.
chun the unavoidable 07.22.04 at 8:56 pm
Has anyone ever really believed this? I know that people have claimed to believe it, with the aforementioned disastrous consequences, but aren’t there better (and more elegant) explanations that center around the concept of ideology or the ignoble lie, for example?
James Surowiecki 07.22.04 at 9:46 pm
Daniel, in the case of Malaysia I would hope that there were a host of diverse, independent Malaysians — in the Finance Ministry, etc. — who could have been relied on, and I have no doubt that their collective judgment (not just about whether to impose capital controls, but about how long to impose, how drastic they should be, etc.) would have been better than the individual judgment of Mahathir.
More generally, I’m perplexed by the criteria you’re using in order to demonstrate the superiority of individual planners to markets. Surely any reasonable accounting of the records of the two strategies would have to include the endless number of disastrous allocations of capital made by government planners, including not just the dismal record of socialist and Communist regimes but also the 3300 or so dams built in India in the past three decades; the urban-renewal programs in the US in the 1960s and 1970s; the capital-allocation decisions made by African rulers in the postcolonial period; Japan’s overinvestment in public works and its ill-conceived gamble on HDTV, etc. As I said, I’m not a believer in the infallibility of unfettered markets, but I’m not sure that in the face of the historical record pointing to the difference between Indonesia and Malaysia is definitive proof of the genius of government planners.
As to the more general proposition that you’re arguing against, it’s not enough, I think, to argue that it’s possible for a well-informed individual to consistently know better than the markets when a capital allocation is making sense. It also needs to be demonstrated that we can identify that individual ahead of time.
Ann 07.22.04 at 10:01 pm
“China has succeeded precisely because it has opened some of its markets, gradually, on its own terms.”
Isn’t it a bit early to say that China has succeeded? It still has a long way to go, and could blow up at any time (taking Taiwan with it). It has done remarkably little about state-owned enterprises, it has manufactured its own AIDS crisis, and the mishandling of the SARS epidemic should show some gaps in its ability to handle problems through planning.
China has come a long way, partly because the Chinese Communist Party first had the foresight to beat the economy to shreds for years, making quick growth off the bottom more feasible. But if you’ve watched the details of the development of the Chinese economy, China is, if anything, an example of how markets can take off and help a country grow in spite of the interference of government.
Keep in mind, we need to consider the various types of regulation. US securities markets have been relatively efficient because regulation has focused on providing sufficient information for investors to make their own decisions. Many countries have instead tried to protect investors by pre-screening companies, thus letting government bureaucrats pick the winners and losers. This tends to be vastly inefficient, as well as an invitation for corruption.
So, it depends on what type of “planning” you’re talking about. If it’s the Chinese Communist Party type, it’s not going to help.
Ian Dew-Becker 07.22.04 at 10:03 pm
This whole argument seems to rest on really abstract grounds. To just in general talk about human intervention in a market doesn’t mean much. There are lots of levels of intervention. I don’t believe that a person can possibly involve themselves in the daily operations of the market and produce a better outcome than the market would have on its own. Myabe certain macro-level controls are needed, but they still rely in the end on the wisdom of the market.
And as for China, there are a couple of problems with using it as your example. First off, protection for nascent industries has been shown to keep them in nascent stages permanently. Having high tariffs until an industry becomes competitive keeps it from ever becoming competitive. Second, a lot of what China has done isn’t so much market intervention, but the selective industiral espionage and flouting of property rights that the United States also used in its economic infancy in the early 19th century. The British were doing everything they could to keep plans of textile mills secret but we paid people to smuggle then out (see Chernow’s book). China is doing many of the same sorts of things through stealing, dumping, and ignoring patent and copyright laws.
Daniel Drezner 07.22.04 at 10:08 pm
How did you arrive at this conclusion? By what metric?
My recollection is that Malaysia’s performance was neither better nor worse than most of the other affected countries. It’s true that Malaysia suffered less than Indonesia, but so did every other country during the crisis.
Indonesia’s unbelievable corrupt-monopoly-rampant pre-1998 economy not a great example of being engaged with the market.
Daniel Drezner 07.22.04 at 10:09 pm
How did you arrive at this conclusion? By what metric?
My recollection is that Malaysia’s performance was neither better nor worse than most of the other affected countries. It’s true that Malaysia suffered less than Indonesia, but so did every other country during the crisis.
Indonesia’s unbelievably corrupt-monopoly-rampant pre-1998 economy not a great example of being engaged with the market.
James Surowiecki 07.22.04 at 10:12 pm
Walt, the book’s thesis is simply that under the right circumstances, groups are very smart, and are often smarter than even the smartest person in them. It’s not really an argument for markets vs. planners (most of the book is not about markets per se), so much as it is a general argument for relying on collective judgments — which are the product of aggregating lots of individual, independent judgments — rather than relying on a single expert. Markets are one way of reaching those collective judgments, but to answer Jonathan’s question there are other methods that work very well: parimutuel pools, the algorithm Google uses to aggregate the judgment of Web sites, and even simple schemes that aggregate numerical forecasts. Regardless, I think the evidence is overwhelming that over time, relying on the collective judgment of a group of people working to solve the same problem will maximize your chances of getting the right answer — or picking the best option from among a set of choices.
I don’t write about development in the book, or about capital crises in any great detail, but one of the obvious problems with most asset markets (and the reason I say that they’re decidedly imperfect), is that not everyone in them is really working on the same problem, which is to say that not everyone is really trying to forecast the net present value of all the potential investments. (Some people are momentum trading, some are just herding in order not to get left behind, some are simply speculating, etc.) This is in contrast to, say, bettors at the racetrack, where every bettor really is trying to predict the chances of victory of the different horses. For this reason and others — there’s no definitive outcome in most asset markets, as opposed to the track — asset markets are far more volatile and less reliable.
On the other hand, I think there is little evidence that individual politicians or policymakers are going to consistently offer better judgments about net present value, either. So I don’t think simply invoking planning as a solution is enough.
dsquared 07.22.04 at 10:13 pm
I don’t believe that a person can possibly involve themselves in the daily operations of the market and produce a better outcome than the market would have on its own
Well, you’re wrong. Example, the Southeast Asian crisis of 1997-99. Paul Krugman spotted that the Asian economies would be much better off introducing capital controls and cutting off the market, and the countries which believed him did better than those who allowed the market to operate on its own.
Which I think also stands as an answer to James; there are plenty enough times when more or less any well-informed individual can see that the market has got it wrong, and to pretend otherwise is just abrogation of responsibility on the part of elected representatives.
abb1 07.22.04 at 10:14 pm
…when a capital allocation is making sense…
This whole line of resoning is making no sense. Making sense to whom? Compare to what?
So far a couple things seem to have been demonstrated empirically:
1. an unregulated market system will relatively quickly self-destruct and
2. a centrally-controlled system will eventually self-destruct although, apparently, not that quickly.
Well – doh. This is quite trivial. Obviously a hybrid is going to be more stable and effective than any extreme. What kind of hybrid – it depends on a particular economy.
The US economy (especially the hi-tech and pharma) is, actually, highly centralized: most of the R&D (which is really the heart of it) is financed and managed by the government, mostly via the Pentagon.
Ann 07.22.04 at 10:14 pm
Regarding “the natural experiment of the 1997-99 Southeast Asian crisis”, countries such as India and the Philippines (and China) prided themselves on largely missing the Asian flu, but the same countries had also largely missed the enormous growth that preceded it.
Malaysia disengaged its currency quickly, and it seems to have worked out fairly well in the end. But much of their success was not from locking in a high exchange rate before it could crash completely. They actually ended up locking in a fairly low exchange rate that helped them to outgrow other countries whose currencies had started to recover. In other words, much of the success came because they didn’t manage to do what they had planned.
You can’t blame the whole Asian crisis on markets, foreign speculators or exchange rate policy. I was living in Asia at the time, teaching MBAs and undergraduate business majors, and there were obvious weaknesses in the markets that no one wanted to address during the boom. Students didn’t want to hear about corporate governance or regulation, and the high growth rates of the Asian tigers was considered proof that Asian ways of doing business (including corruption and nepotism, plus weak accounting and disclosure rules) must be optimal.
Again, it comes back to what you mean by planning – regulations to enhance competition and transparency, or central planning?
Ian Dew-Becker 07.22.04 at 10:18 pm
When I say daily operations I mean micro-managing the market. I realize that on certain days somebody is going to come in and propose a solution. That doesn’t mean that every day there should be some change forced on capital allocation by outsiders. You still haven’t proposed a system better than capital markets, only a bunch of ad hoc patches.
chun the unavoidable 07.22.04 at 10:21 pm
I think the most telling bit of evidence about the superiority of unfettered free markets is the total support that large corporations have for them. ADM is the paradigmatic American example.
abb1 07.22.04 at 10:31 pm
This is sarcasm, right? Price-fixing ADM – heh, heh. Good one.
dsquared 07.22.04 at 10:35 pm
To be honest, I think I’ve said all I have on this. Recapitulating my own points and (I think) a few of John’s:
1. Markets are not efficient in the technical sense referred to in John’s post.
2. Because of this, it is not always the case that market prices incorporate all available information.
3. Because of this, it is reasonable to suppose that there will be periods during which market prices incorporate hardly any information at all.
4. Because of this, it is reasonable to suppose that there will be periods during which a sensible policy-maker will be justified in taking a calculated risk in interfering with the normal operation of markets.
5. Because of this, institutional frameworks which do not all policymakers to override market outcomes are dangerous and should not have been recommended between 1978 and 2000.
John Quiggin 07.22.04 at 10:39 pm
Just a point on the focus on US stock markets. The stock market is not the most interesting case of the EMH in policy terms, but it’s excellent for testing, since the conditions for EMH are met as closely as its possible to imagine a market meeting them.
There are large numbers of participants, markets are liquid on every time-scale from seconds to years, there’s a strong legal framework, no significant government trading activity, long-established and highly-sophisticated financial institutions and so on. If EMH fails here, it fails everywhere.
Maynard Handley 07.22.04 at 10:42 pm
Why do you hate America so, Daniel?
John Quiggin 07.22.04 at 10:43 pm
Jonathan, if you want examples of academics driving stakes into the heart of the EMH, a good place to start is Robert Shiller’s book Irrational Exuberance.
James Surowiecki 07.22.04 at 10:47 pm
Daniel, I’ll just echo Ian here. The question is what’s the best system for making decisions about capital allocation on a daily basis. The fact that Paul Krugman was right about capital controls in 1997-1998 doesn’t mean that he’d be right about how capital should be allocated now. I’m less convinced than you, obviously I guess, that the judgment of individual leaders about complex questions of fact and about an uncertain future is likely to be consistently — and it has to be consistently — better than that of the crowd. Would you really want to trust the day-to-day allocation of investment and capital in Malaysia to Mahathir or his successor –or even to Paul Krugman?
Walt Pohl 07.22.04 at 10:50 pm
James: I see. I hope no one would really disagree with your thesis. :-) Another example would be democracy itself. I know lots of people who believe that a benevolent dictator would provide a better government than a democracy, but unless that dictator is omniscient as well, there’s no way that the dictator will be able to match the information-processing ability of a democracy.
Ian: Three unrelated comments:
1. Daniel isn’t proposing an alternate system, he’s trying to kill off the efficient market hypothesis. The EMT is not just a claim that capital markets are a better method of capital allocation, but a _perfect_ method.
Also, didn’t Japan initially protect its fledging industries from foreign competition? (It’s been so long that I don’t remember.)
Chun: Some people really did believe the EMT. While I’m sure that there was an ideological component, the theory itself fairly seductive in its full mathematical glory.
Maynard Handley 07.22.04 at 10:55 pm
There isn’t one, so how do we know what, of all the genuinely unique things about China, accounts for its relative success? Hong Kong and Singapore, of course, took a radically different approach to development,
Something that is not pointed out nearly enough about Taiwan and Hong Kong is that they were NOT just dirt poor scraps of land that made themselves up through hard work etc. They were, in fact, populated by a very select group of people who possessed a fair damn amount of starting capital, namely the refugees from China in the wake of the Communist takeover in 1949, fleeing with diamonds, gold bars, art and so on.
Given such a starting population and circumstances undoubtedly made things a lot easier. It’s a lot easier to make steel when your starting point is pure iron and a blast furnace than when it is two rock to bang together.
In this respect, South Korea and Japan are more realistic starting points — but sadly they involved substantial state presence, so they of course prove Daniel’s point.
James Surowiecki 07.22.04 at 11:01 pm
Having said all that, I agree with Daniel’s points 4 and 5, although I would replace “policymaker” with “group of policymakers.”It seems to me that the real challenges are figuring out how to maximize the chances that the “policymaker” is sensible (relying on the collective judgment of government analysts and policymakers rather than the judgment of a single politican would help), as well as how to guarantee that interventions during times when markets are, in Daniel’s sense, failing don’t become justifications for interventions in the everyday process of allocating capital.
abb1 07.22.04 at 11:32 pm
Just a point on the focus on US stock markets. … There are large numbers of participants, markets are liquid on every time-scale from seconds to years, there’s a strong legal framework, no significant government trading activity, long-established and highly-sophisticated financial institutions and so on.
Hardly. Rather, there are a handful of large institutions (mutual funds, investment companies, company insiders) who control a significant portion of the market. They have enough leverage to manipulate the “capital allocation” to their personal and institutional advantage – as in the California energy farce a few years ago.
Less central control means more cronyism and so – alas – in the real life you will never get your ideal model, I am afraid.
praktike 07.22.04 at 11:44 pm
Isn’t the debate really about whether markets are efficient under all conditions?
Atrios 07.22.04 at 11:46 pm
Should we do away with trading curbs on the NYSE?
discuss.
praktike 07.23.04 at 12:32 am
A further point.
And doesn’t the good Mr. Surowiecki, bless his heart, admit that his thesis is based on certain conditions being in place?
Well then, I’m glad we all agree.
cure 07.23.04 at 2:05 am
On the Asian Financial Crisis and Malaysia’s “escape”: Yes, Malaysia came out of the AFC much better than many of their neighbors (Thailand, Indonesia). Yes, their use of cap controls contributed. Yes, the herd mentality of the intl. financial markets caused the initial cashflow problems in SE Asia (Thailand really had no structural problems aside from too many 90-day loans which started getting hammered when the Thai Bank ran out of funds to maintain the stable exchange rate – Indonesia’s problems lasted much longer, for instance, because of the cronyism).
BUT…this does not imply that cap controls are necessarily a good thing, or that open capital markets are a bad thing, for developing countries. First, Malaysia will see a decade or two of decreased overseas investment; who would invest in a country that now has a history of restricting your ability to get your money out? Second, Malaysia’s Civil Service is quite competent, and handled the capital controls in a manner that didn’t ruin the economy. Do I trust the Bank of every country to handle matters so well? Of course not.
Here’s one main reason why: As far as I can see, there were racial issues involved in the Malaysia capital controls decision. The bumiputera (Malay + ethnic Bornean) population was generally involved in govt. and local production, while the Chinese Malay and Indian Malay populations were heavily invested in trade. The cap control decision was primarily based on political grounds, not economic grounds. Further, governments, especially quasidemocracies like Malaysia, often make decisions on political grounds. The intl. markets won’t do that.
With closed cap markets, you get less variance, but you also get less future investment and more politicization of the economy. I don’t necessarily know that that’s a good tradeoff.
Ann 07.23.04 at 2:40 am
South Korea and Japan had a “substantial state presence”, but is that what made them succeed? Look at Japan – the strong, successful industries are those that faced foreign competition (through exporting). Industries that have been sheltered (banking, retail, etc.) are pathetic. Japanese and South Koreans have recognised for more than a decade that they need to get away from state guidance of investment (although they’re having a hard time actually doing it). Taiwan, on the other hand, has many strong, dynamic medium-size companies, rather than a few behemoths.
One problem with Daniel’s points 4 and 5 is that there’s no guarantee that decisions will be made by a “sensible” policymaker. The democracy/dictatorship comparison is good. Everyone points to Singapore as an example that strong government control can work well. But for every Lee Kuan Yew, there are far too many Ferdinand Marcoses, Robert Mugabes and Mohamed Suhartos. To compare government control to regulated markets, we have to factor in the probability that decision makers will be affected by greed, stupidity and/or laziness.
One way to think of it is in terms of diversification. Markets sometimes fall victim to herd mentality, but even then there are some looking to profit from the mistakes of others – enough of them will stop the market from going too far in the wrong direction. With central control, there’s a risk that the entire system will go horribly wrong.
Think of what Mao accomplished – during the Great Leap Forward, he managed to bring famine to all of China, Tibet and Xinjiang at once. There had long been periodic famines in China (although there had been amazingly few in Tibet), but to impose disaster on all corners of such a huge, geographically-diverse area at one time was an unprecedented feat, one that would have been impossible if markets had been allowed to function.
Atrios 07.23.04 at 4:15 am
Yes. It’s either free markets or Mao.
decisions, decisions…
q 07.23.04 at 4:50 am
James says: _The job is figuring out the right balance between markets, regulations, and state intervention, and that’s a balance that will be different in different situations._
Now who could disagree with the above tautological proposition? (No sir I want the WRONG balance!) It makes you wonder why the debate exists at all.
The right balance = the devil is in the detail.
Let’s take a specific example (one among 000s): WTO rules will allow the market to rule which means large efficient companies, will extinguish smaller companies. Many large companies are being run for the interests of a minority of the world’s population (although more may benefit indirectly). THEREFORE WTO liberalisation potentially means a polarising of power in the hands of a few: Open market leads to increasing inequality – capital income share up, labour income share down.
A refusal to accept that any planned or managed approach could work is ideologically attractive to those with most of the money! Who is that?
s_bethy 07.23.04 at 4:54 am
I know this isn’t quite on point, but I can’t resist pointing out that you are debating this capital allocation stuff over a medium that received at least twenty years of government funded development before being liberated to the tender mercies of The Market.
John Humphreys 07.23.04 at 5:59 am
q – nearly everything you say about the WTO is dodgy, starting with the idea that WTO rules allow the market to rule.
It is not hard to make many abstract arguments for planning. Nearly the entire economics profession fell for this in the early 20th century. The problem is identifying exactly what this new government institution is going to do and how you’re going to ensure it does a better job. If you had the option of creating a government body that only made the right choices… then fine. Can somebody please name such a government body?
q 07.23.04 at 6:25 am
James says: _The job is figuring out the right balance between markets, regulations, and state intervention, and that’s a balance that will be different in different situations._
John says: _The problem is identifying exactly what this new government institution is going to do and how you’re going to ensure it does a better job._
There is a tautologically true ECHO chamber in this thread. (No, Sir, How do I make sure it does a worse job?)
A refusal to accept that any planned or managed approach could work is ideologically attractive to those with most of the money! Who is that?
(the ECHO back)
Andrew Boucher 07.23.04 at 6:44 am
” …As in the California energy farce a few years ago.” That of course wasn’t the stock market but a new-fangled commodities market. So I think John is right in his reasons for focusing on stock markets.
Somebody’s already said it, but I’ll repeat it since it’s my view as well. Discrediting the EMT is easy because it’s making a universal claim and needs the world to be perfect in order to be true; it’s saying that in all cases this is what happens. And, under all versions of the thesis (strong, semi-weak, weak…), there are cases when it doesn’t hold. The world’s not perfect.
On the other hand that doesn’t invalidate the use of markets, because they might still be better than the alternative. Planners sometimes get it wrong; they sometimes get it right, of course, but they can be wrong. Choosing one data point (look at China!) hardly advances the issue. China may have been lucky rather than good.
Krugman might have been right about the Asian markets, but that doesn’t mean that he will be right the next time. To finish as tangentially as possible, my impression of Krugman is that he sometimes makes predictions which are opposites – e.g. (from my perspective anyway) predicting one week there will be deflation and the next week that there will be inflation; this way it’s easy always to be right. So I think before we crown King Krugman, I’d prefer to see the historical record of everything he wrote in the Asian period, and not just items selected post hoc.
abb1 07.23.04 at 7:12 am
†…As in the California energy farce a few years ago.†That of course wasn’t the stock market but a new-fangled commodities market. So I think John is right in his reasons for focusing on stock markets.
Stock market is the derivative of commodities markets. Basically, the system is corrupt throughout and the stock market is no top of it – corrupted itself plus reflecting the combination of all inperfections below – Enron’s share price goes up.
Cheers.
John Quiggin 07.23.04 at 8:07 am
As it happens, I was just thinking about posting on EMH and the energy farce and will now get moving on it.
Matthew 07.23.04 at 8:43 am
I think the planners working on these would do well to rely on collective decision-making techniques rather than concentrating power in the hands of one or two decisionmakers.
I find this statement considerably ironic, given that the woeful decisions forcing 3rd-world countries to have their economies open were made by small comittees, behind closed doors (at the IMF, etc.) by unelected bureaucrats, mainly informed by the finance ministers of the lending countries. Not suprisingly, the interests of the financial industry were heavily reflected in those decisions. They were not made democratic by being market-driven.
So instead of being vaguely afraid of regulation by conflating it with communism, one should examine who had an interest in voodoo economics, the wisdom of a tiny clique.
And yes, in the first world the consensus is that we have to find the right balance between markets, regulations, and state intervention, that’s the essence of Daniel’s post, but that is not what the free-marketers are saying. And that’s not what was (is?) applied to poor countries…
Mrs Tilton 07.23.04 at 11:11 am
if you want examples of academics driving stakes into the heart of the EMH, a good place to start is Robert Shiller’s book Irrational Exuberance.
And if you want a rather less academic, but entertaining example, try Edward Chancellor’s Devil Take the Hindmost.
Quant à moi, and limited to the stock markets, the EMH is, for all its occasional failures and for all the legitimate caveats one can raise, in its weak to semi-strong form a pretty useful working assumption (so long as one also assumes an adequately liquid stock that receives adequate coverage by analysts).
It’s not the Law of Gravity. But it does lend gravity to the law: it is the theoretical underpinning of the fraud-on-the-market concept. Let us say that I hold shares in a mining company (indeed, let us say it is a company rather like this one). The company has just discovered that it owns a massive and valuable deposit of copper. As rumours of the find begin to spread, the company states publicly (and in bad faith) that, no, there is no copper here. The share plummets. I sell – but not because I have been following the copper story; I simply looked at the price, thought the stock a dog, and decided to get out. A week later, the company says, hang on, we do have a lot of copper. The share takes off, which would make me very happy, if only I had not sold at the lower price. It is the fraud-on-the-market theory that gives me a cause of action. And it does so because it assumes, under less-than-strong EMH, that the market will quickly build all publicly-available information (including, in this case, false information, and hence the fraud) into the price of (adequately liquid, adequately covered) shares. If this is the case, then I am a victim of the fraud even though my decision to sell was not made on the basis of the false denial of the copper deposit. That the shares of the mining company did not rise despite the company’s initial denial of a new copper deposit suggests that strong-form EMH is bollocks; that the share fell after the first statement and rose upon the second suggests that less-than-strong EMH is not.
Some in this comments thread have suggested that a general acceptance of EMH serves the interests of Big Evil Corporations, and so BECs take pains to see that it remains accepted. EMH certainly doesn’t always serve the interests of BECs that are publicly traded and subject to American securities laws.(1) If it is the BECs that are behind all this, then what I would expect to see is a huge effort by BECs and their lickspittle hirelings to make EMH, and with it the fraud-on-the-market theory, go away. I’m not certain one can say this has happened.
(1) More precisely, the interests of the BEC’s management. What the ‘true’ interests of a firm are, and whether they can or should be anything other than the aggregate interest of its shareholders, is a question for another day.
dsquared 07.23.04 at 11:44 am
On the other hand that doesn’t invalidate the use of markets, because they might still be better than the alternative
Not wanting to be a dick here, but it took me an hour and a half to write the parent post and stuff it chock full of examples of when they weren’t better than the alternative and I’m getting rather frustrated that nobody seems to have bothered to read it. Planners sometimes make mistakes. Markets also, sometimes make mistakes. Which is why a combination of planning and markets outperforms a pure version of either solution, particularly when a pattern can be recognised in the kind of mistakes that markets make.
Mrs T: I happen to have a vague friend-of-friend connection to someone who claims to have brought the first ever “fraud on the market” claim in a US Court and even he admits it’s the most appalling blag.
Mrs Tilton 07.23.04 at 12:27 pm
Daniel writes:
I happen to have a vague friend-of-friend connection to someone who claims to have brought the first ever “fraud on the market†claim in a US Court and even he admits it’s the most appalling blag.
Yes, well; litigator, innit? His approach is, ehh, doubtless pragmatic rather than theoretical, and fair play to him, given his job.
That said: the facts in Texas Gulf Sulphur make for a plausible argument that it is not appalling blag; as do those in a good many other cases. (I should note that I carry no professional brief for the FotM theory. I am not a litigator at all, and those of my colleagues who are would be on the other side of the room from the friend of your friend. Usual disclaimers, etc.)
Andrew Boucher 07.23.04 at 12:50 pm
d2: OK, could you please list two countries which today benefit from the mixed approach and two countries which use the market-based approach? Let us see what the states of their respective economies are in two years compared to how they are today. I.e. if you choose for example China, then what is relevant is China’s performance in two years compared to its performance today.
I’m not saying you can’t pick, but it makes the discussion a little more concrete.
Robin Green 07.23.04 at 2:31 pm
That’s not necessarily a fair test, Andrew. Drawing some pretty general conclusions about the application of the EMH and the effects of that in terms of booms and busts, is not the same as being able to reliably predict the relative economic performance of two pairs of countries over a period of just two years.
In other words, there are a lot of factors involved; the effects of shorter-term trends may temporarily overshadow the effects of longer-term trends; etc. etc.
Really, one can’t point to a couple of pairs of different countries over a short period of time and then shout triumhantly “That demonstrates that my policy prescriptions are correct!” (as many capitalist cheerleaders did over the case of the Asian Tigers when they were apparently doing so well). However, when essentially the same policy prescriptions are enforced by lending institutions over and over and over again, with similar disastrous results over and over again… then I think there is cause for drawing some tentative conclusions, don’t you?
Andrew Boucher 07.23.04 at 8:24 pm
Robin: On the one hand you say there are lots of complicating factors, on the other hand you seem to imply that from the failure of “the same policy prescriptions” one conclude something about the markets. These policy prescriptions weren’t just about constructing free exchange markets – so maybe the failure is for a complicated set of reasons, and not just because of a lack of “planning.”
Chris 07.23.04 at 10:07 pm
Um, since when did the efficient markets hypoethesis require that countries hold fixed exchange rates (Argentina, Thailand, and recently Turkey), or for California to decree that the elasticity of demand for electricity be zero above a certain price? I think that we have to clearly separate this hypothesis from policy mistakes made in the name of partial liberalization. Of course the EMH can’t be completely true but when it isn’t, using this as an excuse to justify an unrelated policy just doesn’t make sense. X implying Y does not imply that not X implies not Y.
dsquared 07.23.04 at 10:42 pm
Um, since when did the efficient markets hypoethesis require that countries hold fixed exchange rates (Argentina, Thailand, and recently Turkey), or for California to decree that the elasticity of demand for electricity be zero above a certain price?
Well, nobody forced anyone to invest large amounts of capital in Argentina or Thailand either, but it would have been better if they didn’t.
Guy 07.24.04 at 3:07 am
Ann wrote:
South Korea and Japan had a “substantial state presenceâ€, but is that what made them succeed? Look at Japan – the strong, successful industries are those that faced foreign competition (through exporting). Industries that have been sheltered (banking, retail, etc.) are pathetic.
Porter and Sakakibara document this (for Japan) in a recent Journal of Economic Perspectives article.
burritoboy 07.24.04 at 6:14 pm
A bit off-topic, perhaps:
I’m more interested in discussing, not EMH in isolation, but also EMH as part of overall macro-economic theory. If strong-form EMH is implausible, what conversely does that imply for general equilibrium theory, for instance?
My intuition (perhaps off-base) is that the economics community so quickly and enthusiastically latched on to EMH is that EMH validated much of the previous theoretical work in other topics. Perhaps even to the point of proving the entire superstructure – after all, finally, the economists had one actual market that could be called efficient. Essentially, that if Fama hadn’t done the initial study, someone else would have – and the pressure would have been to declare EMH valid rather than invalid.
burritoboy 07.24.04 at 6:16 pm
A bit off-topic, perhaps:
I’m more interested in discussing, not EMH in isolation, but also EMH as part of overall macro-economic theory. If strong-form EMH is implausible, what conversely does that imply for general equilibrium theory, for instance?
My intuition (perhaps off-base) is that the economics community so quickly and enthusiastically latched on to EMH is that EMH validated much of the previous theoretical work in other topics. Perhaps even to the point of proving the entire superstructure – after all, finally, the economists had one actual market that could be called efficient. Essentially, that if Fama hadn’t done the initial study, someone else would have – and the pressure would have been to declare EMH valid rather than invalid.
Mats 07.25.04 at 11:30 pm
D^2: “I’m specifically arguing against the proposition that it is not possible for a well-informed individual to know better than the markets whether the market is proposing a capital allocation that makes sense ”
Hey, wait! It seems to me that many posters are talking past each other. I basically agree with D**2 here, the 3rd world examples show that (stock) markets doesn’t allocate the aggregate capital stock efficiently.
Yet I see no argument against the market as efficient in investing the last dollar, in allocating capital on the margin, efficiently. With non-linear returns, these two things are quite different
steve kyle 07.26.04 at 2:59 pm
I have always thought these arguments go on at way too high a level of generalization. I am both an academic and a former bond trader. Here is what I am convinced of:
SOME markets work efficiently. SOME markets dont. Evidence can be found in various liberalization exercises, where once you get rid of all the controls and regulations the true structure of the market is revealed. Some (few)resemble textbook atomistic markets. Some are oligopolies. Some are monopolies. Some involve public goods and will NEVER function efficiently with optimal capital allocation on their own.
Even as a bond trader I found that at times the market didnt work all that well. That’s why I could make buckets of money exploiting peculiarities of market structure even there. But most of the time it functioned just like the book said.
There is NO ONE ANSWER. And a good thing too, or we economists would be out of a job.
David Nott 07.26.04 at 7:10 pm
Ref. July 22, Daniel
‘None of these things are true’
It’s ‘None of these things is true’
As a boy in WWII I heard the wrangle between the BBC and its listeners over the frequent line ‘none of our bombers is missing’. It was agreed that was the correct version. None means not one.
David nott
Caleb Wright 07.26.04 at 8:08 pm
I have a question that I hope somebody can easily answer, as this whole debate has been very interesting and I’m a complete economics dilettante.
I just finished reading Stiglitz’s book Globalization and its Discontents. It seems to me that one of his major points, specifically regarding the East Asian crisis, was that the IMF was giving the countries who were willing to follow its prescription huge loans, which were used primarily to prop up the value of the currency, which allowed foreign investors to pull out more of their money than they would have had the IMF not interfered. This policy was obviously tilted in favor of creditors rather than debtors and allowed creditors to skate on their risk analysis, assuming that they’d get paid back if they made bad investments.
Why is this seen as an unfettered free market? Isn’t the IMF itself guilty of planning? Why is this seen as a failure of the market rather than a failure of the IMF’s bad planning?
mrkmyr 07.27.04 at 1:37 am
this does not imply that cap controls are necessarily a good thing, or that open capital markets are a bad thing, for developing countries. First, Malaysia will see a decade or two of decreased overseas investment; who would invest in a country that now has a history of restricting your ability to get your money out?
Investors should want to invest in a nation that will solve collective action market failures, rather than let the economy tank. Just as you should like that your bank will close when an irrational run begins. It is better to wait for your money than lose it all.
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