Why does the efficient markets hypothesis matter ?

by John Quiggin on July 23, 2004

Reading the discussion of earlier posts about the efficient markets hypothesis, it seems that the significance of the issue is still under-appreciated. In this post, Daniel pointed out the importance of EMH as a source of pressure on less-developed countries to liberalise capital flows, which contributed to a series of crises from the mid-1990s onwards, with huge human costs. This is also an issue for developed countries, as I’ll observe, though the consequences are nowhere near as severe. The discussion also raised the California energy farce, which, as I’ll argue is also largely attributable to excessive faith in EMH. Finally, and coming a bit closer to the stock market, I’ll look at the equity premium puzzle and its implications for the mixed economy.

To recap, the efficient markets hypothesis says that the prices generated by capital markets represent the best possible estimate of the values of the underlying assets. So, for example, the price of a share in Microsoft is the best possible estimate of the present value of Microsoft’s future earnings, appropriately discounted for time and risk.

The EMH comes in three forms. The weak version (which stands up pretty well, though not perfectly, to empirical testing) says that it’s impossible to predict future movements in asset prices on the basis of past movements, in the manner supposedly done by sharemarket chartists, Elliot wave theorists and so forth. The strong version, which almost no-one believes says that asset prices represent the best possible estimate taking account of all information both public and private. For policy purposes, the important issue is the “semi-strong” version which says that asset prices are at least as good as any estimate that can be made on the basis of publicly available information. There’s a heap of evidence to show that the semi-strong EMH is false, but the most dramatic, as I pointed out recently, is that of the dotcom boom, when obviously hopeless businesses like Pets.com were valued at billions of dollars. I’ve discussed this a bit more here

An apparent, but not real, moderation of the semi-strong EMH is the formulation offered by James Surowiecki that “whether or not markets are perfectly efficient, they’re better than any other capital allocation method that you can think of.” It’s clear that, if capital markets are always the best possible way of allocating capital then they must produce the best possible estimates of asset values, given available information, and this is just a restatement of semi-strong EMH.

A much more defensible position is that, even if capital markets are not perfect, neither is any alternative, and it is therefore an empirical question whether unregulated capital markets or some alternative, such as regulation or public investment, will yield better outcomes in any particular case. This formulation leads straight to the basic economic framework of social democracy, the mixed economy, leaving, of course, plenty of room to argue about the optimal mix.

Now let’s look at some specific cases where the EMH gives a simple and misleading answer, and where a more careful analysis leads to mixed-economy conclusions.

First, there’s the question of foreign exchange markets. As Daniel observed, the EMH implies that the optimal policy is to allow exchange rates to be determined by unregulated capital markets, in what is called a ‘clean float’. The experience of the Asian crises, and also of Chile and China, suggests that developing countries may do better with controls that limit short-term capital flows. But even among developed countries, belief in the desirability of a clean float has faded. The volatility of exchange rates since the collapse of the fixed exchange rate regime in the mid-1970s has been much greater than expected, and much more than can be explained by any sensible model of rational markets. Most central banks have come to adopt a policy of ‘leaning against the wind’, that is, buying their own currency when the exchange rate is well below the long-run average (sometimes called Purchasing Power Parity, though this isnt quite accurate) and selling when it is well-above. On average, this has been a profitable long-term strategy. A lot of economists, starting with the late James Tobin, would go further and tax foreign exchange transactions in the hope of reducing volatility. The lesson here is that neither rigidly fixed exchange rates nor a perfectly free float is likely to be optimal. You can read some more on this here

Second, there’s energy, and particularly electricity. Until the 1990s, electricity was supplied either by public enterprises (most places except the US) or regulated monopolies. These did not do a perfect job in making investment decisions. Roughly speaking, when engineers were in charge, there was “gold-plating”, notably in the form of excessive reserve capacity. By contrast when accountants or Treasury departments were in charge, capital was rationed tightly, and investment decisions were determined largely on the basis of attempts to get around the resulting artificial constraints.

The EMH implied that private capital markets would do a far better job. This in turn led to the creation of spot markets for electricity which otherwise made little sense, since, in the absence of highly sophisticated metering, most users could not respond to market signals in the required fashion (the big consumers, who could respond, typically had contracts specifying if and how much their supply could be cut in the event of a shortage). In practice, this produced huge reallocations of wealth while failing to produce either sensible signals to consumers or rational investment. Instead, the pattern in investment was one of boom and bust. As a result, there’s been a steady movement away from spot markets and towards the reassertion of more co-ordination and planning of investment. I’ve had a bit more to say about this here

Finally, there’s the equity premium puzzle, that is, the fact that average returns to equity are far higher than can be accounted for by any sensible model incorporating both reasonable risk attitudes and the efficient markets hypothesis. If you reject the efficient markets hypothesis, it’s natural to conclude that the true social cost of capital is close to the real bond rate. This in turn allows us to evaluate privatisation by comparing the profits forgone with the interest saving that arises when sale proceeds are used to repay debt. For Australia and the UK, such an analysis produces the conclusion that most privatisations have reduced welfare. Some of the evidence is in this paper (PDF file), and there’s a more rigorous analysis here (PDF). Responding to this argument, Brad DeLong observes, with customary acuteness that my argument implies that “the natural solution to all this is the S-Word:Socialism:public ownership of the means of production”.

Actually, however, while this aspect of the argument, taken in isolation, would imply that public ownership always outperforms private, there are plenty of factors going in the other direction, such as the principal-agent problems associated with the absence of an owner-manager or a threat of takeover. So, the correct conclusion, as foreshadowed above, is that the optimal arrangement will be a mixed economy.

Determining the optimal mix is a difficult task, requiring lots of case-by-case analysis, but I’ll offer the view that the optimal public share of production and consumption is unlikely to be below 25 per cent, and is typically close to 50 per cent. For a contrasting view, I’ll point to my distinguished predecessor at the University of Queensland, Colin Clark, who thought 25 per cent was an upper bound. I’ll need another big post to spell out my claims here, and this will take some work. In the meantime, feel free to pitch in with your own views.

{ 73 comments }

1

MFB 07.23.04 at 11:08 am

Sounds sensible.

Unlike Prof. DeLong.

2

James Surowiecki 07.23.04 at 11:45 am

John, can you tell me where I wrote or said the words you’ve quoted me here as saying?

3

dsquared 07.23.04 at 11:55 am

I believe that John took that quote from the top of my bit, which I believed to be a fair paraphrase of:

Every day, the US stock market values more than 7000 stocks, which entails, roughly speaking, predicting what the future will be like for those 7000 companies (and their competitors, etc.) for the next 15-20 years, depending on valuation. That’s a near-impossible task. The difficulty of the task isn’t going to change, but what’s a better way of doing it?

on the original thread, and you didn’t complain about it at the time.

4

James Surowiecki 07.23.04 at 12:06 pm

Daniel, that was before I knew I was going to become the poster boy for a position that I haven’t espoused. It’s hardly a fair paraphrase to turn a specific statement (actually, a question) about the relative intelligence of the US stock market into a broad statement about the superiority of all markets, no matter how poorly structured, in all circumstances. In any case, you shouldn’t put quotes around a statement that you think is roughly what someone would say, and call it a formulation that that person has offered, when he hasn’t. If John could revise the post, I’d appreciate it.

5

abb1 07.23.04 at 12:07 pm

“whether or not markets are perfectly efficient, they’re better than any other capital allocation method that you can think of.”

Sheesh. This is not even close.

Sure, there are areas where markets work well, namely mass-production of consumer goods.

If is all capital was allocated by markets, we wouldn’t have:
computers – courtesy of the US taxpayers,
internet (TCP/IP) – courtesy of the US taxpayers,
satellite communications – courtesy of the US taxpayers,
nuclear power – courtesy of the US taxpayers,
Global Positioning System, many life-saving drugs, anything that follows from the DNA research, etc, etc, etc. Sorry, but markets don’t do long-term fundamental R&D…

Any aspect of the economy where you don’t deal with mass-produced, relatively homogeneous and realtively cheap product – markets don’t work well there: car repair, anyone? home improvements? any entertainment outside of the pop-culture?

6

dsquared 07.23.04 at 12:16 pm

Hmmmm … I must say I don’t think that either of our posts misrepresent your view, which AFAICT is that you are rather attempting to have your cake and eat it. I don’t recall any point at which you argued that it was possible to outguess the market except by chance and numerous occasions on which you argued the opposite.

I’ve also found on the Jane Galt thread the following:

To echo you, when I say the market is (relatively) efficient, what I mean is just that over time, the market price of a company is most likely to be the best forecast possible of its intrinsic value. Now, the best possible forecast could be way off, but it’s going to be very hard to consistently come up with a better one. This is an attenuated definition of efficiency, but I think it’s the correct one.

which is pretty much saying the same thing. Unless “consistently” here is doing a lot more work than it appears to be doing, this looks almost exactly like the fallacy that John identfies; the belief that one can claim it is not practical to second-guess the market while not simultaneously being committed to the semi-strong efficient markets theory.

7

dsquared 07.23.04 at 12:23 pm

Abb1, I must dispute strongly the idea that computers came “courtesy of the US taxpayers”. The development of the programmable computer was an international effort which included public and private money.

All the other things you mention happen to have been developed with public money but that doesn’t mean they couldn’t have been developed in any other way. In general, the private sector does a very good job of allocating capital (at least partly because it doesn’t rely on securities markets for more than a tiny fraction of the capital it allocates).

8

Andrew Boucher 07.23.04 at 12:40 pm

“On average, this [central banks ‘leaning against the wind’] has been a profitable long-term strategy.”

If a participant has pertinent information that the market does not, then of course he can beat the market. Central banks have more information than the market as to when they will raise or lower interest rates. So I’m not sure the point is germane.

Electricity: I think this is the best example, because it shows that because of constraints or poor construction, markets may not allow for proper arbitration, and thus not allow for information to make its way into price signals and back again.

Equity premium puzzle: well maybe. I’m pretty skeptical about the puzzle, but I guess I could just be misinformed. For what my opinion is worth, it seems that the equity premium puzzle can be explained by a long-term (fifty year?) trend in the stock market. Doesn’t mean the next fifty years will be like that, or that the equity premium will continue.

9

John Quiggin 07.23.04 at 12:51 pm

James, I’ve changed the post as requested.

10

James Surowiecki 07.23.04 at 12:52 pm

Daniel, again, the quote you cite has to do specifically with the stock market — not with the market for electricity, etc., capital flows, etc. In the original thread, I wrote, “I think many of these questions — privatization, international flows of capital, etc. — are still open ones, and that market solutions may in some of these cases be the best ones possible (which is not to say they’re optimal).” How you square that with what John has me saying now is a little mystifying.

More substantively, in the quote above “consistently” is doing a lot of work, which I think is clear from my book. My argument is not that the stock market always produces the “best possible estimate” of the value of any asset. On any one capital-allocation problem, as it were, it’s more than possible that someone has a better estimate of the NPV of a particular stock. My argument is that over a wide range of stocks and over time, it’s very unlikely that a single individual will do a better job of estimating the value of those stocks than the market does. This is the same point people made in the last thread: the fact that in any one case a person (like Paul Krugman) has better judgment than the market doesn’t mean that over a wide range of problems his judgment would be better than the market’s.

Take the racetrack. There’s no doubt that in any individual race, the judgment of some bettors is better than the market’s. At the Belmont, those people who bet on Birdstone were offering a better prediction of the future than the crowd was. But over the course of 100 races, it’s unlikely that any of the people who bet on Birdstone would do better than the market in picking the outcomes of races. So if you want to maximize your chances of getting a good answer over time, the crowd’s judgment is what you should look to. This is not saying that on any one problem, the market’s answer is at least as good as any estimate out there. It’s saying that over time, the market’s answers will be better than those offered by any one person (whether they be an investor or planner).

In any case, whether I’m trying to eat my cake and have it too or not, I don’t really think it’s up to you to decide whether the words John quotes me as saying misrepresent my view. I didn’t say or write the words, so don’t quote me as having said them.

11

James Surowiecki 07.23.04 at 12:54 pm

Thanks.

12

John Quiggin 07.23.04 at 1:05 pm

As regards quotes, my view is that the person quoted has an absolute right to say whether a paraphrase or abridgement is fair or not. I hope that my strikeout represents this appropriately.

On the substantive point, I’m don’t agree that “consistently” can do the work James wants, at least not without some additional conditions. It’s not necessary that Krugman (or, in the dotcom case, Shiller) can outpredict the market all the time. All that’s required is that Krugman (or Shiller) can sometimes assert with confidence that the market is wrong and that, on these occasions, they can outpredict the market.

13

James Surowiecki 07.23.04 at 1:06 pm

John, I’m with you on the case against the free float, and on the question of electricity markets (though I think the introduction of sophisticated consumer metering will eventually make a real difference in this regard). But as far as the equity premium goes, why is it natural –in the absence of EMH — to conclude that the social cost of capital is equivalent to the bond rate. Isn’t the bond rate itself determined by the market? Why is the first estimate of the cost of capital untrustworthy but the second reliable? And is there a difference between “social cost of capital” and “cost of capital”? (I’ve downloaded your papers, but it’ll take me a while to get through them.)

14

John Quiggin 07.23.04 at 1:26 pm

James, the question you raise is an important one, and I elided a distinction between marginal and equilibrium rates.

Accompanying the equity premium puzzle is a “risk-free rate” puzzle, that the risk-free rate is lower than it ought to be in equilbrium.

In thinking about public investments, it’s then a tricky question whether to use the actual risk-free rate facing governments (plus a small margin for risk) or to use the rate that would prevail in a first-best equilibrium. I prefer the former view, noting that, as public investment expands, the risk-free rate will rise and the equity premium will fall.

If you take the latter view, then it’s reasonable to conclude that the appropriate rate lies somewhere between the observed riskless rate and the observed weighted average cost of debt and equity capital.

15

James Surowiecki 07.23.04 at 1:37 pm

John, I’m not asking that they be able to outpredict the market all the time — just more often than not. A foolish example from my book: if you ask a group of people to guess how many jellybeans are in a jar, the group’s answers are invariably very good — usually within 1-2% of the number of beans in the jar. But on any one experiment, a few people in the group offer a better estimate than the group does. Over ten experiments, though, no one person comes up with more accurate guesses than the group does. So relying on the group maximizes your chances of getting a good answer. But if there were someone who (while not perfect) offered a better guess more often the group, I’d be happy to let him be the designated jellybean-picker.

There is a possible alternative to this model, which is what you seem to be suggesting with the Krugman/Shiller examples. That would be that if individuals are able to outpredict the market on those occasions when they say they can (even if those occasions are rare), we can rely on them. My problem with this is threefold:

1) in the psychological literature, there’s no correlation between confidence and accuracy. Even when people are sure they’re right, they’re no more likely to be right than at other times.

2) I have no idea how to identify these people in advance. We don’t know the right answer to the problem we’re trying to solve, so how do we know who has the right answer? That’s especially the case since we don’t actually know what the historical record of their predictions is. This was Andrew’s earlier point: Krugman may have been right in 1997-1998, but was he right in 1996, 1995, etc.? Was he right in 2001? We don’t know. But I think we need to know that in order to know whether it’s a good gamble to let Paul Krugman set policy.

3) As a practical matter, I think people find it very hard to limit their interventions to cases where they are really sure they have a better answer than the crowd. (Buffett, I think, is good at doing this, which may be in part why he’s so successful.)

One other point, which touches on something Daniel wrote much earlier: if when markets do err, they are more likely than planners to err in an extreme fashion, that would obviously matter from a social-welfare perspective. This is an empirical question rather than a theoretical one, although I’m not sure how you’d answer it.

16

Detached Observer 07.23.04 at 1:38 pm

How about a comprehensive survey of all the literature refuting the semi-strong form of EMH? After all, youve made quite a few allusions to this body of work in the last few posts.

17

John Quiggin 07.23.04 at 1:46 pm

A good starting point is Shiller in
Journal of Economic Perspectives
Vol. 17, No. 1, Winter 2003

There’s also a defence of EMH by Burton Malkiel

18

Jack 07.23.04 at 1:47 pm

All that’s required is that Krugman (or Shiller) can sometimes assert with confidence that the market is wrong and that, on these occasions, they can outpredict the market.

Is that really true? What about all the times people make bold assertions and get it wrong. While there was Paul Krugman getting it right once, there were plenty of people advising opposite actions with even more confidence, for example those advocating following the implications of believing in the EMH.

Even worse, when you decide to let someone make the call Krugman did, when do you stop? How do you systematically intervene only some of the time? What would you be willing to let the Bush economic team get their hands on?

On a different tack, what do you think of the Swedish/Weidner/Robin Blackburn model of state pension pools funded by a tax paid in equity by companies? Would such an institution meet the definition of state ownership necessary for the improved welfare benefit of social ownership?

19

dsquared 07.23.04 at 2:15 pm

That would be that if individuals are able to outpredict the market on those occasions when they say they can (even if those occasions are rare), we can rely on them

The great thing about individuals as opposed to groups is that you can ask them questions about what they mean. So, for example, if you happened across a pathological case in which the group had decided that there were 20,000 jellybeans in the jar, if there was one person there saying “20,000 jellybeans of volume 1cc will not fit into a 5 litre jar”, then you would not need to know anything further about that person’s predictive ability to know that, on this occasion, he had it right.

Similarly, Krugman’s early, predictive arguments with respect to the Asian boom were based on arithmetic and adding-up constraints, as were the majority of Shiller’s comments about the dot com boom. It is not possible for a company delivering pet food at a discount to justify the market capitalisation it had. When the market gets it wrong, it is not uncommon for it to get things so wrong that they are not consistent with fundamental constraints that are beyond matters of opinion or confidence.

Jack: I’ve got Blackburn’s book on pensions but to be honest I haven’t cracked the spine yet; it looks ballsaching. Is it any good?

20

abb1 07.23.04 at 2:18 pm

Dsquared,

Abb1, I must dispute strongly the idea that computers came “courtesy of the US taxpayers”. The development of the programmable computer was an international effort which included public and private money.

All the other things you mention happen to have been developed with public money but that doesn’t mean they couldn’t have been developed in any other way. In general, the private sector does a very good job of allocating capital (at least partly because it doesn’t rely on securities markets for more than a tiny fraction of the capital it allocates).

if you must dispute – please do:

http://www.amc.army.mil/amc/ho/studies/eniac.html
Fifty years ago, the U.S. Army unveiled the Electronic Numerical Integrator and Computer (ENIAC) the world’s first operational, general purpose, electronic digital computer, developed at the Moore School of Electrical Engineering, University of Pennsylvania. Of the scientific developments spurred by World War II, ENIAC ranks as one of the most influential and pervasive.

On your second point: well, actually – what is your point?

When did the private sector allocate any capital for any fundamental R&D? space exploration? nuclear research? microbiology? anything at all?

It’s all either the DOD or government grants to Universities.

You say the private sector could have done it too? Well, why didn’t it happen? I’ll tell you why: these projects don’t pass the cost/benefit analysis. These things simply didn’t guarantee quick and sufficient return on investment.

It’s OK, though – markets are good for other things – like mass-production of consumer goods.

21

dsquared 07.23.04 at 2:29 pm

Abb1, although most people recognise ENIAC’s claim to priority, there were other programming machines which also claim priority and ENIAC was certainly not developed in a vacuum. The British (Colossus) and Poles did an awful lot of work on these machines. Nobody involved with ENIAC would pretend it was a purely American effort.

22

fung_wah 07.23.04 at 3:00 pm

abb1:

When did the private sector allocate any capital for any fundamental R&D? space exploration? nuclear research? microbiology? anything at all?
It’s all either the DOD or government grants to Universities.

I can’t speak for many of the other fields… but are you serious about asking about the private sector “allocating capital” for “fundamental” research in … microbiology?!

I’m involved in a (government-funded) microbiological research effort… and I can tell you, with certainty, plenty of private corporations put plenty of money into fundamental research in the area. It happens all the time. They are major competitors of (and sometimes, collaborators with, or suppliers to) any publicly-funded biological or computational-biological research program.

Now, they may not necessarily publish the resulting knowledge publicly… but that’s a different issue.

23

pw 07.23.04 at 3:02 pm

Although ENIAC and the Harvard Mark I and the Colossus were nice prototypes, almost all of the development work and the fundamental R&D that made computers what they are today were carried out by private companies (some with government grants and contracts, some without). Notably many of the biggest early players in the field were effectively monopolists (e.g. Bell Labs, IBM, Xerox) who could allocate capital without reference to what would usually be considered market constraints. Consider, for example, Bell’s “research tax,” where the head office simply made a command decision to direct a percentage of every phone bill in the US to basic communications-related research.

The computer industry is probably an excellent example of how well mixed economies do (I don’t know whether the monopolists should be considered “government” or whether a separate category should be created for thinking about them). You need some connection to the market to keep people from being complete idiots of one particular sort, and you need some essentially market-free allocation to keep people from being idiots of a different sort.

Although it’s not clear exactly how this should be accomplished, it appears that you also need a mixed economy of enterprise scales. The computer industry (for example) would never have progressed as fast as it did if not for the presence of companies with tens of thousands of workers and with “thirty-four people including the janitor” (who today of course would be outsourced).

24

Nicholas Weininger 07.23.04 at 3:03 pm

First, from the (very true) premise that “if capital markets are not perfect, neither is any alternative” it does *not* follow that “it is therefore an empirical question whether unregulated capital markets or some alternative, such as regulation or public investment, will yield better outcomes in any particular case”. There may be sound, general theoretical reasons to believe that capital markets, even when very imperfect, are less imperfect than the alternatives; and I suspect the public choice folks would argue that there are such reasons. You can’t jump from the existence of market failures (which, as you say, hardly anyone disputes) to “it’s all over but the empirical investigation”.

(All this lays aside the deeper philosophical question of whether you can actually produce a coherent , empirically measurable definition of “better outcomes”. I’m enough of a radical subjectivist to dispute that this is even possible; but that’s a completely different argument.)

Second, energy “markets” are a bad example. Plenty of analysts of the California mess have pointed out the ways in which the “deregulation” process there was incomplete and retained significant regulatory distortions of the trading process, distortions which in fact operated to prevent traders from taking account of available information. See for example:

http://www.rppi.org/ps280central.html

The failure of a half-deregulated, distorted pseudo-market is not evidence against the efficiency of real free markets; it’s evidence of the bad effects of empowering regulators to rig the rules in hopes of producing their desired set of outcomes.

I note also that your linked paper on speculation and LTCM provides another such case in point. Your account shows clearly that the problem in the LTCM case was not a lack but an excess of government intervention in the market: namely, the willingness of the Fed to bail out investors over whom they exercised no regulatory control created a risk-reward disconnect. There’s nothing in the nature of free markets that requires such bailouts to exist; and indeed the obvious free-marketeer’s answer is that all such bailouts should be prohibited in advance, so that everyone can know the government will not protect them from the consequences of their speculation. You may call this “abandoning any attempts to maintain the stability of the financial system”; I’d call it desisting from a form of meddling that actually decreases stability.

25

q 07.23.04 at 3:24 pm

Now “markets” generally depend on buyers and sellers, and the efficency of a market is affected by the numbers of buyers and sellers. With the same information set, a market in a product which is non-substitutable with only one seller will probably have a higher equilibrium price than one with many sellers.

The existence of _multiple equilibriums_ leads us to outcomes which are technically neutral, though we would of course be able to morally rank the outcomes. _multiple equilibriums_ means that for an information set X, equilibrium F(X) is indeterminate, so which single result of F(X) is the _efficient market_ one is a moot point.

The set of equilibriums we can achieve is affected by the structure of the buyers and sellers that we have in the market.

All markets have rules. In defining the rules for a market, it is worth considering the likely multiple equilibriums, and the extent to which the rules can provide the optimal outcome.

There is no necessary connection between the owners of individual buyers and sellers in a market and the equilibriums. Hence government owned sellers are neither necessarily more inefficient nor more efficent than privately owned sellers.

26

puzzled 07.23.04 at 3:32 pm

abb1:
nuclear power – courtesy of the US taxpayers

One can argue that the crucial work for commercial nuclear power was done in the Manhattan Project but the first commercial nuclear reactor started operation in 1954 in Russia. The first Western commercial reactor went operational in 1957.

This rather strengthens your argument, I think.

27

James Surowiecki 07.23.04 at 3:45 pm

I don’t want to defend the prices set during the bubble, which as I’ve said I think was a period of systematic irrationality. But I’m not really sure the Pets.com example is the best demonstration of collective idiocy. I think at its peak, the company was valued at around $400 million, which is a lot but not, I think, so utterly improbable as to be “beyond matters of opinion and confidence.” And although it’s hard to parse out exactly from the 10-K, it appears to be the case that Petsmart’s online division is actually doing quite well on the Net now.

“When the market gets it wrong, it is not uncommon for it to get things so wrong that they are not consistent with fundamental constraints that are beyond matters of opinion or confidence”: is this more true of markets than planners who have been given the power to make unilateral decisions? I have to say that looking at, for example, the Bush administration’s approach to calculating the odds on whether there were WMD in Iraq does not fill me with faith in the inherent moderation of individual decisionmakers. And I have little doubt that if there had been, for instance, an internal market in the intelligence community on the question of WMD that the conclusions the market reached would have been significantly more moderate than those reached by the administration.

28

dave heasman 07.23.04 at 4:53 pm

Whose money developed the computer? “The development of the programmable computer was an international effort which included public and private money”
True.

Who put the most money in? Well,in England the first commercial computer was developed practically from scratch by a firm of grocers with a sideline in teashops. J Lyons developed the “Leo” in the early 50s. It cost too much for them to keep improving,andthey chose not to flip and become a computer company. Later the British Government funded huge amounts of fundamental research, and sank ridiculous amounts of cash in a company named ICL, which was a dead loss from start to finish.
Meanwhile back in the States, the largest ever software project, at the time certainly, and possibly even now if you scale up the money for inflation, was IBM’s development of its “OS” (later MFT, later MVS) operating system from 1966 to 1971 or so, immortalised in Fred Brooks’ “The Mythical Man-Month”. Funded mostly by the DoD, under the same justification as the freeway system.
There’s not been much real innovation in computing since then, partly because ofallthe private research money..

29

Jason McCullough 07.23.04 at 5:11 pm

“In general, the private sector does a very good job of allocating capital (at least partly because it doesn’t rely on securities markets for more than a tiny fraction of the capital it allocates).”

You know, it’d be nice to see an explanation of why the hell everyone’s so obsessed with the equity markets when they’re only decorative when it comes to funneling capital to companies. There’s an efficient market for you…..

30

Jack 07.23.04 at 5:20 pm

dsquared,
haven’t read the whole thing but heard him talk and skimmed the book.

The analysis of the problems is pretty convincing and thorough and there are some very good stories. His solutions are more plausible than I expected. Paying for the switch from pay as you go to fully funded by taxing corporations ten per cent of their profits in new equity each year is the idea relevant here. I don’t know if his suggestion that we upgrade the basic state pension to £7-8k pa without means testing and with an earnings link is totally mad, a high opening bid or a prescient prediction of the effects of the forthcoming grey revolution.

31

abb1 07.23.04 at 5:26 pm

Private investment has only one goal – to make money, to receive profits (I hope no one is going to seriously dispute this). More precisely: to maximize the total amount of profits weighted by their probability and timing of their arrival over a period of time. Obviously profites expected 10 years from now are seriously discounted compare to tomorrow’s profites – that’s the reason for the R&D problem.

Let’s assume for a second (and this may be the case, indeed) that it’s true that the collective wisdom of market participants does a good (or the best) job of maximizing this value.

What does it tell us? Not much. Does it tell us that the public interest (however defined) is going to be served by following this procedure? No, not necessarily.

All it says is that this particular game is being played in the most efficient way, that the resources will be allocated to satisfy this particular goal of maximizing this particular function.

Is this function correlated with the function representing public interest? I suppose it does, but to what degree? Depends on the circumstances, I guess.

32

dsquared 07.23.04 at 5:34 pm

James; the Tradesports Iraq WMD contract was trading at 80% in April 2003. What went wrong?

(the contract has stopped trading, but I was taking the piss out of it about this time last year (scroll down))

33

dsquared 07.23.04 at 5:36 pm

James; the Tradesports Iraq WMD contract was trading at 80% in April 2003. What went wrong?

(the contract has stopped trading, but I was taking the piss out of it about this time last year (scroll down))

34

JRoth 07.23.04 at 5:38 pm

I think abb1’s research claims are unnecessarily strong, but get at the fundamental point, that mixed economies outperform either extreme. That this should be a relevation to anyone raised on this planet is a mystery to me. Are one-sided solutions ever the best solutions? Passive car safety features without active? Eat less but get no exercise? Strong climbing without time trial speed?

Regarding the semi-strong EMH, I’m pleased that D^2’s 2:15 comment largely ended the debate, since I think it captures exactly the difference between market predictions of value and individual predictions of value. Regarding James’ example of the Bush Admin’s handling of WMD intel, I don’t think that the problem was informed people making honest error; it was cherry-pciking and predetermined conclusions. I don’t see how an “intelligence market” would have changed Rumsfeld’s or Perle’s minds – do you?

On the defense of the valuation of Pets.com, you’re right that it’s not the best example. John cited the best (imo) example in his last post on the topic: When Palm had its IPO, its market valuation was such that the value of the shares of Palm owned by 3M exceeded the market valuation of 3M. It doesn’t take a Krugman or a Schiller to spot the flaw in that valuation. Yet that’s what the efficient market came up with. Odd, no?

35

Jay 07.23.04 at 5:54 pm

I’ve seen a few descriptions of results in “behavioral finance” that do more to invalidate the EMH for me than any anecdote about the dot-com boom or currency markets.

In particular, these experiments show that human beings will behave in a way that is both predictable and economically irrational. But ALL the decision makers in markets are humans, so we would expect such mechanisms to introduce a bias.

Let me describe one such experiment, though I don’t have a reference: I have a deck of 52 cards. I choose one of the cards at random and assign it to you, with the understanding that the card will be placed back in the deck, and one drawn at random. If it is the card chosen, you will receive 52 dollars. Otherwise, you will receive nothing.

So you have a lottery ticket. I now try to buy that ticket back from you. Finance theory says that the clearing price should be slightly less than a dollar. I do this with many subjects and take the average selling price.

Now I change the experiment by allowing the subject to pick the card. This has the effect of driving up the selling price, typically to above a dollar, even though the expected value of the outcome has not changed.

In short, humans tend to overvalue stuff that they pick themselves.

36

Nicholas Weininger 07.23.04 at 6:22 pm

jay: you’re right, all the decision makers in markets are, in fact, human. However, this is also true of any other human institutions. There are no philosopher-kings around to save us from our own inbuilt biases– a fact to which promoters of “mixed economies” pay far too little attention.

With regard to dsquared’s 2:15 comment: I actually think that comment nicely illustrates the epistemological arrogance all too common in the social “sciences”. The comparison he makes depends on the implicit premise that we can be as confident– or at least, somewhere near as confident– about constraints on justified market capitalization as we can be about physical laws. This premise is breathtakingly ridiculous.

abb1: as one example of private money funding basic, long-term-payoff R&D work, I’d point to the fact that Microsoft Research employs a large number of pure mathematicians to do pure mathematical research, including several of the very best in the world. They’re not the only private employer that does so, but they have lately become the largest. It’s hard to think of a field in which payoffs are more distant or uncertain than pure math.

37

dsquared 07.23.04 at 6:27 pm

The comparison he makes depends on the implicit premise that we can be as confident— or at least, somewhere near as confident— about constraints on justified market capitalization as we can be about physical laws. This premise is breathtakingly ridiculous

When the Palm shares owned by 3M have an implicit valuation greater than the market capitalisation of 3M, what would one say?

38

James Surowiecki 07.23.04 at 6:34 pm

JRoth, surely one problem with reliance on individual policymakers is that it’s hard to distinguish in advance between “informed people making honest error” and “cherry picking and predetermined conclusions.” (Daniel would disagree, but I lack his unerring ability to separate geniuses from fools.) Even those who are cherry-picking, after all, are doing so because they’re convinced they’re right.

I think it’s unlikely that an intelligence market’s verdict would have changed Rumsfeld’s mind. But I think it would have produced a more reasonable and sensible forecast than the “it’s a slam dunk!” offered by the individual planner George Tenet. And that would have been good to have on the record. (I’m working on a piece to this effect right now.) Henry talked about the potential benefits of such a market in the post that Daniel referred to earlier: “one could create an information market that would allow anonymous CIA analysts to express their skepticism about Iraqi WMDs by shorting WMD “stocks” without fearing reprisal from on high. This would actually be a rather useful exercise. I wonder why DARPA isn’t funding it?”

Actually, DARPA was funding it, until it got killed during the uproar over PAM.

Daniel, I’d be surprised if the TradeSports traders knew any more about WMD in Iraq than what they read in the papers (although I would have been intrigued to see what a market that Iraqis participated in would have produced). That’s why I suggested the market should have been internal to the intelligence community.

39

James Surowiecki 07.23.04 at 6:47 pm

3Com, not 3M.

I do think one of the things you can say is that valuations extrapolated from minuscule floats with little or no short-selling possible have a very good chance of being insane. I also don’t think anyone is really contesting the fact that the collective judgment of the stock market in late 1999/early 2000 was horrendously bad. What I want to know is: was it worse than Lysenko’s judgment in 1935?

Just kidding.

40

Andrew Boucher 07.23.04 at 6:51 pm

“Second, energy “markets” are a bad example. Plenty of analysts of the California mess have pointed out the ways in which the “deregulation” process there was incomplete and retained significant regulatory distortions of the trading process, distortions which in fact operated to prevent traders from taking account of available information.”

I think it’s a good example, for the following reason. One reason for skepticism about planning vs. markets is that markets are, so to speak, objective, whereas planning has a subjective element. In brief, while surely there is good planning, how does one determine what good planning is?

The electricity market in California introduces a doubt about the objectivity of markets – there can be things which proclaim themselves to be markets but, because they are not poorly constructed or badly run, are not efficient. By extension this makes it possible to doubt whether markets in the developing world are truly efficient. So, while planning + markets may not be better than markets, planning + inefficient market may be better than just inefficient market.

41

dsquared 07.23.04 at 7:03 pm

In brief, while surely there is good planning, how does one determine what good planning is?

This is, as we say, an empirical issue. My contention with regard to developing country capital accounts, and John’s with regard to other areas, is that mixed solutions have historically outperformed pure market solutions. It’s true that you can’t pick and choose between good and bad planners a priori, but, to put it in the form of a probability textbook, the evidence appears to be that the urn from which one blindly draws planners has enough good ‘uns in it to make a degree of planning worthwhile.

42

abb1 07.23.04 at 7:07 pm

Nicholas,
I don’t think pro-market argument based on companies like Microsoft, ATT, Walmart, GE or GM really proves anything. If Microsoft’s investment is an example of what the free market does, then why can’t we argue that the federal government is, basically, a publicly traded corporation with a CEO and board of directors? They do sell their bonds to investors, don’t they? You do have one share of it, don’t you? You can sell your share (sort of) by moving abroad.

So, yeah, if this is true, it doesn’t surprise me that Bill Gates is doing something atypical, something stupid (from the market POV) – hey, he can easily afford this little eccentricity…

43

James Surowiecki 07.23.04 at 7:16 pm

Daniel, one thing that I’m intrigued by in all this: it’s not really as if you’re drawing blindly from an urn of planners. In some countries, you’re electing them in genuinely free elections, in others they’re seizing power in coups, in others they’re representatives of a longstanding dominant party, and so on. Does the method by which planners are picked make a difference?

44

abb1 07.23.04 at 7:23 pm

The electricity market in California introduces a doubt about the objectivity of markets – there can be things which proclaim themselves to be markets but, because they are not poorly constructed or badly run, are not efficient.

Again – what does it mean: “not efficient”? The California energy incident was highly efficient from the point of view of the investors – they made like bandits, maximized their profits to the fullest extent. It just that in that particular case their objective and public interest were pointing into opposite directions. In fact, these two objectives never exactly match, only in this case the discrepancy was overwhelming…

45

Ann 07.23.04 at 7:28 pm

“So, while planning + markets may not be better than markets, planning + inefficient market may be better than just inefficient market.”

But how do we compare this to the value of inefficient planning? Getting back to the jelly bean example, we have to decide how likely it is that both A) one person can provide consistently better estimates than the group AND B) that person will happen to be a close relative or golfing buddy of the person in charge and thus will be made responsible for jelly bean estimation. Pointing to isolated examples like Warren Buffet isn’t enough. We’re biasing the comparison if we focus on the past mistakes of markets relative to an idealized view of the perfect planner.

As for George Bush’s estimate of the probability of WMD in Iraq, that’s not the right comparison. Bush administration officials said repeatedly that we had no way of knowing what Iraq had and thus that we should err on the side of caution, since it was possible that their programs and stockpiles exceeded our best estimates.

Thus, you would have to look at what proportion of intelligence analysts thought that there was a possibility (or perhaps a “reasonable” possibility) that the capability existed, not whether they considered it the most likely estimate.

46

dsquared 07.23.04 at 7:37 pm

Pointing to isolated examples like Warren Buffet isn’t enough

Again, I don’t want to come over here as petulant, but myself and John have written a couple of thousand words between us pointing to several examples in widely different fields.

James: but you aren’t drawing blindly from possible market processes either. Despite what Robin Hanson thinks, the purpose of securities markets is not to act as a free lunch for observers interested in predicting things. Markets are there to provide, in Joan Robinson’s phrase “a convenience for rentiers”. Which is why they have laws designed to make them more inefficient, by preventing anyone with inside information from trading on it. I’m prepared to stand on the historical record here, which, I cannot apparently reiterate enough, is that mixed economies do best over a wide and important class of problems.

47

Nicholas Weininger 07.23.04 at 7:39 pm

dsquared: I’d say it’s a short-term anomaly off of which a speculator could make a killing, if he happened to know *which* valuation was wrong and approximately how wrong it was. And I wouldn’t trust the verdict of anybody not putting his money where his mouth is on those latter questions. I’d certainly not trust a bureaucrat whose principal personal interest lies in his consolidation of political power.

Furthermore, allowing such irrationalities in the market to flower unchecked serves a very salutary purpose: namely that irrational investors eventually get punished big-time for their irrationality and thus receive a blunt lesson. As happened in the aftermath of the dot-com boom, for example. It’s not the job of regulators, or anyone else, to save people preemptively from the consequences of their own bad judgment.

abb1: you’re moving the goalposts. MS is not a purely free-market entity, to be sure; no private business is in our current welfare-regulatory-statist world. But it is not unusually non-market-ish– in fact, if you accept the legitimacy of IP rights (which is a different argument) it is much closer to the market ideal than most– and it is certainly a hell of a lot more market-dependent than the government.

In particular, it operates for the private profit of its shareholders, not in the “public interest”; it raises revenue through the sale of products to willing consumers; and it does not receive any significant quantity of government funds tied to research. If your theories about market incentives are right, then, it has no incentive at all to fund pure research. And yet it does.

48

dsquared 07.23.04 at 7:48 pm

I’d certainly not trust a bureaucrat whose principal personal interest lies in his consolidation of political power.

Again not wanting to seem patronising about this, but you would thereby have chosen the economic outcome of Indonesia and Thailand over that experienced by Malaysia and Korea. I can’t emphasise this enough; the experiment wih completely free capital markets in the developing world has been a disaster.

49

Ann 07.23.04 at 8:25 pm

I think (or at least hope) that everyone read the examples at the top, but there are examples going both ways. Your argument seems to be that, since either markets or planning may lead to errors, a combination is best. But a combination may also lead to the worst of both worlds, with planners stepping in at the worst possible time. Thus, we have to look at probabilities of error, correlations, incentives, etc. If we can identify specific circumstances under which markets are most likely to make mistakes, and limit policy-makers to intervening only in the right way, only in those circumstances, then I don’t think any of us would argue that this would be inferior to pure markets. But we can’t guarantee any of that.

On the Asian currency crisis example, I would argue that one lesson was that all of the countries would have experienced fewer problems, regardless of their currency policies, if they had focused more on good corporate governance and stricter accounting standards during the boom period. Yes, in the end, Malaysia made a good choice. But for the future, encouraging developing country bureaucracies to interfere more often in markets will be less productive, in my opinion, than encouraging them to adopt greater transparency, better corporate governance, tighter accounting laws, etc. Rather than focusing on how to trap investors that may want to leave a country, why not focus on a more efficient environment that investors will be less likely to want to leave?

I just don’t feel comfortable with giving bureaucrats a free hand to pick winners and losers in the market, since there are many, many examples of this power corrupting the entire system and leading to massive problems. Markets shouldn’t be unregulated, but there are ways to regulate them to try to level the playing field and enhance both stability and efficiency, without putting massive power in the hands of a few bureaucrats.

On the energy market, I do a case study in my classes of a build-operate-transfer project of a power plant in the Philippines. We spend a lot of time talking about the externalities of the power industry. Power plants are expensive, with enormous up-front capital costs, and they take time to build. Future power supply and demand is uncertain. From a producer’s standpoint, it’s costly to have excess capacity. From society’s standpoint, there’s a huge oppportunity cost to NOT having excess capacity. California adopted aspects of British deregulation but missed one of the most important features. The UK deregulated power production at a time when they had a large amount of excess capacity, yet they still paid producers some amount for unused capacity. California began with very little (if any) excess, yet included no incentive for producers to spend millions on capacity that might sit unused for years (plus it was hard to even get new construction approved in California). If there are clear externalities or differences in incentives, these have to be worked into the design of an optimal market, and they weren’t, so it doesn’t seem like a clean example.

In my earlier Mao example, the point was that there’s far less diversification when one planner at the top has too much power. With markets, bubbles occur when herd mentality takes over and too many people stampede in the wrong direction at the same time. But with central planning, it only takes one… There are risks either way, but that doesn’t mean that a combination is automatically best. It means that we should focus on ways to improve incentives and information for decision-makers. If we’re going to use some sort of planning, then we first need to figure out how to give the planner the right incentives. What concerns me about this debate is that there seems to be an implicit assumption that planners are always capable, hard-working and trying to do the right thing, and there are many counter-examples to that assumption.

On this comment about stock markets:
“laws designed to make them more inefficient, by preventing anyone with inside information from trading on it. ”

Insiders are allowed to trade, but they’re not allowed to front-run information that doesn’t belong to them. If a company is going to make an announcement tomorrow, giving the same information to everyone at the same time, why is it more efficient to allow insiders to use that information to trade today, taking advantage of those that won’t hear the news until the announcement tomorrow? The same information is soon incorporated, either way, but risk is lower for outside investors if this type of insider trading is banned.

50

Sebastian Holsclaw 07.23.04 at 8:28 pm

“I’m prepared to stand on the historical record here, which, I cannot apparently reiterate enough, is that mixed economies do best over a wide and important class of problems.”

In what class of economies? Are the lessons of the developing world necessarily the same as for the developed world? What do you mean by mixed? The US economy is definitely more market-oriented, and yet it typically outperforms the European more controlled markets even though the US also spends a huge amount of its GDP on the military while the EU countries do not. Why can’t the EU states keep up even though they don’t have the drain of defense?

51

James Surowiecki 07.23.04 at 8:31 pm

Daniel, I think “What is the purpose of securities markets in the real world?” and “How can securities markets be used as a prediction tool?” are two separate questions, and I wouldn’t read off an answer to the second question from your answer to the first. Nor are the tremendous flaws of some markets necessarily present in all markets, let alone in all mechanisms for producing collective judgments. I think the evidence — very little of it drawn from traditional securities markets — that in the right circumstances groups consistently produce better judgments than even the smartest individual is overwhelming (of course I would say that). But that doesn’t mean that the right circumstances are always present, or that markets are always the best mechanism for tapping into collective wisdom.

Anyway, though, my question to you was serious rather than trying to score a point: Do you think it makes a difference how the planners are picked?

52

Nicholas Weininger 07.23.04 at 9:01 pm

dsquared: as usual, I see our dispute is reducing to epistemology. I just don’t think the Asian crisis experience you keep harping on constitutes the decisive proof you think it does. For one thing, as other commenters on earlier versions of this thread have pointed out, there are lots and lots of variables relevant to that situation which have nothing to do with the inherent defects, or lack thereof, in free capital markets.

Not to mention that it’s a pretty short-term example. There were many such short-term outcomes adduced in the ’80s as proof that Japanese industrial policy was superior to that of the US. Why is the outcome of the Asian crisis any more persuasive?

Finally, as I said, I think punishing corruption and irrationality is a feature, not a bug. As ann said, all of the countries in the Asian crisis would have done much better but for their governments’ pre-crisis misdeeds; I don’t think allowing countries to escape the consequences of those misdeeds is a good thing, even if it produces better economic numbers in the short term.

53

dsquared 07.23.04 at 9:03 pm

Why can’t the EU states keep up even though they don’t have the drain of defense?

Because the citizens there work fewer hours.

54

Ann 07.23.04 at 9:15 pm

“you would thereby have chosen the economic outcome of Indonesia and Thailand over that experienced by Malaysia and Korea. I can’t emphasise this enough; the experiment wih completely free capital markets in the developing world has been a disaster.”

These aren’t clean examples. Indonesia had other problems, after years of government decisions being driven by which of Suharto’s children or golf buddies was due for a kick-back. And with Thailand, I remember how Thai businesses thought that they were genuises back in 1993, when they learned that they could borrow at lower interest rates if they borrowed in dollars rather than baht, as long as they didn’t hedge (since everyone “knew” that the baht was being managed, even though there was no formal commitment). And when the currency started to fall, plummeting Thai stock prices didn’t distinguish between companies with heavy, unhedged US$ debt and companies with little currency exposure. Was this a failure of markets? No – corporate disclosure was so poor that no one knew which companies were exposed and which weren’t.

Yes, Malaysia probably made the right decision that one time. I don’t think that anyone is arguing that it’s impossible for planners to ever do anything right. But if we have to bet on just one alternative or the other, I think that the odds tend to be better with (regulated) markets than with too much power in the hands of bureaucrats.

55

Sebastian Holsclaw 07.23.04 at 9:51 pm

“Why can’t the EU states keep up even though they don’t have the drain of defense?

Because the citizens there work fewer hours.”

So we have an intentional trade-off that is going to become very difficult to maintain as the European population ages. Or really even in the next 5-10 years. But aren’t you suggesting that the economies of Europe ought to be noticeably better than the US economy? With their better economic systems shouldn’t they be able to keep up with fewer hours?

56

abb1 07.23.04 at 9:57 pm

Nicholas,
Microsoft is not a typical private sector company for many reasons, as you know. I suspect that this particular idiosyncrasy is a creation of 6000 pound gorilla there – Bill Gates. There’s little doubt that he can do pretty much anything he wants – profits be damned and shareholders be damned.

Now, let me ask you: what percent of Microsoft’s revenue is spent on these mathematicians? Is it more than Microsoft spends on paper clips?

Anyhow, I don’t think anyone will dispute that overwhelmingly large portion of R&D funds comes from the public sector (including non-profits). Clearly your little counter-examples are only exceptions that prove the rule, as they say.

57

John Quiggin 07.23.04 at 10:05 pm

I wanted to follow up PW, and observe that the biggest private-sector contribution to the Internet was Unix, which, like a lot of other good things, came from Bell Labs.

The impossibility of deciding of whether a regulated monopoly, with an implicit social service objective as well as shareholders who wanted profits should count as public or private is typical of the mixed economy.

But there’s no doubt about the fact that telecommunications reform gutted Bell Labs, leaving Lucent as a ghostly remnant.

58

Nicholas Weininger 07.23.04 at 10:14 pm

abb1: Certainly most pure research funds now come from government. But that hasn’t always been the case, and it doesn’t answer the question of whether we would have large-scale research work going on in the absence of the welfare-regulatory state; government is notorious for crowding out other providers in any business it gets into, research or otherwise.

It’s also certainly true that MS only spends a tiny percentage of its budget on pure research. So what? Government funding for pure research is also a tiny percentage of government budgets.

59

James Surowiecki 07.23.04 at 10:14 pm

abb1, in terms of R&D money as the government calculates it, you’re just wrong. I don’t have the most recent numbers ready to hand, but by the late 1990s two thirds of annual U.S. R&D spending was funded by private industry. Private industry has accounted for a larger share of R&D spending every year since the late 1980s.

Now, most of that money is spent on development, so maybe you don’t mean R&D strictly speaking. But even in terms of dollars invested in “research,” public-sector funding does not account for “an overwhelmingly large portion.” It’s more like 60% — and it’s worth remembering that a hefty chunk of that goes to military research, most of which is of dubious benefit to the rest of us.

60

dsquared 07.23.04 at 10:38 pm

These aren’t clean examples

With respect, the efficient markets hypothesis has nothing in it about “clean examples”. If markets are so fragile that they can’t cope with conditions in the developing world, then they should not have been introduced there. Which was, at the risk once more of sounding petulant, my point.

61

John Quiggin 07.23.04 at 11:18 pm

James, I wanted to pick up, and endorse, your point about the importance of the institutions under which planners are picked. Democracy is important and so is liberalism (in the JS Mill sense). On average, dictators do pretty badly, and the kind of arguments you appear to be making in your book (haven’t read it yet) help to explain why, I think.

62

abb1 07.23.04 at 11:41 pm

James,
I am talking about scientific research, research that is not related to any commercial product and is not likely to produce any commercial results any time soon. Space exploration project in the 50s and 60s, for example. Or CERN. I live in Geneva where CERN is building the so-called Large Hadron Collider – 27 kilometers long 100 meters underground particles accelerator. This is what I am talking about. I strongly suspect that these projects are financed by the public sector to the extent of – well – 100%? 95%? No, it must be 100%.

20-30-40 years from now this will hopefully produce commercial applications that will be mass-produced by the private sector. Just like the space exploration project of the 50s produced satellite communications decades later. Just like publicly-financed DOD-developed in 1940s computers were handed over to the private sector for commercial mass(not so “mass”, but still)-production in the 60s. And so on and so forth.

This is very simple, widely known and quite common, I don’t understand what you, guys, so unhappy about.

63

James Surowiecki 07.23.04 at 11:45 pm

John, that’s certainly what I would suspect to be true. The simple fact of some kind of accountability for decisions would presumably be of some benefit, but I also think, as you suggest, that some of the factors I talk about in my book would make a democratic selection process more likely to be a good one.

64

James Surowiecki 07.24.04 at 12:10 am

abb1, I don’t think there are very many people who are against the government funding basic research. I also think that most of that research will never have commercial applications: the evidence for spin-offs has always been overhyped by government officials trying to defend their budgets, and as the technological complexity of research projects grows, the potential for mass-produced spin-offs shrinks. But that’s fine with me: I think expanding the world’s pool of knowledge is an eminently worthwhile thing to invest in.

65

Sebastian Holsclaw 07.24.04 at 2:00 am

I don’t know how I missed you California example on the first read, but I find it odd that you can blame the problem on EMH when the companies weren’t allowed to engage in long-term contract-making. I suspect that the signals produced in long-term contracts are a major vehicle for efficient markets.

66

Jonathan Goldberg 07.24.04 at 2:30 am

I thought that the received wisdom is that the private sector tends to underinvest in R&D relative to payoffs for society as a whole. Part of the reason for this is that non-monopolies cannot recover all the gains from research, and I note (as does PW, with a different emphesis) examples of research funding by IBM, ATT, and Microsoft, which were or are monopolies.

Time horizon is also a factor, as are intellectual property rights. For instance, the bulk of the research money spent by pharma is on me-too drugs that contribute little to welfare but much to profit.

Moreover, research that is not published fails to yield its full social benefit.

An aside; re:

I wanted to follow up PW, and observe that the biggest private-sector contribution to the Internet was Unix, which, like a lot of other good things, came from Bell Labs.

Calling Unix a contribution to the Internet seems to me a strech. The first nodes (Internet Message Processors, or IMPs) on what became the Internet didn’t have operating systems; the programs ran on the bare metal. The computers they connected sometimes ran Unix. Internet protocols were built into Unix at Berkeley, with government funding, and put into ATT Unix later.

67

Phill 07.24.04 at 2:45 am

How to get a Nobel Prize in Economics.

Option One: Propose a model of the economy based on some completely unrealistic assumptions that make the math halfway tractable.

Option Two: Take unrealistic assumptions and claim that they are immutable and universal truths. Extra points are awarded for convincing governments to base their policies on said immutable truths. Outcome of said policies will not be considered.

Option Three: Take unrealistic assumptions and demonstrate that as anyone who gave the matter any critical thought would realize they do not reflect universal truths, in fact they are the reason why the theories confected from them have manifestly failed.

Repeat as necessary.

68

Ann 07.24.04 at 3:20 am

“If markets are so fragile that they can’t cope with conditions in the developing world, then they should not have been introduced there.”

Perhaps our difference is that you’re judging the efficiency of the market by whether or not it continued to fund a country, regardless of whether or not the country was worth funding. Yes, the withdrawal from many Southeast Asian countries was abrupt (and such volatility can be a problem in itself), but I’m not sure that the withdrawal was any more excessive than the boom that preceded it. The countries had potential but also had serious problems that weren’t being addressed. Perhaps the drop was more efficient than a continued bubble would have been, even though planners at the time would have prefered to sustain the bubble.

69

James Surowiecki 07.24.04 at 5:15 am

Ann, not to presume to speak for Daniel — since he and I have become some fierce sparring partners — but I think he’s judging the efficiency of the market, appropriately, by whether its assessment of the NPV (or the equivalent) of the productive assets of these countries was relatively accurate or not. If a decision-making mechanism radically overestimates the value of assets — leading to a serious misallocation of capital — and then suddenly reconsiders its previous judgments, leading to a dramatic dislocation of all the workers and hard assets that had previously been misallocated, I think anyone would be hard-pressed to call that efficient. That doesn’t necessarily mean that planners were a good bet to do better (though arguably they did better in Malaysia, and certainly did better in China), but I don’t think it’s reasonable to say that investors’ collective judgment about East Asia in the late 1990s was good.

70

Jason McCullough 07.24.04 at 6:06 am

Surely if unregulated capital markets were so fine and dandy, you’d be able to find a power that got big on them. Mysteriously hard to find…..

71

James Surowiecki 07.24.04 at 6:31 am

Actually, I don’t think the US capital markets were regulated in any meaningful sense until the 1930s, and I’d say America’s growth rate after the Civil War and during the first thirty years of the twentieth century was pretty damn good.

72

Ann 07.24.04 at 9:55 pm

My point was that the goal of planners in Malaysia was to maintain the unrealistically high asset values from before the crash, not to promote accurate valuation throughout the period (they could have encouraged that through better accounting, etc.). I agree that there was huge volatility, due to inaccurate valuations at both ends.

Why do you say that planners “certainly did better” in China? Do you know of examples where the Chinese Communist Party has been particularly skillful in terms of planning or regulation? If so, I would argue that they’re isolated cases. China controlled its currency at the time because they’re communist control freaks who don’t trust markets, even though they’ve agreed to flirt with them a bit at the edges. They control everything, all the time. By chance, that one time, control worked out well. But in general, the lesson of China is that markets can be strong enough to offset horrendously poor regulation.

If you have examples of good management by the Chinese Communist Party, I would be interested. But there are many examples of laughably poor planning. When I taught in Hong Kong, we were told that we should try to give examples in class of “capital markets with Chinese characteristics”, and we joked that we wished we could find examples of “Chinese markets with capitalist characteristics”.

73

Ann 07.25.04 at 1:58 am

Correction:
I said before that the Chinese Communist Party hasn’t floated the reminbi because they’re control freaks. But, to be fair, they can’t afford open capital markets because of their banking system.

Comments on this entry are closed.