What does it all mean

by John Quiggin on October 26, 2008

There’s been a bit of discussion about what Alan Greenspan really conceded in his recent testimony. Although Greenspan was less opaque than usual, I won’t try to second-guess him any further, and will instead ask again what the crisis means for the way we think about economics and the economy. There are two big economic ideas that look substantially less appealing in the light of the current crisis.

The first is the macroeconomic hypothesis, often called the Great Moderation which combines the empirical observation that the frequency and severity of recessions declined greatly from 1990 to the recent past with the explanation that “the deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle”.

The second is the microeconomic idea, central to much of modern finance theory called the Efficient Markets Hypothesis. In its most relevant form, the EMH states that prices observed in asset markets (for stocks, bonds, foreign exchange and so on), reflect all known information, and provide the best possible estimate of the value of earnings that assets will generate.

On the Great Moderation, it is worth citing Gerard Baker’s piece from January 2007 at greater length to show how rapidly things have changed. Baker says

[Financial deregulation] gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods.

In the City of London and New York, the creation of the secondary mortgage market, cushioned banks from the effect of a sharp downturn in their core business. The globalisation of finance meant that downturns in one market could be offset by strength overseas. The economies that took the most aggressive measures to free their markets reaped the biggest rewards.

The Great Moderation offers another precious lesson in an old truth of economics: the power of creative destruction. The turmoil of free markets is the surest way to economic stability and prosperity.

I’m not picking on Baker in particular when I observe that it now seems that all of these claims are the exact reverse of the truth. Consumers have built up unsustainable gaps between income and consumption, banks have amplified their risks rather than cushioning them and the economies that took the most aggressive steps (like Iceland) are now in the deepest strife.

Of course, we have yet to see how deep the recession arising from the current crisis will be, but it already seems clear that it will be among the worst since the Depression in many countries. Typical forecasts for the US project 8.5 per cent unemployment next year, not quite as bad as the early 80s and early 90s, but worse than any other post-war recession. And there’s no guarantee that 8.5 per cent will be the peak.

Going beyond this single episode, the failure of the Great Moderation undermines, perhaps fatally, the idea that highly developed financial markets are a stabilising force in macroeconomic terms. Indeed, it suggests a reappraisal of the two decades or so since the emergence of a fully globalised international financial market from the turmoil of the 1970s. Beginning with the global stock market crash of 1987 there have been a series of financial crises and associated recessions. The link from the 1987 crash via monetary policy reactions to the recession of 1990-91 is a bit tenuous admittedly, but many developing countries experienced recessions driven directly by financial crises in the 1990s, as of course did Japan. Then there was the dotcom boom and bust in the late 90s.

After this crisis, the Keynes-Minsky view of financial markets as inherently destabilising looks a lot more appealing than the opposing view, argued most prominently by Milton Friedman. In this context, it doesn’t matter whether the financial markets caused the crisis or merely facilitated and amplified the results of excessively lax monetary policy (Daniel argues strongly that monetary policy is the primary cause of the crisis, but I don’t buy the claim that financial markets were merely passive transmitters of monetary impulses).

The failure of the Efficient Markets Hypothesis is, perhaps, an even more significant outcome of the crisis than the end of the Great Moderation.

The EMH implies that, provided governments get prices right (avoiding distorting taxes, internalising externalities and so on) it’s impossible to improve on the allocation of investment capital generated by private markets. The converse doesn’t hold automatically. Even granting that private markets are subject to bubbles and fads, and that their investment decisions may not make sense in the light of publicly available information, it doesn’t necessarily follow that governments can do better. Still, for large scale infrastructure systems, the case for leaving investment planning as, in Keynes words ‘the by-product of the activities of a casino’, looks a lot weaker now than in did before this crisis. Of course, for anyone who cared to look, the ludicrous investment decisions made during the dotcom boom had already undermined the EMH.

Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century. I’ve written a more detailed version of this argument here here

At a more trivial level, until the severity of the crisis became apparent, Eugene Fama, the leading proponent of the EMH, was the hot favourite for the Nobel Prize in Economics. I think it’s safe to say that Robert Shiller, author of Irrational Exuberance, is now a much stronger candidate to get the next Nobel to be awarded to a finance theories.

{ 72 comments }

1

Tim Worstall 10.26.08 at 12:20 pm

“Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example).”

I think the logical inference is that government “might” or “could” be better, but not that it actually would be. There are stories going around now about how Chavez has been underinvesting in Venezuela’s oil extraction industry for example. No, I don’t know, but does anyone want to make the case that BP or Shell would have done the same? Or managed that long term investment better or worse?

Or, say, the water companies in the UK. One of the reasons for their privatisation was that government simply wasn’t going to stump up the necessary (or perhaps desired is better) investment to improve the systems. And investment in the system has indeed risen since privatisation. It could of course be that the companies are investing too much now, but I’m not sure that’s an argument many would want to make. Which means that if they are investing the right amount now then too little long term investment was made when they were in government hands.

“it doesn’t necessarily follow that governments can do better.”

Quite.

2

tristero 10.26.08 at 12:53 pm

I’m going to assume that you have given the children’s explanation of the Great Moderation and EMH. I have to say that to an economics layperson like myself both notions are strikingly simplistic and naive. The world simply can’t, and doesn’t, work this way.

3

Alex 10.26.08 at 1:11 pm

No, I don’t know, but does anyone want to make the case that BP or Shell would have done the same?

I will. Try the Texas City explosion a couple of years ago, which fried a dozen or so workers alive, and which independent investigators concluded was directly due to BP not wanting to pay for safety. Further, as the refinery was off line for months afterwards, you can hardly argue that it was incredibly efficient.

Or perhaps Railtrack…further, this is a really shittily poor excuse for an argument: One of the reasons for their privatisation was that government simply wasn’t going to stump up the necessary (or perhaps desired is better) investment to improve the systems.

We’d better privatise this because we won’t invest in it. We won’t invest in it because we want to privatise it. QED! Further, if it was economically worthwhile for private-sector investors to invest in it, how much more so would it be for the government to do so with a hurdle rate several hundred basis points lower? Your argument was self-serving drivel when the Tories made it; it’s still drivel now.

4

Mort Young 10.26.08 at 1:18 pm

Let’s look ahead: Why did Greenspan admit he was wrong about the economy?
1. Because he was wrong, and it hurt him deeply. He was treated as a demi-god during his long stay as head of the Fed.
2. He knew he was wrong, I believe, when he approved of Bush’s tax breaks for the wealthiest slice of the US taxpayers. But he did it because he did not want to step down or be pushed.
3. When his term ended, and the new chairman took over, Greenspan broke the ‘rules’ by continuing to speak out on the economy, undercutting his successor.
4. What next? An op-ed piece in the Wall Street Journal or the NY Times, explaining how right he is to admit he was wrong.
5. Pardon my cynicism, if possible.

5

Walt 10.26.08 at 1:27 pm

John, do you really think any actual real-world event could falsify the EMH?

Tristero, the Great Moderation really did happen, though it looks like something of a mirage now. Also, while the EMH is not true, it could have been true. There’s even some small amount of evidence for its truth.

6

tristero 10.26.08 at 2:20 pm

Walt,

The point I’m getting at is that while these ideas may appear to fit local, or transient, trends they sound, a priori, too rigid to serve as generalized theories. I will take your word for it that the Great Moderation did happen. The problem is the extrapolation, or elevation, of that trend into a guiding principle into the distant future from ’87. On the surface, that seems highly unrealistic, and in fact it was.

Regarding EMH, I’m sorry but I don’t understand theories that “could have been true.” In this particular case, it is obvious that EMH couldn’t possibly factor in all the real world contingencies and vicissitudes that have an impact on the market. EMH sounds more like a moral ideology than a theory, like saying in principle a communist society could work to the benefit of all.

In fact, I’m having a hard time coming up with a reason why a theory of markets like EMH is either useful or necessary. Can’t one simply approach the data one gathers and make suggestions/reccomendations/proposals based on a pragmatic, empirical approach, no ideology needed? Sometimes the market may need hands off, sometimes it needs government intervention, sometimes it needs a combination of the two, sometimes not. End of grand theory.

I admit my ignorance here. But my flabbergasted response to these theories is that they were/are far too simplistic to explain what I am certain is as complicated a reality as any other human endeavor, be it foreign policy, say, or the arts, or medicine. Please correct me if my impression is wrong, but this is not how the one economist whose work I know, Krugman, speaks. He seems more concerned with a non-ideological, but highly informed, pragmatism.

7

John Emerson 10.26.08 at 2:36 pm

One thing I love about economics is that it has all the right answers right there on the shelf mixed in indistinguishably from all the wrong answers. We (the collective world we) just happened to pick the wrong unlabeled bottle of Economic Science off the shelf. And now the economic scientists who gave us the bad advice (or did they?) are having a grand old time chatting about what the problem is, while the rest of us dumbly watch.

8

Rich Puchalsky 10.26.08 at 3:12 pm

John, the right answers and wrong answer may all be mixed together indistinguishably, but ad hom is highly predictive about which answer any individual will pick. Maybe, as Quiggin writes, the real world will force a realignment of economic opinion. But I doubt it. I think that we will simply continue privatizing the profits and socializing the losses, and some academics will say this is all wrong, and the rest of the bought-and-paid-for people will say that it’s fine, because after all the rich can never lose out as long as the losses are socialized.

9

ScentOfViolets 10.26.08 at 3:33 pm

In fact, I’m having a hard time coming up with a reason why a theory of markets like EMH is either useful or necessary. Can’t one simply approach the data one gathers and make suggestions/reccomendations/proposals based on a pragmatic, empirical approach, no ideology needed? Sometimes the market may need hands off, sometimes it needs government intervention, sometimes it needs a combination of the two, sometimes not. End of grand theory.

That rather closely replicates my opinion, and dovetails rather nicely with Galbraith’s emphasis on ‘exoteric’ rather than ‘esoteric’ knowledge.

This is also one of the reasons why I don’t think I’m particularly liberal, at least in the economic sense: I have never plumped for a centralized command economy. I happen to think capitalism, price signaling, etc works pretty well. I limit my screeds against ‘blood sucking parasites’ to no more than one a day :-) And yet, somehow, I am a ‘liberal’, a ‘socialist’, because I think that sometimes there are market failures, failures which can be empirically measured, and that sometimes government must step in to ameliorate these failures.

Note that I never advocate government intervention on the basis of some sort of ‘theory’. I say that the government needs to exert some regulatory authority in the area of, say, food and drugs, because as a matter of fact radium tablets were once sold to enhance manliness, and capsules full of tapeworm heads were touted to the ladies as a miracle ‘diet pill’. Iow, by noting with my own eyes and/or looking at the historical record some sort of obvious failure.

Apparently with the free market ideologues, the libertarians, etc., theory is supposed to trump my own lying eyes. And if it doesn’t, I’m either stupid or evil.

10

MQ 10.26.08 at 3:35 pm

If you look at GDP variation, the Great Moderation did happen. (It may be that this naturally happens as societies get richer and goods and labor markets get deeper). But even as it did, financial markets showed more variation, not less.

It now seems pretty clear that the financial sector is the big threat to the Great Moderation, instead of being an explanation for it.

11

Seth Finkelstein 10.26.08 at 3:47 pm

I think there are really two different “EMH”‘s in existence. I’ve been fascinated by this since the dot-boom/bomb. There’s the “indexing ” (weak) EMH – roughly, that indexing is the optimum risk/reward financial strategy. Then there’s some sort of “true value” (strong) EMH, that the current price of a stock somehow reflects a Platonic idea of value.

I think the “true value” (strong) EMH is obviously false, and it’s basically a market religion, because it being false suggest markets aren’t great social allocators, which is an absolute heresy to many ideologues.

The “indexing ” (weak) EMH is much closer to be true, in the sense that it’s very difficult to reliably profit from the irrationalities of the market – that is, the irrationalities exist, but are not repeatedly trade-able. As in “The market can stay irrational longer than you can stay solvent”.

12

Seth Finkelstein 10.26.08 at 3:49 pm

Ack, I see you basically said that here:

http://www.uq.edu.au/economics/johnquiggin/news/EMH0207.html

But maybe you’re being unfair to Fama.

13

bob mcmanus 10.26.08 at 4:04 pm

The “Great Moderation” was just a massive continuous global creation of liquidity since around 1982. It financed industrialization in China & EM’s and consumption & Ponzi finance in the US.

Just finished a little book on JM Keynes investment strategies. After speculatin’ in the 20s, Keynes became a value investor (Buffett) and never ever again followed the markets up or down. Keynes would say that the EMH was right in principle at least a large part of the time but he invested as if it were always wrong. Keynes would buy or sell only when the markets were wrong enough to provide a large margin of error.

And IMO this is the guiding principle of Keynes-Minsky social policy. The markets are always completely wrong. The safety nets & regulatory structures have to be big enough to make the markets irrelevant to the well-being of the polity.

14

Chris 10.26.08 at 4:14 pm

John, the right answers and wrong answer may all be mixed together indistinguishably, but ad hom is highly predictive about which answer any individual will pick.

Sure, but I think that’s part of the deeper point. Sometimes you need answer A, sometimes you need answer B. You generally don’t know which in advance. There are plenty of ideological A-ites and B-ites telling you which answer you *always* need, and proposing grand theories of why A (or B) is a cure for all economic ills. Both are wrong. But realizing their mutual wrongness doesn’t help you *distinguish* between the times you need A and the times you need B.

Real economics, like real medicine, demands different treatments for different conditions. Grand theories of a single cause for all problems, or a single remedy for all problems, are just as much quackery in economics as they are in medicine.

In short, economics has too many pharmacists (and some downright snake-oil peddlers) and no diagnosticians.

15

bob mcmanus 10.26.08 at 4:55 pm

The 1st lesson of the “Great Moderation” and its crash:

The markets do not, and cannot, provide adequate reliable information to help guide gov’t economic, fiscal or monetary, policy.

Uncertainty needn’t be so scarey. It could mean, among other things, a well-considered industrial policy.

16

ehj2 10.26.08 at 5:17 pm

The failure of EMH in long-term planning is why we don’t use it to decide military expenditures.

Short-term planning, however, desires to maximize profits, advantaged by manufactured scarcity — which is why we shouldn’t rely on EMH for any strategic need, like energy, clean water, healthy food, etc.

Free markets, at the extreme, want the price of labor to be zero, which will be the case when all manufacturing can be accomplished by computerized robotic systems. Free markets work toward their own demise by failing to ensure the survival of funded consumers to purchase production.

We’re now hitting the world’s resource constraints at the same time we’re eliminating the need for human labor, and the transition to a future economic system which serves human needs will demand significant societal (government) intervention.

17

AcademicLurker 10.26.08 at 5:18 pm

“In its most relevant form, the EMH states that prices observed in asset markets (for stocks, bonds, foreign exchange and so on), reflect all known information, and provide the best possible estimate of the value of earnings that assets will generate.”

I’m with Tristero on this one. How did supposedly intelligent people ever take this seriously?

18

J Thomas 10.26.08 at 5:23 pm

“In its most relevant form, the EMH states that prices observed in asset markets (for stocks, bonds, foreign exchange and so on), reflect all known information, and provide the best possible estimate of the value of earnings that assets will generate.”

Aren’t the arguments that people who make bets about who will win the election are doing the same thing? That the gambler’s markets must inevitably reflect all known information and provide the most accurate odds possible?

19

a 10.26.08 at 5:57 pm

“The markets do not, and cannot, provide adequate reliable information to help guide gov’t economic, fiscal or monetary, policy.”

What better way to measure inflation expectations than by looking at the price of TIPS?

20

bob mcmanus 10.26.08 at 6:38 pm

18: I don’t believe it should be a priority of economists and gov’ts to measure and manage inflation expectations. I would guess if y’all do believe it to be a priority, you will somehow find “reliable” indicators that are “responsive” to policy.

2) It’s all Keynes’ beauty contest. TIPS doesn’t even measure investor’s assessments of inflation expectations, but what investors think are the inflation expectations of other investors. It is hard for me to believe reliable data can ever come out of such reflexive ground. Inflation can probably be managed; expectations not so much.

3) The job of economists & gov’ts are not to support/protect the markets. We don’t build Hoover Dam, GG Bridge, or Interstates to create jobs with the multiplier, but because those projects are desirable in themselves. We don’t refrain from or limit projects like UHC or high-speed rail because they are “unnecessary” or “countercyclical” or “too expensive”

4) It is precisely a gov’t not reflective or conditioned by markets or “market efficient” that will create the stability to make markets work. Are China’s reserves too big? Obviously not.

21

DanSeattle 10.26.08 at 6:47 pm

AcademicLurker, Tristero:

EMH is also what underlies the political markets, too. In theory, the reason the Iowa Electonic Market works, or “works,” is because it reflects All Known Information. (Outsiders will aggregate news stories and other information sources; insiders will be unable to resist leaking information to the market by making purchases. The Truly Wise will interpret “+3%” as a meaningful number. Bad Actors who attempt to manipulate the market will be acting on bad information, and thus will be ultimately punished.)

And, um, that would be why I don’t look at the electronic political markets either.

22

ScentOfViolets 10.26.08 at 7:20 pm

Free markets, at the extreme, want the price of labor to be zero, which will be the case when all manufacturing can be accomplished by computerized robotic systems. Free markets work toward their own demise by failing to ensure the survival of funded consumers to purchase production.

BINGO. That is part and parcel the sole justification for economics as pushed by the Chicago School. In fact, this has been the fundamental fact of American Conservatism since the late nineteenth century. The ‘top’ people have been famously concerned with just two things: an enemy from abroad, come to take their wealth, i.e., the Yellow Peril in all it’s Godless Communistic variations; or a domestic enemy, come to take their wealth, e.g. the Common Workers driven into a frenzy by such dubious philosophies as Socialism,who would rise up one day and murder them all in their beds.

And that’s why there is all this folderol about about ‘scientifically’ proving that the minimum wage is Bad, or ‘scientifically’ justifying the immense compensation given to CEO’s and other Top people. That’s the domestic side. On the foreign side, this is why there is so much money thrown into the military, and indeed, why it is touted as one of the few justifications of the federal government.

I really don’t think there is much more to it than that. Certainly these two concerns have remained constant for well over one hundred years.

23

TheWesson 10.26.08 at 7:35 pm

EMH: In a bubble or a panic, prices are set on an iterative basis, on the basis of what people think other people expect or think, on the basis of what the history of the price has been.

Iterating in this manner, a price can’t be settled on, due to positive feedback (price setting comes about via negative feedback.) This kind of iteration can blow up a fluctuation of an arbitrarily tiny magnitude into an arbitrarily large magnitude.

So the EMH fails in a bubble or panic, because market prices do not reflect the information available, because the information dominating the market is not really information.

This kind of non-information is typically called ‘sentiment’ I suppose.

24

Matthew Kuzma 10.26.08 at 7:46 pm

Your discussion of oscillations and damping in the markets stood out at me at first read because of the inaccuracy of the physical metaphor (damping forces reduce amplitude, as a rule, not frequency), but then I began to wonder to what degree a physical oscillator can be an educational metaphor for an economy.

The reason I would be hopeful that something good could come of the comparison is because physical oscillators are incredibly widespread and the rules governing them are universally identical. Waves literally show up everywhere and in all cases the underlying math is the same. All you need is a restorative force that is proportional to the displacement, so say tension in a violin string or gravity for a pendulum, and some sort of mass capable of carrying momentum (which doesn’t need to be a literal mass, as in the case of resonating circuits where the momentum-carrying component is the induced magnetic field) . Once you have those two things, the frequency is always proportional to the square root of the restorative force divided by the mass.

Of course comparisons between economics and physics are not new, and have rarely lead to anything useful, but harmonic motion is incredibly versatile and I wonder if it isn’t possible to find some fit in economic analysis.

25

John Quiggin 10.26.08 at 8:44 pm

Matthew, there was a huge amount of work done on this kind of model from the 40s to the 70s when active fiscal policy was used to stabilise the economy. That didn’t work so well, of course, mainly because of the failure to take proper account of inflationary expectations, and so there has been a lot less interest in the kind of “fine-tuning” associated with this approach. But, perhaps, we’ll see a revived interest in this kind of control theory approach, hopefully with a little less hubris about what can be achieved.

26

Martin Bento 10.26.08 at 8:55 pm

Political markets as a test of the EMH would seem to suffer from the fact that political markets belong to a class where all information that could affect the outcome has to be widely-known, because information that is not widely-known will not affect the outcome. If Obama were gay, or McCain had personally tortured people in Vietnam, there may be a few people who knew about these facts, but they would remain electorally insignificant unless more widely exposed. So hidden information doesn’t matter, as it is of no value if hidden. The exception would be if it is predictive – if you know that news of Obama’s homosexual affairs is about to leak – but such foreknowledge would be a rare occurrence.

27

Colin Danby 10.26.08 at 9:10 pm

The search for rules governing business cycles, not to mention cycles within cycles, goes back well before WWII, though with much less mathematical formality. I don’t know how much it was was inspired by analogies to physics, but I think I can argue that to the degree it was, the analogy was unhelpful (attractive though the math Matthew mentions is). Re control theory, this might be a good time to revisit Mirowski’s _Machine Dreams_.

Thanks for the mention of Minsky, John! I happened to hear Stiglitz last week who also singled out Hyman M, and made an explicit plea for a plurality of doxies in economics teaching.

It’s a pity Post Keynesianism has so little blog presence at this moment, but http://www.levy.org/ is worth a visit every now and then.

28

bob mcmanus 10.26.08 at 9:58 pm

It’s a pity Post Keynesianism has so little blog presence at this moment

Econospeak …Michael Perelman, Brenda & Barkley Rosser

Thomas Palley

James Galbraith at TPM and around; others have academic pages

when active fiscal policy was used to stabilise the economy. That didn’t work so well

Coulda fricking fooled me. After thirty-odd years of flat real wages and increasing inequality ending in Great Depression #2 I am seriously wondering about the social goals of the Neo-Keynesians. I don’t wonder abour the social goals of the Neo-Classicals.

29

John Emerson 10.26.08 at 10:07 pm

28: As I understand, Brenda and Barkley are unrelated and don’t necessarily get along. That was Bob’s joke, I guess.

30

Mrs Tilton 10.26.08 at 10:09 pm

Seth @11,

SFAIK the EMH comes in at least three flavours, not only two. The weak form is a truism*, the strong form voodoo on stilts; the argument is all about the middle form, i.e., the notion that the price of an asset reflects all publicly-available information about that asset.

And I’ve always thought, and still think, that this is a good idea. It simply isn’t, and never has been, as good an idea as its fetishists would have you believe. (For that matter, in many ways one can view ideas about EMH as one would ideas about “The Market” generally, writ small.) It’s one thing to say that, “All else being equal, under normal circumstances, the price of a highly liquid share that is well covered by analysts probably does come to reflect, within a short time, pretty much all the information that non-insiders can get”, and another altogether to say, “That share’s not overpriced. It can’t be overpriced. No share can be overpriced, that would be mathematically impossible, do you hear me!!!111!”

* A while ago Daniel Davies of this parish mentioned in passing a colleague who thinks that even weak-form EMH may be untrue to the extent that one can, under certain circumstances, make money off its untruth. Fascinating, and I’d like to learn more about it, but suspect I won’t if the guy actually is sustainably making money off it. For the rest of us, in any event, “past performance is no guarantee etc.” probably remains good advice.

31

Walt 10.26.08 at 10:13 pm

Tristero, the Great Moderation already demonstrates the limitations of the approach you suggest: “Can’t one simply approach the data one gathers and make suggestions/reccomendations/proposals based on a pragmatic, empirical approach, no ideology needed?” The Great Moderation was a pragmatic, empirical fact that led us astray because we didn’t understand its source.

I’m not the best person to defend the EMH, since I’ve always been critical of it, but why is it impossible that the market price of an asset be the best available predictor of its future worth? Advocates of the EMH are not saying that the market has some sort of supernatural ability to discern all possible information, but that the market will not make systematic mistakes. If the market did make systematic mistakes, then you could make money by simply identifying the systematic errors and trading against them. Thus traders would have a lot of incentive to find errors and exploit them until they went way. I don’t believe the argument, but it’s not completely crazy.

32

bob mcmanus 10.26.08 at 10:23 pm

28:My understanding about the Rossers is quite different.

” Brenda Rosser said…
Well, I’ve managed to confuse my husband no end! The confusion seems to be with the concept of net savings versus gross savings.” …comment of Oct 17

Link …but there are people around who actually know the two

33

bob mcmanus 10.26.08 at 10:48 pm

31: ” It might have been supposed that competition between expert
professionals, possessing judgment and knowledge beyond that of the
average private investor, would correct the vagaries of the ignorant
individual left to himself. It happens, however, that the energies and
skill of the professional investor and speculator are mainly occupied
otherwise. For most of these persons are, in fact, largely concerned, not
with making superior long – term forecasts of the probable yield of an
investment over its whole life, but with foreseeing changes in the con-
ventional basis of valuation a short time ahead of the general public. …Keynes, GT p154″

34

derrida derider 10.26.08 at 11:40 pm

I agree with walt – the EMH in its most common form (the form as he stated it) still makes a certain amount of sense, but it misses the systemic implications of “the market can stay irrational longer than you (or any other individual) can stay solvent”.

Take the current $Australian versus $A exchange rate. On any plausible fundamentals it is obviously way too low – the $A has now depreciated against the Icelandic Krona, ferchrissakes. The information that tells you it is too low is freely available and indeed has been commented on by market players. But where are the players at the moment with the risk appetite, time horizon and liquidity to push it back towards those fundamentals?

35

J Thomas 10.26.08 at 11:43 pm

If the market did make systematic mistakes, then you could make money by simply identifying the systematic errors and trading against them. Thus traders would have a lot of incentive to find errors and exploit them until they went way. I don’t believe the argument, but it’s not completely crazy.

Yes, and evolution never leads a population into an evolutionary dead-end, because if it did the population would go extinct and there would no longer be a population in an evolutionary dead-end.

Ah, no.

Well, see if this example says anything. I once invested in Borders Bookstore. Basicly, they decided that it didn’t make sense for them to invest large sums in selling over the internet and compete directly with Amazon, so they invested moderate sums to do the internet things that made sense to them. This did not fit the dot.com philosophy and the price of their stock was cut in half and I bought. I considered the market was making a systemic error. So I waited, and the price went down. And I waited some more and the price went down some more. After awhile I bought more when the price of the stock I bought had nearly cut in half again. And the price went down. I held onto my Borders stock and after several years I sold it for about 100% profit, when the dot.com bust came and the market decided that Borders was OK after all.

To get that profit (around 30% per year) I had to hold a losing stock for years. If I’d needed to sell early I’d have lost money, I sacrificed liquidity. If I’d known when the dot.com bubble would end I could have bought Borders a few months ahead and gotten the same profit in much shorter time, but I didn’t know that.

It could be argued that the dot.com boom was not a systemic mistake but merely a one-time error that got corrected. I can see it that way, I only got one chance to profit from it by buying Borders.

So, to be a truly profitable systemic error, what would work a lot better would be for most investors to decide on Monday that Borders is no good and sell it for whatever they could get. But then Tuesday they’d decide that Borders was great and buy it at any price. And Wednesday they’d decide again that it was no good and sell, but Thursday they’d decide it was great and buy.

If I could find a systemic error like that then I could really profit. A quick reliable way to make lots and lots of money fast. Except other people would notice the pattern and join me in betting against the flow, and pretty soon there would be enough of us that it would even out.

So that’s the kind of systemic error that mostly won’t happen. An error where the market repeatedly and reliably goes up and down a predictable amount. The more reliable it is, the more people will notice and correct it.

But the more irregular the period of the oscillation and the less reliable the amplitude, the harder it is to exploit.

36

John Emerson 10.27.08 at 1:11 am

I must have encountered the Rossers on a day on which they were not getting along.

37

Seth Finkelstein 10.27.08 at 1:24 am

Mrs Tilton @ 30 – No, the weak form of the EMH has one significant real-world implication, namely, that if you want to invest in stocks or similar assets, investing in a “managed” fund is a waste of expenses at best, and a downright wealth-transfer from you to the fund manager at worst. Just buy the cheapest index fund. This matters for, e.g., people’s 401(k) accounts. There is a lot of money spent to convince people that the above is not true – from those who benefit from the convincing.

“the price of an asset reflects all publicly-available information about that asset.”

That’s true, roughly. But the trick is to realize that doesn’t tell you the value of the asset, to the extent price and value are not defined to be equal. One key to the paradox is to grasp there’s a self-reference, in that the price of an asset is a prominent bit of publicly-available information about the asset, so it can influence itself (A complex way of saying “The Greater Fool Theory”)

38

Tom West 10.27.08 at 2:18 am

EMH may have had one positive outcome. It may have prevented unknown numbers of pikers losing their shirt trying to ‘beat the market’.

39

roger 10.27.08 at 2:23 am

Worstall’s use of the oil companies here is a large invitation for a refutation: “No, I don’t know, but does anyone want to make the case that BP or Shell would have done the same? Or managed that long term investment better or worse?” Actually, Shell is notorious for having overestimated the future capacity of its leased fields, and shocked the market last year by re-evaluating them downward. Moreover, the entire oil industry seems to have learned one lesson and one lesson only from the collapse of prices in the 90s – don’t invest in development! Hence, the surprising decline in money allocated for exploration and development even this spring, when companies like Exxon were swimming in money – yet were allocating less money on a percentage wise basis to new exploration than they did in the late nineties. Information is not neutral, it isn’t a quantitative entity – it is a combination of qualitative judgments and quantitative analysis. Thus, it is nutty to think of information as a thing that is best known about by company execs. Often, the thing they know best is that hiding losses temporarily will insure them time to sell their stock options. Group think, a professional salesmen’s bias towards optimism – look at the struggle of the national realtor’s association to deal with declining house sales in such a way as to make it seem like they are bottoming out, or not declining at all (for instance, by changing comparisons between the date line of data – month to month comparisons instead of comparisons of the the month to the month last year, etc.). I don’t believe for a second economists don’t know this – they simply don’t care. They have as little incentive to change as the stock option selling execs of Enron. They will get quoted by the same sources, they will get published by the same journals.

40

Mrs Tilton 10.27.08 at 2:31 am

Seth @37,

though I agree that buying the index is prudent for many people, I’m not sure the implication of weak-form EMH is really “you can’t beat the market”. I’d say it is more “technical analysis is nonsense”. (And what DSquared was referring to was a possible example of that statement not being true.)

41

Omega Centauri 10.27.08 at 3:44 am

I would think that the existence of a few fund managers that over a period of a couple of decades have seriously beat the market would refute EMH. I’m thinking primarily of Buffet, and Soros here. That level of overperformance has to be well into black swan territory (i.e. not simply good luck). Of course it seems pretty clear, that only a handful of people seem to be blessed with real stockpicking ability, but even one counter example is enough to disprove the hypothesis.

42

Seth Finkelstein 10.27.08 at 4:05 am

Not really. I think at the Buffet or Soros level, you’re getting to the point where they may have truly private information. The EMH doesn’t say nobody at all can have trade-able non-public information. Just that all public information is distributed widely enough so that nobody can use it to much advantage in general.

It’s more of a statistical statement – there’s some small situations where it breaks down. But almost by definition, that’s not going to be you.

43

notsneaky 10.27.08 at 4:39 am

“it misses the systemic implications of “the market can stay irrational longer than you (or any other individual) can stay solvent”.”

Actually I think the weak-to-medium form of EMH encompasses that dictum, which is where the suggestion to invest in indexes rather than try your luck at speculatin’ comes from. The weak-to-medium form of EMH allows for bubbles and big time deviations from whatever may be “fundamental” values (as in your example with A$ vs. I-Kr) it just says that you won’t be able to time when the bubble pops so you still can’t beat the market.

Also, for the record I agree with MQ in 10, Seth in 11 and 12, and Mrs. Tilton in 30 and with most of the things Walt says. In regard to the Great Moderation, the standard story that was/is being told is about the competence of monetary policy rather than financial markets – basically, no more 70’s style mistakes of ignoring inflation expectations and trying to exploit a shifty short run Phillips curve, and no more blind faith in rational expectations which will make a Volcker style disinflation costless, but rather some happy medium between the two, with inflation targeting or some variant as a stable nominal anchor. Maybe that doesn’t look so good now either, but given that other countries central banks’ followed a quite different policy than Greenspan, and that they are still affected by this whole mess means that the monetary policy might have played only a secondary role (contra Daniel). Of course one could argue ‘contagion’ or something.

44

John Quiggin 10.27.08 at 5:33 am

Well, I suppose there are different versions of the Great Moderation out there, and the crisis is really bad only for those that rely on
(i) financial deregulation; or
(ii) improved US monetary policy

For other countries, you could reasonably claim good management overwhelmed by the combination of global financial integration and unjustified faith in the US financial system.

45

Sebastian 10.27.08 at 6:02 am

“Well, see if this example says anything. I once invested in Borders Bookstore. Basicly, they decided that it didn’t make sense for them to invest large sums in selling over the internet and compete directly with Amazon, so they invested moderate sums to do the internet things that made sense to them. This did not fit the dot.com philosophy and the price of their stock was cut in half and I bought. I considered the market was making a systemic error. So I waited, and the price went down. And I waited some more and the price went down some more. After awhile I bought more when the price of the stock I bought had nearly cut in half again. And the price went down. I held onto my Borders stock and after several years I sold it for about 100% profit, when the dot.com bust came and the market decided that Borders was OK after all.

To get that profit (around 30% per year) I had to hold a losing stock for years. If I’d needed to sell early I’d have lost money, I sacrificed liquidity. If I’d known when the dot.com bubble would end I could have bought Borders a few months ahead and gotten the same profit in much shorter time, but I didn’t know that.”

This story is interesting in light of the mark-to-market accounting rules which were implemented in November 2007. No bank, insurance company, or other financial institution other than a hedge fund could make a bet like the one described once the mark-to-market accounting rules start to force increasing cascades of selling in a ‘long-term’ investment like that. As soon as the price starts to go down quickly mark-to-market will force them to sell into the fire sale, further reducing the price, triggering other parties to be forced to sell.

[note: I’m not trying to blame mark-to-market for the whole disaster. The disaster was systemic, in the sense that there appear to have been lots of things which worked together to transform the after-effects of the bursting of the US housing bubble into a full on crisis. The funny thing about it is, is that the housing bubble didn’t pop. It deflated in a fairly orderly fashion. ]

46

Mr Denmore 10.27.08 at 6:11 am

Derrida, at 34, the answer to your question is they are here: They’re called the RBA.

From Bloomberg today:

Oct. 27 (Bloomberg) — Australia’s central bank bought the country’s currency for a second day to arrest a 35 percent drop in the past three months as prices slumped for commodities that generate 70 percent of the nation’s export earnings.

Australia’s dollar pared declines after the Reserve Bank of Australia intervened as the currency neared its weakest level in five years against the U.S. dollar and a record low versus the yen. The Group of Seven industrialized nations are concerned about excessive moves in the yen, according to a joint statement read by Japan’s Finance Minister Shoichi Nakagawa today.

The central bank “provided more liquidity to the foreign exchange market,” a spokesman for the Sydney-based RBA said today by phone. He declined to be identified. The intervention came amid similar circumstances to those on Oct. 24 when the RBA bought Australian dollars, according to the spokesman.

47

notsneaky 10.27.08 at 6:14 am

Yes, but good management which is “overwhelmed by the combination of global financial integration and unjustified faith in the US financial system” really isn’t good management unless you claim that it could not have done any better. What kind of actions could non-US central banks have undertaken too have prevented that kind of contagion, short of restrictive capital controls or the like?

I’m not entirely convinced about the failure of US monetary policy. If the Fed had popped the housing bubble in 2001 or whenever what then? Ten years of Japanese style stagnation?

The failure of regulation (or the lack of it) of the financial system did play a more obvious role.

48

Martin Bento 10.27.08 at 6:21 am

OK, let’s move ahead to remedies for a moment. Krugman and others have called for fiscal stimulus, damn the deficit. I saw again today one of the business blatherers challenging Austin Goolsbee on what spending Obama will cut because of the crisis. I think we need a petition that a lot of economists could sign and publicize that could be pointed to in that situation to convince the media that austerity is exactly what we don’t need right now, notwithstanding that the IMF has repeatedly imposed in on other countries in times of financial panic (and demonstrated by the results of those policies). Anyone interested in taking up such a petition? I emailed Krugman, but I guess he’s not going to do it.

Also, if we assume deflationary pressures from both the crisis itself and possibly from some of the desirable remedies (e.g., there may be an argument for increasing reserve requirements, but that would be deflationary), it creates room for some countervailing inflationary pressures, no? While we’re epatering the Friedmansie, maybe we should go for (not so) broke and just print money. What are the arguments for and against monetizing at least at least some of that debt? Yes, it’s inflationary, but there is a counterbalance. The alternative would be to leave it as debt to be dealt with later. Though monetizing is normally regarded as the irresponsible course, it does mean paying (in inflation) now for the stimulus we get now, rather than passing it on, does it not?

49

rortybomb 10.27.08 at 6:46 am

There’s two big critiques of the EMH: (1) those who work out of “behavioral economics”, which argue that cognitive biases throw market prices out of whack, and (2) those who take a “limits to arbitrage” approach – that the Friedman/Fama approach to how the EMH works requires people to be able to short stocks effortlessly, when in reality it requires capital/time/etc. and is subject to noise-trader risk which it isn’t compensating.

I’m curious as to how it’ll go from here in the finance research – I certainly hope more of #2, and less of #1, which I think dodges the real problems. It could probably use a #3 – animal spirits sometimes.

50

dsquared 10.27.08 at 9:39 am

Look, weak-form EMH is gone, guys, it’s dead. Andrew Lo killed it. There are measurable and robust momentum effects, under and over reactions and lead/lag relationships between large and small cap stocks.

I think I’m going to strike out for the wilder shores of contrarianism here and say that I don’t necessarily think that US monetary policy has been a failure. People forget just how bloody nasty things looked in 2001. Massive monetary easing and taking advantage of the global savings glut still looks like the right thing to have done to me; and the real estate boom was an obvious and necessary consequence of that monetary easing. The benefit of the consumption smoothing over the last seven years shouldn’t be underestimated, and if we have a recession less severe than the early 1980s then we’ll have done pretty well when you consider the magnitude of the shocks.

Different financial regulation could certainly have helped avoid the actual bank collapses we’ve had, but it would have meant that monetary policy would have had to have been even more aggressive in 2001 to avoid a recession (and indeed that it might have been impossible to do so).

51

J Thomas 10.27.08 at 12:06 pm

I think I’m going to strike out for the wilder shores of contrarianism here and say that I don’t necessarily think that US monetary policy has been a failure. People forget just how bloody nasty things looked in 2001. Massive monetary easing and taking advantage of the global savings glut still looks like the right thing to have done to me; and the real estate boom was an obvious and necessary consequence of that monetary easing.

Maybe. Imagine that you’ve had a serious sprained ankle and it hurts to walk on it. So you inject yourself with a big dose of amphetamines and painkillers so you can run without noticing the problem. That might make sense when there are ten minutes left at the big game. But you don’t want to do that day after day.

http://en.wikipedia.org/wiki/Balance_of_payment
“The United States has been running a current account deficit since the early 1980s. The U.S. current account deficit has grown considerably in recent years, reaching record high levels in 2006 both in absolute terms ($758 billion) and as a fraction of GDP (6%).

“Milton Friedman has tried to explain that cheaper, riskier, foreign capital is exchanged for “riskless”, expensive, US capital and that the difference is made up with extra goods and services. Nevertheless, Friedman’s interpretation is incomplete with respect to countries that interfere with the market prices of their currencies through the changes in their reserves so only applies to Canada and, to a lesser extent, the United States.”

Current account deficit 6% of GDP. 2006
GDP growth rate 2.2% of GDP. 2007

I say, this is something that will cause a crisis. The longer you wait to fix it the worse it will be.

If monetary policy got used to help us ignore the problem then monetary policy got misused.

If there was something we could have done about it but we built houses instead, then we made a great big mistake.

Maybe monetary policy couldn’t have fixed this problem. Maybe it could only have helped some other plan to fix the problem, and once we had the plan ready we’d know what interest rate etc we’d want. But there was no plan. All we did was delay the problem until we couldn’t delay it any longer.

52

Miracle Max 10.27.08 at 2:13 pm

The ‘Rossers of EconoSpeak’ are unrelated. Barkley’s wife Marina is a professor (comparative systems) with him at James Madison Univ in Virginia. Brenda is an activist w/o econ Ph.D. in Australia who commented so much and so well on EconoSpeak that we made her an author.

And don’t forget bona fide Ph.D.s Peter Dorman, James Devine, and Kevin Quinn, as well as worldly philosopher The Sandwichman.

53

John Emerson 10.27.08 at 2:20 pm

I’m going to go Dsquared one better and say that the destruction of civilization as we know it is really not all that big a deal, and might even be a good thing.

54

del 10.27.08 at 2:23 pm

Or, say, the water companies in the UK. One of the reasons for their privatisation was that government simply wasn’t going to stump up the necessary (or perhaps desired is better) investment to improve the systems. And investment in the system has indeed risen since privatisation.

I’m in the water business, so to describe the poor state of infrastructure investment post-privatization would be telling tales out of school. I’ll just say 1) that it isn’t enough to say that “investment” has risen, it would have to rise by more than profit takes out; and 2) that it’s disingenuous to say that “government” wasn’t going to invest, as if government wasn’t in the hands of the very people who hated progressive taxation and loved them some selling off of the family silver. “We have to privatize, because we’re not investing”, in that situation, is a bit like “let us do what we want or the dog gets it”.

55

Walt 10.27.08 at 3:05 pm

Daniel: God, I can’t believe I’m defending the EMH, but as of 2007 the EMH was not dead, and Lo definitely did not kill it. (Whether it should have killed it is a different matter.) I’ve been confidently told by financial economists that most financial economists think the stock market is semi-strong form efficient (I doubt anyone has ever done a survey). This is as recently as two years ago.

56

dsquared 10.27.08 at 3:17 pm

I suspect that might be true as a sociological statement about financial economists, but so much the worse for financial economists’ keeping up with the state of research on the specific question of equity market weak-form efficiency. Lo’s voluminously documented that there are autocorrelations in equity returns series.

57

Sock Puppet of the Great Satan 10.27.08 at 3:28 pm

“Not really. I think at the Buffet or Soros level, you’re getting to the point where they may have truly private information.”

Or, Soros and Buffet don’t worry about their end-of-year bonus, and have sufficient of a reputation that a few quarters of sucky returns won’t cause investors to bolt.

This actually sounds like a

“I think I’m going to strike out for the wilder shores of contrarianism here and say that I don’t necessarily think that US monetary policy has been a failure. People forget just how bloody nasty things looked in 2001. ”

Yeah, but the suckitude would probably have been less contagious. Yeah, real estate run-ups would have resulted, but the longer interest rates were held low the more expectations became adaptive and not rational. Plus there’s the inequity of the wealth transfer from those entering the housing market to those exiting, and the drag that higher house prices would have over decades on consumption by those who bought the houses at their higher prices. (Assuming that inflation targets remain low.)

A U.S. fiscal policy which skewed gains to the wealthy also I’d say was the reason interest rates were held unhealthily low for so long . Without Greenspan shooting the economy with adrenaline and keeping the wealth effect going, there just weren’t enough gains in median income to keep the economy growing.

“Massive monetary easing and taking advantage of the global savings glut still looks like the right thing to have done to me; and the real estate boom was an obvious and necessary consequence of that monetary easing.”

Still trying to wrap my head around that weak-form EMH might be dead, as it’s been the main reason I don’t pick stocks.

58

mpowell 10.27.08 at 3:31 pm


Look, weak-form EMH is gone, guys, it’s dead. Andrew Lo killed it. There are measurable and robust momentum effects, under and over reactions and lead/lag relationships between large and small cap stocks.

As someone who is not an economist but has a very strong math background, how hard is it going to be for me to gain anything from these articles?

59

Gar Lipow 10.27.08 at 3:33 pm

I would say all this is also an argument for something I’ve said repeatedly on the old MaxSpeak, and on Gristmill – that while putting a price on emissions is a neccesary part of fighting climate chaos, public investment is not only also essential, but more essential. Putting money on a scale comparable to military spending (though maybe not as high the scale – say in the U.S. 200 billion to 300 billion annually) is best way, and maybe the only way to transition away from fossil fuels fast enough to avoid some major tipping points. Regulation is also critical. Pricing, though probably unavoidable, is the least important of the three. In buildings, transport, and electricity production what needs to be done is easily measurable – emissions per kWh, per square foot or person inhabiting buildings, per passenger mile, per ton-mile. The industrial sector is a critical area where “emissions per what” is less easy to answer, which is why pricing can’t be avoided.

Further, while there is room for technical improvements, the technical choices are pretty clear.

In electricity the fight is clearly between renewables, nuclear or a mix of the two. Fossil fuels with capture and storage is not going happen in the time frame and scale we need; with today’s technology or likely breakthroughs over the next few decades it will stay more expensive than both renewables and nuclear.

The means both of making new buildings more efficient, and of retrofitting existing buildings to improve their efficiency are also well known via insulation, sealing of ducts and of openings to the outside and so on. (Also more efficient lighting and appliances.) Once that is done, depending on various circumstances, ground source heat pumps or solar heating can supply much of remaining demand – further reducing building demand.

Similarly in transporation the answer is obvious – electric trains for most freight – with trucks use only to get goods to an from rail freightyards. Simlarly electrification is the answer for passenger transport electric cars, plus to some extent electric trains , the latter obviously where populatin distribution supports it. (Yes, bikes, walking, more telecommuting too – but mainly electric cars and trains.)

In the above sectors, emissions pricing will help, but mainly as a way of mopping up.

Because industry involves such a huge mix both of means and of ends, emissions pricing/permits will have to be the major means of control . Though even here there are some clear choices. About 70% of industrial consumption is in boilers – so various means to reduce emissions from these will be needed. (Or where this can’t be done, waste heat from such boilers can produce electricity as a side effect.) Much of the remaining energy not used in boilers drives motor, and means to make these more efficient are well know. A high percent of industrial motors are used to drive pumps, and again we know how to make pumps much more efficient. So clearly there is room for effciency regulations to improve industrial effciency. But it is also worth remembering that a lot the ways to improve industrial efficiency require more cleverness than simply improving key processes. For example, a lot of steel making is close to maximum thermodynamic efficiency. But you can still improve industrial processes to reduce scrapping during steel manufacture and during steel use. And for that matter you can substitute other stuff for steel, sometimes with huge savings in energy and improvements in quality. This is the kind of thing markets are good at and rule based regulation or subsidies do badly. That is why in industry, unlike other sectors, reductions will have to be reduced via emissions taxes or auctioned permits.

60

dsquared 10.27.08 at 3:41 pm

#58: depends. Probably not too bad if you have a look at the articles in Campbell, Lo & Mackinlay, “A Non-Random Walk Down Wall Street” or some of the papers on Lo’s website.

61

mpowell 10.27.08 at 3:46 pm

60: Thanks, I’ll take a look when I get a chance.

62

rortybomb 10.27.08 at 6:56 pm

Second, “A Non-Random Walk Down Wall Street”; if you are very good at statistics, “The Econometrics of Financial Markets” by Campbell/Lo is the big reference, though slightly out of date.

If you get really interested, the papers listed here are a solid basis of the debate as it was 2 years ago:
http://www.sfu.ca/~kkasa/econ482.html

Dsquared: Great comments, but I’m still not convinced that autocorrelation and other related stock movements aren’t just proxies for risk (consistent with EMH). Look at the momentum chaser blowup in the hedge fund community in 2007!

63

MQ 10.27.08 at 8:07 pm

There’s two big critiques of the EMH: (1) those who work out of “behavioral economics”, which argue that cognitive biases throw market prices out of whack, and (2) those who take a “limits to arbitrage” approach – that the Friedman/Fama approach to how the EMH works requires people to be able to short stocks effortlessly, when in reality it requires capital/time/etc. and is subject to noise-trader risk which it isn’t compensating.

What about liquidity risk? I never understood how it wasn’t possible that the arbitrage opportunities identified on the market weren’t real returns to tiny risks of a failure of liquidity in certain markets, or what instruments would be safer in case of a big financial blowup. Actually, I never understood how you could serenely say that a seeming mispricing wasn’t because of lack of information — you just didn’t know something subtle about the seemingly underpriced asset. I just don’t understand how real actions guided by EMH can rule this out.

64

Mr Art 10.27.08 at 8:27 pm

Before we dance on the grave of the Great Moderation, can we at least wait until unemployment and/or inflation hits 10%?

65

J Thomas 10.27.08 at 9:50 pm

Actually, I never understood how you could serenely say that a seeming mispricing wasn’t because of lack of information—you just didn’t know something subtle about the seemingly underpriced asset.

If you assume that it’s publicly-available information that you lack, why is it that everybody but you has access to that information and factors it into their choices?

66

MQ 10.27.08 at 10:23 pm

J. Thomas, I assume you’re saying here that the model assumes all relevant information is public, or no one has relevant private info, but we can’t assume this in the real world.

Also, on a deeper level — the (few) arbitrage strategies I understand in any detail often seemed to proceed by assuming that small premiums people were earning for some particular type of asset were based on public but silly information, people assuming that asset was a little less risky than some other type that looked legally identical. Well, maybe the folk wisdom was right. Maybe people have some prejudice that looks irrational in normal times but is actually a small risk that will only show up in times of great financial stress. I remember someone claiming that LTCM hadn’t actually earned an arbitrage profit when it was going well, but had been fairly compensated for the risk involved in betting on obscure bond types issued by less trustworthy governments.

67

J Thomas 10.28.08 at 4:47 am

J. Thomas, I assume you’re saying here that the model assumes all relevant information is public, or no one has relevant private info, but we can’t assume this in the real world.

Bear with me a moment.

Suppose that John Quiggen is the brother-in-law of an executive secretary at a public company, and she has handled some _very interesting_ documents that convince him this is the time to buy. And he tells me. I trust John, so I buy. But I can only afford to risk $10,000 on this inside tip. And there it stands. I have had inimal influence on the price.

But I tell you, my good friend, and you trust me, so you buy. You can only afford to risk $20,000 on this inside tip. We have had minimal influence on the price.

You tell dsquared and he trusts you, so he buys. He can only afford to risk $5,000. The three of us have had minimal influence. Dsquared tells rortybomb, who trusts him and buys. He can only afford to risk $500,000. Now we’re starting to influence the price a bit. Should it be considered public knowledge by now? Or is it still a secret?

As long as the bulk of the money is behind the public consensus view, a small minority who knows the truth will have small effect. I’m thinking the biggest effect will come when roughly half (weighted by #dollars) of the investors know the inside scoop and the other half doesn’t. From that point on the dwindling minority that doesn’t get it will have an increasingly smaller influence on the price.

So given a mass of people who have access to the public knowledge, a small minority that has correct special knowledge will not have a large effect. They are a contrarian small minority. They can presumably make money but they will not have a large effect on price.

Am I wrong?

68

beezer 10.28.08 at 10:00 am

I’m not an economist, but you all seem to be a cordial bunch. I have a question. What would be the likely effect of raising the tax rate to 80% on investments held less than six months?

69

dsquared 10.28.08 at 10:18 am

I’m still not convinced that autocorrelation and other related stock movements aren’t just proxies for risk (consistent with EMH).

Hmmmm … I would be almost prepared to entertain this in respect of the size and value anomalies, but it’s quite hard to see what sort of risk momentum anomalies would proxy for.

Look at the momentum chaser blowup in the hedge fund community in 2007!

Evidence is very ambiguous here as far as I’m concerned – it is not like “buy and hold” has had fantastic returns these last 12 months either, and the strategy outlined in Khandani & Lo’s “What Happened to the Quant Funds in August 2007?” actually made back most of its drawdown in the following months.

70

J Thomas 10.28.08 at 11:51 pm

I’m not an economist, but you all seem to be a cordial bunch. I have a question. What would be the likely effect of raising the tax rate to 80% on investments held less than six months?

I’d expect liquidity to go way down. Brokers would lay off staff.

Maybe the options markets could take over? When you buy a stock you sell the right to buy it in 6 months at some price. Maybe at 4 months the price for that option goes down enough that you buy it back, and then you sell it again at 3 months. Etc. Even though the sales of the stock are regulated, if sales of the options stay unregulated then people might manage their short-term bets that way.

Maybe you could sell an option to sell at market. Then someone who thinks he wants to hold the stock a shorter time could buy the option, say, a few days ahead of time. When it comes due if he wants to sell then you sell for him and he doesn’t pay the tax because you’ve held it for 6 months. If he wants to buy after all then he buys it from you and then he’s stuck with it for 6 months — but he can sell the option.

I expect the biggest result of a tax like that is that the finance industry would stage an all-out advertising and astro-turf-roots campaign to claim that the tax is anti-free-enterprise, anti-liberty, anti-industry, anti-capitalism, anti-American-Way, anti-prosperity. That it destroys americans’ retirements. That it empoverishes widows and orphans. That it results in a flight of capital from the USA, the investors we need to keep America great will all move all their money to foreign stock exchanges and US businesses will all go bankrupt and the Treasury will have to default on savings bonds.

There would probably be a move in Congress to impeach a president who let the IRS make a ruling like that. Surely Congress wouldn’t pass such such a tax law. It would be too unpopular.

71

J Thomas 10.29.08 at 1:51 pm

And yet, it’s a great idea.

Maybe we could start out with an 80% tax on profits from stocks sold within 3 days, and gradually increase it to 6 months?

72

Walt 10.29.08 at 3:40 pm

The “explanation” for momentum is that it’s too small to make money off of it — the profits you make would be eaten up by the transaction costs.

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