Bookblogging: Keynes and the Efficient Markets Hypothesis

by John Quiggin on July 13, 2009

This is the first in what I hope will be an extensive series of extracts from my forthcoming bestseller Dead Ideas from Live Economists 1. I’m inviting comments and suggestions from readers, with free copies of the book for the ten best. To avoid cluttering the home page, the substance will be over the fold, with only a short intro like this for each post.

Update The discussion has been very helpful, though a lot has more to do with what will come later. In this section, I’ve changed the para about Keynes speculative career a little.

Dead Ideas from Live Economists: The Efficient Markets Hypothesis

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done, JM Keynes, General Theory of Employment, Interest and Money Ch 12, p142 in Google Book edition, Atlantic Publishers

If there is one economic doctrine that has been central to thinking about economic and social policy over the last three decades, it is the Efficient Markets Hypothesis, or more properly, the efficient financial markets hypothesis. The EMH says that financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production.

Although economists since Adam Smith have pointed out the virtues of markets in general, the EMH with its focus on financial markets is specific to the era of finance-driven capitalism that emerged from the breakdown of the Keynesian Bretton Woods system in the 1970s. The EMH justified, and indeed demanded, financial deregulation, the removal of controls on international capital flows and the massive expansion of the financial sector that ultimately produced the greatest financial crisis in history.

Some more linking material to come here

Keynes and the casino

Few economists have been successful investors, and quite a few have been disastrous failures. But after a narrow escape from disaster early in his investing career John Maynard Keynes made a fortune for his Cambridge college by speculating in futures markets It is a striking paradox that Keynes was among the most scathing of all economists in his assessment of the role of financial markets.

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done” (General Theory Ch 12, p142 in Google Book edition, Atlantic Publishers

During the decades of the long Keynesian boom, financial markets were tightly regulated, and, as a result, financial crises disappeared almost entirely from the experience and memory of the developed world. At the margin, substantial profits could be made by finding ways to work around the regulations, while relying on governments to maintain the stability of the system as a whole. Not surprisingly, there was a warm reception for theoretical arguments that presented a more favorable view of financial markets.

Keynes’ views were reflected in the systems of financial regulation adopted as governments sought to rebuild national economies and the global economic system in the wake of World War II. The international negotiations undertaken at a meeting in Bretton Woods, New Hampshire, in 1944, where Keynes represented the British government, established an international framework in which exchange rates were fixed and movements of capital tightly controlled.

National governments similarly adopted policies of stringent financial regulation, and established a range of publicly-owned financial institutions in response to the failures of the private market. In the United States, a host of regulatory bodies were established to control financial institutions. The Glass-Steagall Act established the Federal Deposit Insurance Corporation (FDIC) and prohibited bank holding company from owning other financial companies. The Federal National Mortgage Association (later quasi-privatised as Fannie Mae, and then renationalised during the early stages of the 2008 meltdown) was established to support the mortgage market.

Although the details of intervention varied from country to country, the effect was the same everywhere. Banking in the 1950s and 1960s was a dull but secure business, resembling a public utility in many respects. Parents scarred by the Depression urged their children to look for ‘a nice safe job in a bank’.

The Efficient Markets Hypothesis changed all that.

1 The title suggested by Miracle Max was Dead Ideas from New Economists, a more direct play on Todd Buchholz’ New Ideas from Dead Economists. I like it a lot, but it has elicited some puzzlement from readers who aren’t aware of Buchholz (quite a few). Any thoughts on this would be welcome also.

{ 76 comments }

1

Silly Bugger 07.14.09 at 12:28 am

Re footnote 1: How about Zombie Economics: Refuted Ideas That Must Be Destroyed, Before They Kill Us All! (I’m one of those who never heard of Buchholz’ book)

2

Kieran Healy 07.14.09 at 12:33 am

Unfortunately, The Poverty of Theory is already taken.

3

Righteous Bubba 07.14.09 at 12:46 am

In the potential Dead Ideas from New Economists it clangs to describe an orthodoxy as new. If the economists bringing the dead ideas were new we could just hope they didn’t get jobs or something.

4

John Quiggin 07.14.09 at 1:48 am

We could have a whole section in the Invisible Library of book-Spoonerisms that have yet to be written. If I ever get to work properly on the non-profit sector, for example, I can write The Economic Analysis of Foundations.

5

TGGP 07.14.09 at 1:52 am

Scott Sumner seems the most dedicated champion of the EMH these days. He says Keynes wasn’t such a great investor, and we should not accept his view of the EMH, here.

6

John Hardy 07.14.09 at 3:10 am

Dead Ideas from Living Economists sounds better to me.

7

John Hardy 07.14.09 at 3:13 am

Although you might want to go back to your old theme: Refuted economic doctrines

8

StevenAttewell 07.14.09 at 5:20 am

Dead Ideas From Live Economists is a better title, in that it preserves a nice parallelism, and New Economists is too inside baseball a term for a general audience.

9

a 07.14.09 at 6:57 am

How and Why the Efficients Market Hypothesis Led to Such Inefficiency

10

Katherine 07.14.09 at 8:10 am

I quite like the title, although I have absolutely no prior knowledge of Tod Buchholz. I agree with Steven Atwell though that Dead Ideas From Live Economists makes more sense to someone who doesn’t get the inside joke.

PS I think, as a layperson trying to educate herself on economics, that I’m going to find this series fascinating and very useful. So thanks for that.

It does bring up a question though – what is your intended audience? I understand, I think, what you’ve written above, although I could do with a few pointers as to why the regulation you have described leads to dull but reliable stability – it makes sense instinctively, but that’s no basis for an informed opinion. I don’t know whether this is a reasonable request though, if the book is specifically aimed at your fellow economists. Is someone like me going to find all of it readable (although perhaps missing some of the complicated stuff), or am I going to get lost pretty soon?

11

Tracy W 07.14.09 at 9:02 am

The EMH says that financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production.

Wrong.There are many forms of the EMH, but the most famous one comes in three versions, which roughly are:
1. The weak form – future prices cannot be predicted by analysing past prices. You can’t beat the financial markets in the long-run by using past price information – chartists are wrong.
2. Semi-strong form – financial market prices reflect all public information, and you can’t beat the markets in the long-run by using past information.
3. Strong-form – financial market prices reflect all public and private information, so you can’t beat the markets in the long-run by insider trading either.
See for example “Efficient Capital Markets: A Review of Theory and Empirical Work.” by Fama, 1970 at http://www.jstor.org/pss/2325486
(Note, my language is a bit loose here, it’s a blog comment).

I don’t know anyone who believed 3, even before the financial crisis, including Fama, who formulated the three hypotheses. The debate is over 2 and 1. (And there’s also been a shift in debate about EMH to “how efficient are markets?”) I don’t see anything about how Fama’s version of the EMH demands any particular form of regulation or deregulation of financial markets, I guess the most obvious policy idea is that people shouldn’t be discouraged from purchasing index funds.

You are welcome to criticise the idea that financial markets are the best possible guide to the value of economic assets, but why do you keep calling that idea the Efficient Markets Hypothesis? Perhaps you could relabel that section “Dead Ideas from Live Economists: The Strawman’s View of the Efficient Markets Hypothesis”.

I also note that you haven’t disproved the hypothesis you are labelling a dead idea, in that you haven’t identified a better way of valuing economic assets.

12

JoB 07.14.09 at 9:27 am

John,

On the title: I don’t think your change is an improvement (I didn’t know this original but it’s just a better title so you might want to abandon tinkering with it): there are economists that are alive & kicking that are opposing exactly what you oppose in this excerpt. Furthermore, these are the better known ones to the public at large nowadays; ‘economist’ isn’t as pejorative as ‘banker’. I’d explore something like ‘The Big Cover-Up’, ‘The False Economic Consensus’, ‘Deregulation now deregulated.’ … I know none of these have the bite they should but there should be something in this direction which avoids a false generalization over economists.

It depends on the intended audience as well. But I gather you go for a large, interested but non-expert one (people like me, I guess).

On the excerpt: not being an economist, I think the ‘invisble hand’ is one of the beauties of all of modern thought (right up there with Darwin). From reading Smith, I always had a sense that it is quite important to have the right boundary conditions, the right context & ‘good’ non-economic drivers. Isn’t that an angle you might want to pursue? – that 90’s financial markets never met – & when unregulated never can meet – the constraints of free, fair and informed access. If you look at what happened in the past decennia, there clearly is evidence of very visible hands of a few of the ‘players’ hoarding capital in pre-specified ways aligned with their short term interest. I don’t think unregulated financial markets ever were ‘free’, in an original sense, they were an elaborate oligarchy with deregulation purposely designed & fitted, to suspend normal interventions under traditional anti-trust laws.

13

John Quiggin 07.14.09 at 9:50 am

Katherine, my target audience is pretty much the CT readership, or at least that component who are interested in economic debates, but aren’t professional economists. So, please tell me if I’m losing you.

Tracy W, there is more coming, which will cover the various forms of the EMH. Please hold fire until you’ve read it.

JoB thanks for this point.

14

Hidari 07.14.09 at 10:15 am

‘How about Zombie Economics: Refuted Ideas That Must Be Destroyed, Before They Kill Us All!’

Or ‘Vampire Economics! Putting a stake through the heart of dead economic ideas that won’t stay dead. ‘

Featuring: John Quiggan as Van Helsing! Joseph Stiglitz as his handsome, brave assistant! And Milton Friedman as the Evil Count (sic) whose dead eyed army of the undead have spread like a plague throughout University economics departments! They are alive…yet dead! Dead….yet alive! Can nothing stop this plague of the undead? Too many vampires….aaaaaaaaaaaieeeeeeee!

Feel free to use the above as your blurb for the paperback.

15

John Quiggin 07.14.09 at 10:26 am

Thanks for that: I think I might try Employment, Interest and Money … and Zombies. It seems to be an effective formula.

16

Salient 07.14.09 at 10:47 am

Dead Ideas from Living Economists sounds better to me. / Dead Ideas From Live Economists is a better title, in that it preserves a nice parallelism, and New Economists is too inside baseball a term for a general audience. / I agree with Steven Atwell though that Dead Ideas From Live Economists makes more sense to someone who doesn’t get the inside joke.

If John’s going to drop the inside joke, I’d suggest the very straightforward title Dead Ideas From Today’s Economists. I get the Dead/Live parallelism, but it strike me as a parallelism at the expense of making sense.

Also, I think New Economists is pretty good. It might work even for someone who doesn’t get the inside joke. Naively, I originally assumed “New Economists” just meant “the latest couple generations of economists” (and thus I basically understood what the book will be about). Learning later that it was a quasi-Spoonerism only made the title more fun. On the other hand, “Live Economists” sounds a bit more like stand-up or breaking news (is this a book about stupid things economists say in live interviews?).

17

nickhayw 07.14.09 at 10:47 am

Hey John,

A few comments from a layman with a layman’s interest in economics. I hope you’ll forgive me if I misinterpret anything.

1. You write, ‘few economists have been successful investors, and quite a few have been disastrous failures’. If you’re looking for trivia-type filler, I would love you to expand a bit more on this. The contrast between Ricardo’s success and Malthus’ tentativeness comes to mind. I find the history of economic thought pretty interesting, but it can also be dry at times, and that kind of colour-writing keeps it alive.

So if your average reader is anything like me, a digression on economists’ private lives is always going to be a nice prelude to weighty discussion. Those little biographical details (of the kind you mention with Keynes making money for his college = great stuff!) just bring the ideas to life, make them so much more immediate.

2. The paragraph immediately following your Keynes quote, the one that begins ‘during the decades…’, seems out of place, at least chronologically. It feels like the next three or four paragraphs ought to come before that one – that way you’re not jumping from ‘paragraph describing conditions fertile for the acceptance of EMH following the Keynesian boom’ to ‘paragraphs describing the conditions that led to the Keynesian boom’. I’ll confess to being confused on first read because I wasn’t sure which way you were going.

Looking forward to the book!

18

Tracy W 07.14.09 at 11:14 am

John, the problem is that you’re defining EMH to mean something that sounds similar, but is quite different, to what Fama labelled the EMH, and what every textbook and article I’ve read about the EMH, at least the ones that sought to at least lay out the pros and cons fairly, defines it.
Rather than using more words to try to clear up this matter in the future, wouldn’t it make sense to use a label that isn’t so confusing to start with? Aren’t you at all worried that some semi-savvy would-be investor would be persuaded to invest in some chartists’ scheme on the assertion by the chartist that “Don’t worry, the EMH was totally disproven by the financial crisis, see Quiggin’s book”?
Plus, to appeal to your self-interest, by calling the hypothesis you wish to attack EMH, don’t you risk people who do know how Fama defined EMH dismissing you as an ignoramus? And won’t some of those people be the very ones you want to convince?

19

John Quiggin 07.14.09 at 11:30 am

If you’re not going to accede to my request for patience, TW, you could at least try Google, which would lead you straight to this post (the first in the series that led to this book on the EMH).

https://crookedtimber.org/2009/01/03/refuted-economic-doctrines-1-the-efficient-markets-hypothesis/

I lay out the weak, semi-strong and strong forms of the hypothesis, discuss the evidence, note the general acceptance of the weak form, limited support for the strong form (not zero as you claim) and generally respond to all the points you’ve made. I don’t intend to debate you further until I’ve put the relevant sections of the book up for general discussion.

20

dsquared 07.14.09 at 11:32 am

As far as I can see, any version of the efficient markets hypothesis worth holding is going to have something like John’s point as an obvious logical consequence. If market prices reflect all publicly available information, then any regulation will either effect prices (which would have to be an efficiency loss) or not (and have no effect). In particular, if any version of the efficient market hypothesis is true, then anti-bubble monetary policy is a bad idea.

Aren’t you at all worried that some semi-savvy would-be investor would be persuaded to invest in some chartists’ scheme on the assertion by the chartist that “Don’t worry, the EMH was totally disproven by the financial crisis, see Quiggin’s book”?

Perhaps this question might be more pointedly asked to Prof Jeremy “Stocks For The Long Run” Siegel? Or in general to the cultists of buying and holding index funds, who I have to note are doing really quite a lot worse than they would have done if they’d followed some fairly simple stop-loss discipline?

21

John Quiggin 07.14.09 at 11:37 am

Actually, TW, I see you responded at length to this post, but with the same misconceptions, some of which may be cleared up by the more lengthy treatment I’m leading up to. At any rate, it’s not very helpful to raise the distinction between the three forms of the hypothesis when you should already know that I am going to cover this.

22

dsquared 07.14.09 at 11:37 am

note the general acceptance of the weak form

btw on this, the weak form of the efficient markets hypothesis isn’t generally accepted any more by financial econometricians – it’s generally accepted that it’s been refuted, by Andrew Lo and his co-authors. Over short time horizons, past prices are informative about future ones in a number of ways; there’s some debate over how this predictability maps onto the underlying market microstructure, but it is there, and there are plenty of algorithmic trading firms (google term is “automated market maker”) which do systematically make money out of the falsehood of the weak-form EMH. I would hate it if some CT reader was offered the opportunity to invest in Renaissance Medallion Fund, but turned it down because they’d read in our blog comments section that the weak-form EMH was still alive.

23

Commenterlein 07.14.09 at 12:12 pm

Dsquared, the weak-form EMH works about as well as any theory in the social sciences. The reason it works so well is exactly because there are arbs which aggressively make markets and try to profit from short-term price pressures. It obviously doesn’t work perfectly, and in fact it shouldn’t, for the reasons laid out in Grossman and Stiglitz’s aptly titled 1980 paper “On the impossibility of informationally efficient markets”.

The interesting issue is not in short-run price deviations, and if John thinks it is he better show us the billions of dollars he has made. Instead the interesting issue is in the big swings away from long-run value, which are incredibly difficult (i.e., expensive and risky) to arbitrage.

24

steven 07.14.09 at 12:47 pm

I actually think Silly Bugger’s suggestion of Zombie Economics is a really good title (you can tinker with the subtitle of course). To me there is something inherently offputting about a book whose subject is advertised as Dead Ideas

25

financial economist 07.14.09 at 12:52 pm

Commenterlein, the argument that identifying a market anomaly means you automatically make billions of dollars was itself shown not to hold in general some time ago. If you are risk neutral and have infinite resources, then sure. See, for example, De Long, Schleifer, Summers, Waldmann and “Limits to Arbitrage”, by Schleifer and Vishny. Though Jim Simons has made billions of dollars doing it, a point that Dsquared alluded to above.

For high-frequency data (intraday), I doubt anyone believes in the EMH. That would explains the existence of algorithmic market markers. It’s over horizons of longer than a day that’s somewhat more controversial. Though Dsquared’s right again there that there’s lots of evidence against it. “Value” stocks outperform “glamor” stocks. Periods in which the aggregate dividend-to-price ratio is high tend to be followed by periods in which the aggregate dividend-to-price ratio is low. Individual stocks tend to keep moving in the same direction for about a year, and then tend to reverse their direction. Stocks tend to underreact to the information contained in earnings announcements, etc., etc.

26

dsquared 07.14.09 at 1:00 pm

the weak-form EMH works about as well as any theory in the social sciences

No, there are plenty of theories in the social sciences which haven’t been voluminously refuted. The tape record of past prices is informative about the future. The stock market is not weak-form efficient. There is still plenty of predictability in returns left even after the algo industry has taken its share. Your business school professors are *wrong* about this one. (And while we’re on the subject of what Eugene Fama said, the definition of weak-form efficiency states that past prices aren’t informative about future returns, not that they are informative but that it’s difficult to make money out of it. Market efficiency is a statement about the information content of prices, not about who can and can’t make money. And people can and do make money out of the failure of weak-form efficiency, in spades).

27

Kevin Donoghue 07.14.09 at 1:09 pm

A couple of suggestions, not that I think John Quiggin needs my advice:

Give Bachelier a mention. Some of the Republican EMH fans might be turned off if they knew that a Frenchman got there first.

Distinguish between the claim that market prices discount all the freely available information and the claim that they provide useful signals which entrepreneurs can use. (I notice that a lot of the Panglossian economists mix up these two quite different points.) That’s Keynes’s main complaint about speculation after all; he doesn’t begrudge the players their fun, but he worries about the fact that the level of employment and the rate of capital accumulation are affected by the spinning of the whirlpool.

28

dpinkert 07.14.09 at 1:15 pm

How about “The Return of the Refuted: Dead Ideas From Living Economists”? It would be a play on Freud and Buchholz.

29

Salient 07.14.09 at 1:20 pm

(google term is “automated market maker”)

(Thank you for this!)

30

Salient 07.14.09 at 1:21 pm

I actually think Silly Bugger’s suggestion of Zombie Economics is a really good title (you can tinker with the subtitle of course).

Sure, except the Zombie thing is an inside joke, too.

31

Hidari 07.14.09 at 1:23 pm

‘I actually think Silly Bugger’s suggestion of Zombie Economics is a really good title (you can tinker with the subtitle of course)’

It’s certainly a lot better than ‘autistic economics’ which is not only vague, but vaguely offensive as well.

‘Zombie’ also conjures up quite a few images which are relevant to neoclassicism and neoclassicists as a whole: difficult to kill, seem to be alive but actually dead, eat people’s brains, will destroy the human race if not stopped, etc.

I suppose that would make the ‘new boys’ ‘Post-Zombie Economists.’ Perhaps you could put ‘post-zombie economist’ on your business card, John?

32

Bunbury 07.14.09 at 1:37 pm

If belief in the EMH had prevented someone from investing in one of the the other RenTec funds or with Bernie Madoff there would be less reason to apologise.

Or in general to the cultists of buying and holding index funds, who I have to note are doing really quite a lot worse than they would have done if they’d followed some fairly simple stop-loss discipline?

Not really anything to do with the EMH and good luck with the CPPI lite. In a few years time you won’t necessarily be pleased to have a portfolio with a lot of government bonds bought at very low yields and only a little equity. Negative gamma strategies don’t always work out so well and work particularly badly when risks turn out to be greater than expected.

The example does highlight one of the big problems with the EMH — fixing a timescale over which the market ought to be efficient. There’s no real reason to think that the market has a stationary target or that efficient for the market is efficient for you.

Even if you don’t believe that the implicit evolutionary mechanism removes all the financial equivalents of the appendix and vestigial legs, it is still a great source of null hypotheses. No alternative covers as wide a range of situations and is so easily available.

33

Bunbury 07.14.09 at 1:39 pm

PS I would prefer Dead Ideas from Living Economists to Dead Ideas from Live Economists.

34

Hidari 07.14.09 at 1:57 pm

Zombie Economics! Dead economic ideas that won’t stay dead…and how to kill them!

35

Tracy W 07.14.09 at 2:06 pm

John, perhaps I should know that you are planning to cover the three forms of Fama’s EMH, but I fail to do an awful lot of things that I think I should do, let alone things that other people think I should do. Nor do I see how your plans to write about the three versions of Fama’s EMH elsewhere reduces the confusion caused by your calling your hypothesis “financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production” by the name EMH. After all, now I have to distinguish between Fama’s EMH and what you name EMH, rather than just being able to refer to EMH. And many readers are just not going to be sitting there making complicated deductions about what you mean when you use a word. The general rule I use when writing is that if one reviewer misreads what I mean, some other readers are going to, so I may as well rewrite it to be clearer.

Or in other words, it’s nice that you intend to clear up my misconceptions, but I don’t see the point in insisting on introducing them in the first place.

limited support for the strong form (not zero as you claim)

I am not aware that I claimed zero. I just re-read my comments, and also did a search for the word zero, and I can’t see where I claimed that. I did claim that Fama himself doesn’t believe in the strong form, didn’t believe in the strong form in 1991, long before the economic crisis, and provided a link and a page number in support of my statement. I personally don’t know of anyone who believes the strong form of Fama’s EMH, and you didn’t cite anyone who believes it, but I do try to avoid claiming that zero people believe anything ever since I came across breatharians who say that they believe that we don’t need food and drink to live. Given the existance of breatharians, it strikes me as likely that you could find someone who says that they believe in the strong form of Fama’s EMH, but whether that person is any more influential in economic policy than the breatharians are in agricultural policy is a rather separate question, and I think an important distinction to make in evaluating real-world policy decisions.

D-squared: If market prices reflect all publicly available information, then any regulation will either effect prices (which would have to be an efficiency loss)

How does this work? For example, take the Pigovian case for taxing pollutants. Some pollutants cause a negative externality, so self-interested actors make inefficient decisions from society’s point of view. Applying the right level of tax to emissions means that self-interest actors take into account the externalities, thus increasing efficiency. Of course, there are always administrative and other costs from taxes, but assuming the pollutant is bad enough, the efficiency gain from reducing the pollutant would offset the costs of the taxes. Am I missing something?

Or take another argument for regulation. “In a best-case world it would be desirable to let big players fail. However our political system appears incapable of refraining from bailouts, creating an increasing moral hazard problem for financial markets. Therefore, as a second-best solution, we should regulate to stop players from getting so big.”
The one thing that the crisis has convinced me of is that I don’t know enough about financial markets to evaluate this sort of argument properly, but I don’t see how the truth or otherwise of any form of the EMH affects the validity or otherwise of this argument.

In particular, if any version of the efficient market hypothesis is true, then anti-bubble monetary policy is a bad idea.

And this follows because? And showing my ignorance, what is anti-bubble monetary policy, anyway? Raising interest rates sharply?

I’ve googled “automated market maker” with Google Scholar and got a lot of papers about something Hanson introduced which looks like something that provides liquidity to prediction markets (I first did a general Google and got a number of results about something that provides liquidity to the Sim Exchange and some job postings). Can you provide a specific paper behind this claim? I am particularly curious as to why, if there are algorithmic trading firms, they haven’t competed the excess returns away.

36

Bunbury 07.14.09 at 2:21 pm

Tracy, the Goldman software scandal might be a better lead than something from Hanson.

37

dsquared 07.14.09 at 2:43 pm

The example does highlight one of the big problems with the EMH —fixing a timescale over which the market ought to be efficient

Not sure what you mean here; if the market’s efficient, it needs to be efficient over any time horizon.

38

dsquared 07.14.09 at 2:44 pm

I am particularly curious as to why, if there are algorithmic trading firms, they haven’t competed the excess returns away.

basically because there isn’t an infinite number of them and they aren’t infinitesimally small, a phenomenon that’s surprisingly common in non-blackboard economic problems.

39

Kieran Healy 07.14.09 at 2:56 pm

because there isn’t an infinite number of them and they aren’t infinitesimally small, a phenomenon that’s surprisingly common in non-blackboard economic problems.

Obviously what needs to happen here is for economists to push back against the econophysics thing and become experts on neutrinos.

40

dsquared 07.14.09 at 3:00 pm

In fairness, it was an economist (Bachelier) who invented the Brownian Motion equations, so when it comes to infinitesimal things, they really do walk the talk.

41

Barbar 07.14.09 at 3:04 pm

The EMH says that financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production.

Tracy seems outraged by this statement, but if you removed the “The EMH says that” part, she clearly would agree with it.

Then if you asked her why she agreed with it, she would produce an argument more or less identical to the argument supporting the EMH (weak version or semi-strong version).

So I don’t see what’s wrong with what John wrote.

42

A-ro 07.14.09 at 3:40 pm

Regarding the title: either you’re riffing off Buchholz or you’re not. If you’re not, you don’t have to use the “X ideas from Y economists” construction. The zombies theme has real merit here because you’re talking about ideas that should be dead but are walking around interacting with things. But rather than using the word “zombie” why not undead?

Ideas:

Undead economics: ideas we killed that are still eating our brains
Undead ideas from living economists

43

Kevin Donoghue 07.14.09 at 4:09 pm

…it was an economist (Bachelier) who invented the Brownian Motion equations….

I don’t think Bachelier knew he was an economist. Interestingly, Keynes mentions Bachelier in his Treatise on Probability, but he doesn’t seem to have been aware of his theory of speculation.

44

Cosma Shalizi 07.14.09 at 4:25 pm

Bachelier did not know he was an economist, because he wasn’t; he was a mathematician whose thesis was supervised by Poincaré and he taught and published in math.

As for the connection of market “efficiency” to actual economic efficiency in allocating capital, this seems relevant: http://www.jstor.org/pss/2329517

In general, let me very strongly recommend Justin Fox’s excellent new The Myth of the Rational Market.

45

sj 07.14.09 at 4:27 pm

On the zombie theme, how about “Night of the Living Fed”? (on googling this, it appears nearly 500 people thought of this one first…)

46

Bloix 07.14.09 at 4:39 pm

The level that this is pitched at would have been just right for me when I was in law school, studying corporate law and regulation. Law students are exposed to an extraordinary amount of potted EMT (yes, it’s given the dignity of a T) and other dead ideas when studying issues like securities regulation and shareholders’ rights. I don’t know if lawyers and law students could be an intended audience for your book, but we certainly have need of something like it.

47

Kevin Donoghue 07.14.09 at 4:42 pm

Bachelier did not know he was an economist, because he wasn’t

But couldn’t he have been of the Devil’s Party without knowing it?

48

Martin Bento 07.14.09 at 4:46 pm

I suggest going with “Dead Ideas from Live Economists” or even “Undead Ideas from Live Economists”, but putting the zombie motif in the cover art. Real EC comics-style zombies eating the brains of live economists, perhaps recognizable as Becker et al. Zombies that all like like Milton Friedman. I also like “The Economic Ideas That Wouldn’t Die!” with appropriate screaming face.

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Martin Bento 07.14.09 at 4:50 pm

How about “don of the Dead: Milton Friedman and his Zombie Mafia”

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P O'Neill 07.14.09 at 5:37 pm

Mr Bubble himself, Alan Greenspan, May 2001

As I have indicated on previous occasions, identifying bubbles and their ultimate demise is exceptionally difficult. Indeed, as I already noted, movements in asset prices most often reflect changing underlying fundamentals. Forecasts that an increase in an asset price is a bubble would likely run counter to the conventional wisdom of a large segment of the investment community, or asset prices would not be so high.

http://www.federalreserve.gov/boarddocs/speeches/2001/200105242/default.htm

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Sebastian 07.14.09 at 5:38 pm

I think the tricky area is ‘best possible guide’, right? Because they could suck and still be the best possible guide.

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belle le triste 07.14.09 at 5:41 pm

since we’re already deep into the pedants-duke- it-out stage:
vampires = the undead = metaphor for capitalists bcz they suck yr blood
zombies = the living dead = metaphor for intellectuals bcz they eat yr brains

obviously many on the internet fail to respect the undead/living-dead distinction, but they are idiots without brains to eat

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ejh 07.14.09 at 5:49 pm

I should also mention that we’ve had successive postings from Belle and Sebastian, though not in that order…

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cwrd 07.14.09 at 5:51 pm

dsquared: if the emh is kaput, can we trust the capital markets to allocate capital efficiently? Or is it one of those “the worst except for all the others” situations?

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Bill Harshaw 07.14.09 at 6:58 pm

I know I’m over my head, but the “Lords of Finance” mentioned that Keynes had to be bailed out of bad investments a time or two, which complicates the idea of the brilliant economist making a fortune. Even a brilliant economist was seriously wrong at times.

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Stigand 07.14.09 at 7:27 pm

I don’t see Keynes’s combination of lucrative speculation and scepticism about markets as a paradox.

I can imagine that the experience of regularly beating the market in one’s own investments makes it easier to conclude that the market is imperfect. After all, one might conclude, if the market functions effectively, why do I keep making money?

A version of the same mentality leads some politicians who have been successful as entrepreneurs to be more in favour of an activist industrial policy than one might suppose they would be. Michael Heseltine in the UK, for one. A business – especially an owner-managed one – is the ultimate command economy.

An interesting question is whether politicians and economists in this position are scaling an assumption that can’t be scaled. I can easily believe that it’s much harder to pick winners with a $10bn stimulus package than with a $100mn venture fund, and easier to run a single business through central planning than an economy.

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dsquared 07.14.09 at 7:39 pm

#55: no, this isn’t true. Keynes once did get into some bad trouble when a speculation against the Weimar German mark (ie, about as right as a call could be) went against him in the short term. However, he was able to borrow money to meet his margin calls (something he would presumably have been aware of when he sized his position initially) and ended up making money on it.

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Phil 07.14.09 at 8:07 pm

After all, one might conclude, if the market functions effectively, why do I keep making money?

Yep. In a market that clears perfectly, nobody has an edge – and presumably nobody makes any money.

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Alex 07.15.09 at 12:19 am

A version of the same mentality leads some politicians who have been successful as entrepreneurs to be more in favour of an activist industrial policy than one might suppose they would be. Michael Heseltine in the UK, for one.

Alternative explanation: politicians with no experience of business whatsoever have the opposite opinion due to the Dunning-Kruger effect. Think about it: you are arguing that *entrepreneurs* of all people aren’t free-markety enough! In fact, EMH is so fantastic that only people who only take part in the economy by accepting taxpayers’ money and buying stuff, but who aren’t civil servants, oh no sir, can appreciate it!

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E. Teresa Touey 07.15.09 at 12:29 am

Dead Ideas from Live Economists is good. My main summary title for the present economy and the aftermath of all the politics and economic policy that have gotten us here is: Beyond Greed is Good.

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Tracy W 07.15.09 at 8:36 am

Dsquared: basically because there isn’t an infinite number of them and they aren’t infinitesimally small, a phenomenon that’s surprisingly common in non-blackboard economic problems.

If by automated you are referring to a computer system, I would have thought two automated market makers per financial market would be sufficient to push returns from their process to zero. You don’t name the result you are referring to with an infinite number of players in the market, but that sounds very much like the mathematical proof that under perfect competition all players earn their marginal cost as none of them have price-setting power. Trading in a financial market, okay, say hypothetically I can move super-fast and thus respond to new information before every other investor, then I have an edge and could beat the market return consistently (ignoring trading costs). Say I have one competitor who can also move as fast as me. So say some new news is uncovered, and my competitor starts buying Enron shares as super-fast as me, wouldn’t this undercut my profits? I guess you are assuming some limits on my financial backing, but presumably as I and my competitor get more and more money from our trades, we can afford to buy or sell more and more shares and thus presumably will just wind up moving the market more and more rapidly. Am I missing something?

Also, have I missed the bit where you provided a more specific citation for your claim about the automated market makers?

Barbar, it depends how you define “best possible”. And if you want to know how I would disagree with it, for some definitions of the words “best possible”, it’s actually not the EMH approach, it’s that democracies, and all other forms of governments, make mistakes too. Quiggin states that the economic crisis has refuted the claim that “financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production”. I’m going to call this the CI argument. To disprove the CI argument he must therefore have in mind some other guide to the value of economic assets and therefore to decisions about investment and production (and of course a definition of “best” and a definition of “possible”). And he must prove that this other guide is better. To take an extreme example, chemotherapy has a lot of downsides as a treatment for cancer, but according to the experts it’s still the best way to treat many cancers, because we don’t have a better alternative.

Quiggin doesn’t actually state what he thinks is the better way, he talks about the 1950s and 1960s, but sharemarkets were in operation in the western countries during that time. The Bretton Woods system may have reduced international capital flows, but as far as I know financial systems were still being used to value many economic assets.

And valuing economic assets if you don’t use markets is a difficult problem. What discount rate do you use? Do you use a discount rate at all? How do you account for risks, given that you don’t know the probabilities of them? What happens if some people disagree with your valuation system? Do you want to insulate the valuation system from some political pressures, eg politicians choosing to pursue uneconomic investments in marginal electorates, and if so, how? On a different thread at Crooked Timber I raised the question of how MPs salaries should be set, and those of other government only-jobs like judges and police officers. No one mentioned a definite rule as to how their pay should be calculated. Quiggin’s failure to be explicit about what his better way of valuing economic assets actually is, is rather noticeable to me.

Furthermore, I understand that the reason that Bretton Woods broke down was that Lyndon Johnson’s administration in the USA was inflating the US dollar to pay for the Vietnam war, and the other big countries in Bretton Woods eventually weren’t willing to keep paying the costs of that policy. Now perhaps it is possible to constrain governments so that no future government will behave in such a way as to bring down the future system, but Quiggin offers no plan about how to do so, and the intentions of many politicians in the past have failed to produce lasting constitutional settlements, see for example Fiji’s constitutional upheavals. This is why I queried here how Quiggin defines the word “possible”. Rational people can disagree about what constraints on future governments are possible.

Somehow I think I have a very low chance of getting a free copy of Quiggin’s book. :)

Phil – in a market that clears perfectly the marginal participant should be making enough money to compensate for the time they spend given their other opportunities, and any extra pains from their occupation. (Or, if being in that market is a pleasure in its own right, the money you should get would be discounted by the pleasures, which is how amateur theatre companies can continue to operate). When it comes to lending money, different time preferences can explain some money making.

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dsquared 07.15.09 at 9:23 am

If by automated you are referring to a computer system, I would have thought two automated market makers per financial market would be sufficient to push returns from their process to zero.

I would definitely advise further research before entering into the highly competitive and complicated world of algorithmic trading. The Themis Group White Paper is a good place to start in getting a handle on how technical these things can get. Basically, the problem is a) limited capital to place positions and b) neither markets nor computers are black boxes – everything depends on the very exact market microstructure of how an order gets filled, and on the way in which the computer is set up to minimise latency (Counterstrike players have absolutely nothing on algo hedge funds when it comes to whining about their ping times).

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Phil 07.15.09 at 9:51 am

in a market that clears perfectly the marginal participant should be making enough money to compensate for the time they spend given their other opportunities

That looks like two different meanings of the word ‘perfect’, one descriptive and one normative. Put it another way: is it possible for public information to be so good, and competitive pressures so high, that everyone trying to sell gets driven down to their own cost price? And even if it’s not possible, isn’t that one definition of a market that clears perfectly?

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John Quiggin 07.15.09 at 10:05 am

Tracy, as I think I’ve already pointed out, there is a lot more to come. The points you raise will be addressed, though I doubt you will be convinced. But I’m finding your contributions useful, and you are still in the race for the coveted free book.

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Not Really 07.15.09 at 3:55 pm

> b) neither markets nor computers are black boxes – everything depends
> on the very exact market microstructure of how an order gets filled,
> and on the way in which the computer is set up to minimise latency

I stand in awe of how much efficiency, in the engineering sense of that word, such activities add to the ability of the human species to feed and clothe itself, preserve its planet, and prepare for its future. I mean, there are just ALL KINDS of decisions involved in farming, manufacturing clothes, pumping oil, housing the elderly, etc that require changes in strategy, tactics, management, and capital investment every microsecond or so and which can go horribly wrong in the 75ms a ping packet takes to travel from Farmville Iowa to New York City.

Not Really

Not, in case that isn’t clear.

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Tim Wilkinson 07.15.09 at 5:12 pm

JQ – first, this book looks like being a Good Thing.

Obviously there are known, and probably unknown, unknowns about what is going into the finished product, but just based on looking at this and the intro from the point of view of one whose economics is pretty rudimentary, I think you might want to step back a bit and deal with some of the concepts involved, like (path-dependent Pareto-) efficiency, information (perfect and otherwise), price-taking (everyone a price-taker! There’s a nice bit of fetishism.), perfect competition (with little bits of tinkering to provide a modicum of realism), revealed preference, etc etc.

Otherwise, to my eye anyway, the broad sweep of neoclassical macroeconomic doctrine – and its counterparts – tends to come across as just so much free-floating jargon (i.e. more so than it actually, is I suspect).

Obviously you don’t want to (or rather aren’t here trying to) write an economics textbook, though judging from what I was given for A-level and during my brief undergrad flirtation with the idea of reforming the subject from within, a good one is sorely needed – ‘Economics as if people/reality really mattered’. Actually that might provide an alternative genre of titles – cos if the original allusion isn’t accessible enough (and I certainly didn’t get it), the main appeal of that whole range of possibilities seems to me to be reduced significantly.

But anyway, in the finished collection anyway, you might want to/are planning to address some or all of those dogmas-dressed-as-definitions-or-methodologies – and the order in which that is done could help a lot with exposition.

The EMH seems pretty wierd to me – like a lot of economic theorising, rather convoluted and either a strong vacuity/tautology suspect, or a pretty onviously silly assertion that no one can beat the market because everyone already knows everything. Isn;t it basically a distributed crowdsourcing sort of idea, combined with the assumption that people will only reliably aim at accuracy if it’s in their own self-interest? It could certainly do with some very detailed unpicking (not suggesting that no-one has thought of that, nor more relevantly that you haven’t.)

Shorter: non-economists are being chucked in the deep end.

FWIW, some sort of highly perspicuous running analogy might be useful (and a magic pony).

And titles – The Dead Hand of Adam Smith? Dismal Dogmas? Holding Economists to Account? Just brainstorming, not suggesting these are much good.

& BTW (not entirely germane), there is a prevalent tendency on the part of economists to ignore the sheaf of caveats that they keep in the bottom drawer, apparently for the sole purpose of producing them occasionally in misleading rebuttal of allegations that they haven’t taken them into account. I’m probably wrong, and don’t mean to be impudent, but something rather similar seems to be exhibited here on the Ashes thread: As regards unsporting behavior and so on, it all depends on what the fans want. If we cheer on our side when they engage in sledging and time-wasting, we’ll get more of it. If we cheer the player who walks without waiting for the umpire, that’s what we’ll get.

I think the simplifications involved in the no barriers, perfect info, non-tuism, zero transaction cost, instantaneous, no externalities etc. model are just too easy to accept, so that the (acknowledged) complications which lead far, far away from the idealised version have to shout very loudly indeed to get incorporated into any given analysis. Which is why, even though it might be possible to produce a realistic model along ‘ideal efficiency/general equilibrium + concessions to reality’ lines, the odds are always stacked against it actually being done properly – and a different approach is IMO needed. Unfortunately I haven’t got round to developing that just yet. Maybe for your next book?

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John Quiggin 07.15.09 at 10:39 pm

Tim, on the Ashes point, I agree it’s a gross oversimplification, but then it was a blog comment. In blog comments, at least, I think it’s reasonable to keep the qualifications in the bottom drawer.

In this case, the standard “hard-nosed” analysis is one that completely ignores the economic character of the activity (a part of the entertainment industry) and acts as if the true professional is one who wants to win the game/series/retain Ashes at all costs. I was just pointing that out, in an overstated fashion as you note.

Obviously, there are plenty of reasons why the outcome in (say) tomato markets doesn’t reflect consumer preferences, but it would be silly to discuss tomato producers as if their primary concern was winning a Tomato of the Year award or similar.

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Bruce 07.16.09 at 1:33 am

The EMH says that financial markets are the best possible guide to the value of economic assets

In order to refute this, is it not necessary to propose a superior guide to the value of economic assets? I don’t believe the EMH claims that market prices are accurate, only that they are relatively better than other methods.

The existence of bubbles do not disprove the EMH. If assets are obviously overpriced, why would wise investors not make long bets that the price of assets will fall? I suspect it is because they don’t know the when or by how much prices will change any better than those running up the prices.

Warren Buffet lost billions betting that the US dollar was overvalued. Almost all commentary I read supported his position based on the fundamentals. Finally after his contracts ended the dollar went down and everyone said he was right about the fundamentals but simply had the timing off. Then the dollar shot up even higher and now everyone “knows” it is overvalued. Is this a bubble? Is there a better guide to the future value of the dollar than the current value? If so, put your money where your mouth is and make some cash!

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Tracy W 07.16.09 at 7:30 am

Phil, I don’t know about you, but I’ve never discovered anything perfect outside mathematics. My description was meant to be normative, not positive. The value of talking about perfect markets is that it can help in understanding imperfect ones, like engineers use the concept of perfectly efficient engines.

I don’t know how we could measure whether everyone would be driven down to their own cost price in a real market because I don’t know how we would measure “own cost price”, so I’m unable to answer your other question. Of course the fact that I don’t know how to do something doesn’t mean that it’s impossible, I could just be showing off my ignorance yet again.

John Quiggin – that’s good to know.
D-squared – thanks for the link.

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Jock Bowden 07.16.09 at 9:47 am

JQ

The EMH says that financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production.

This is not strictly so. EMH merely says the price of an individual security at any point in time reflects all known public information about that security. Therefore, at market level, an individual, on average, cannot outperform the market, because that individual could not possibly have all the information that has made up these market prices. Of course, the corollary is that the best way to outperform the market is to have inside information that is not public. So you buy then, and sell when that inside info becomes public.

Now, of course when you get into 2nd year economics when assumptions start being relaxed, you find that the rules for small cap stocks, illiquid stocks, and so on have additional or different informational qualities.

It is no longer 1975. We all know about asymmetric information , transactions costs, and so on. Even Harvard Business School has taught its MBA graduates the EMH is crap for over a decade.

Also, I don’t know anybody – trader, investor, manufacturer – who makes their investment and production systems assuming that ” financial markets are the best possible guide to the value of economic assets”. Sure, calculating your cost of capital might involve theories that assume some form of EMH, but most of your decision-making would come from company reports and market intelligence, cash-flow analysis, etc.

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Phil 07.16.09 at 10:13 am

My description was meant to be normative, not positive. The value of talking about perfect markets is that it can help in understanding imperfect ones, like engineers use the concept of perfectly efficient engines.

IANAE – boy, am I NAE – but it seems to me that you’re still using ‘perfect’ in two different senses, and covering the gap by using two different senses of ‘normative’. You said:

“in a market that clears perfectly the marginal participant should be making enough money to compensate for the time they spend given their other opportunities, and any extra pains from their occupation”

But a perfectly efficient engine isn’t one that consistently gets me to work on time – it’s a description of how the mechanism functions, not what outcomes it delivers. Similarly, I don’t see how it can be in the definition of perfect efficiency for a market that any participant makes “enough money”. It seems more likely that perfect efficiency would mean that nobody has any kind of edge, since there are no imperfections or pockets of localised knowledge to exploit – whether they’re happy about that state of affairs is secondary, surely.

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andthenyoufall 07.17.09 at 2:50 am

Another vote for Dead Ideas From Living Economists (rather than “live”)

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Tracy W 07.17.09 at 11:30 am

Phil – actually the definition of engine efficiency is simply output energy in the useful form divided by input energy. A perfectly efficient engine has output = input = 100%. So the definition of perfectly efficient for an engine is about its outcomes, not about how the mechanism functions (especially since no one has built a working 100% efficient machine, which rather makes it difficult to say how it functions).

More generally, you can define the word “perfect” however you want, there’s no committee in charge of the English language. In mathematics, a perfect number is a positive integer which is the sum of its proper positive divisors. This as far as I can tell has nothing to do with how engineers or economists use the word perfect. If you want to define a perfectly efficient market as one that functions in a particular way, there’s nothing to stop you. In terms of clarity of English it might not be the best idea, but that’s not stopped many economists in the past. Or engineers.

Similarly, I don’t see how it can be in the definition of perfect efficiency for a market that any participant makes “enough money”.

It isn’t. It’s a result of the definition of a perfectly efficient market, as defined at least in the Econ 300 microeconomics course I took. As the definition of a perfectly efficient market includes that there are no transaction costs and infinite knowledge, the consequence is that if participants in the market get less utility from participating than they would doing something else, they stop participating in the market and go and do that something else. Also, if a non-participant in that market can increase their utility by starting to participate, they promptly do so (no transaction costs and infinite knowledge, of course). As I stated before, I don’t believe that any real world markets are perfectly efficient, the model simply has its uses for understanding real world markets.

Incidentally, economists talk about utility, not happiness. If someone doesn’t value being as happy as much as some other goals, eg acting for the greater glory of God, then it is at least theoretically possible for them to knowingly chose to act in ways that reduce their happiness. The point of using the word “utility” is to avoid arguments about what ends people aim at.

Dsquared, I’ve read the article you pointed me to – thanks. Some points:
1. The existance of liquidity rebate traders doesn’t strike me as affecting the truth or otherwise of the EMH one way or another. If the market centers want to pay people for posting orders then that strikes me as the same in concept as paying for an interior decorator to make your office look fantastic so you can lure people to meetings. Neither may be a wise use of your money, but I don’t see how someone could devise a trading scheme to beat that.

2. Predatory Algos and Program Traders – why do people keep writing institutional algorithms that are open to such manipulation? The article itself ends by recommending not doing that.

3. The AMM by learning hidden information, aren’t they increasing the efficiency of the financial market? I still don’t believe in the strong form of EMH, in fact my reading around this has started to convince me of the relative merits of the adapative markets hypothesis, but the AMM strikes me as improving the efficiency of the financial markets relative to whatever they were before (I’m using efficiency here in something like the engineering sense of output/input, not in the sense of perfect efficiency).

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Phil 07.17.09 at 12:29 pm

As the definition of a perfectly efficient market includes that there are no transaction costs and infinite knowledge, the consequence is that if participants in the market get less utility from participating than they would doing something else, they stop participating in the market and go and do that something else.

Let’s bracket out outcomes, results and consequences; in fact, let’s bracket out alternative courses of action and assume that our (imaginary) perfect market is the only game in town. We’ve got zero transaction costs and infinite knowledge, and we’ve got self-interested participants each of whom has an interest in maximising income and minimising outgoings.

My observation was that, in that (imaginary) setup, the tendency will be for everyone trying to sell to be driven down to their own cost price – with the result that nobody has an edge and nobody makes a profit.

What’s wrong with that picture?

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Tim Wilkinson 07.18.09 at 6:32 pm

Jock Bowden – at market level, an individual, on average, cannot outperform the market

That’s quite a good formulation for bringing out what looks like a tautological aspect to the EMH.

I don’t know anybody – trader, investor, manufacturer – who makes their investment and production systems assuming that “financial markets are the best possible guide to the value of economic assets” well, quite – this also shows the convoluted nature of the thing, perhaps analogous to the idea that everyone is a price-taker. As though the market takes its course and the participants are just enganged in hovering around the underlying equilibrium it dictates. I’ve never heard a clear formulation of the Invisible Hand which didn’t seem trivial either, for that matter.

NB I don’t think I’m disagreeing with you here. Just remarking on the EMH in its proffered formulation.

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Tracy W 07.20.09 at 2:10 pm

Phil, I can’t spot any flaws in your model. Just one thing – can you remind me what the point of this model is now? I’ve gotten confused.

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