Thursday, February 10, 2011

Why the Efficient Market Hypothesis (Weak Version) Says Nothing about the Ability to Identify Bubbles

One answer we keep hearing to that entirely reasonable question, “Why didn’t economists predict the crash?”, is that economic theory, in the form of the Efficient Markets Hypothesis, proves that reliable prediction is impossible. Sure, it is argued, some people like Brad Schiller and Dean Baker were jumping up and down and pointing to a housing bubble, but there are always Cassandras, and it is purely coincidental that these particular Cassandras turned out to be right. No doubt there are a range of other economists saying all sorts of things today, and in retrospect a few of them will be right too. But no one outpredicts the market on a regular basis, so there is no reliable way to know whose predictions today will prove correct in the future. This, we are told, is the lesson we need to learn from the EMH.

The logical fallacy here is so obvious that I would not bother with this post if it were not for the persistence of the EMH defense. So here goes.

First, for those not already versed, there are two levels of the EMH. The strong level says that market prices reflect the fundamental forces acting on an economy: there is no better measure of the true opportunity cost of something than its market price, or prediction of the future supply and demand conditions than its appropriate future, etc. This is known to be false, due to systematic biases and anomalies like overshooting, calendar effects, etc. That is not at issue.

The discussion largely centers around the weak version which says that, while market prices may not always be a great guide to real economic forces, their movements are not systematically predictable. At every moment, prices reflect all the forecasts of all the market participants who, between them, have access to all potential information and ways of utilizing it. A price moves only when new information arises. But to be truly new, this information has to be unpredictable—otherwise it is simply an inference from information that already exists. Because the information is unpredictable, so is its effect on prices. The randomness of price movements in turn implies that no one can outperform the market in betting on where they will go.

I have no problem with this. The fallacy arises when this argument is invoked to deny the possibility that economists can identify bubbles in real time. If you’re so smart you can spot a bubble, why aren’t you rich? If people could spot bubbles with any predictability, then the EMH would be wrong—but we know it’s right.

Let’s put aside the possibility that even the weak EMH can be wrong from time to time. We don’t need to go there; the error is more basic than this.

Let’s put ourselves back in 2005. It is two years before the unraveling of the financial markets, but I don’t know this; all I know is what I can see in front of me, publicly available 2005 data. I can look at this and see that there is a housing bubble, that prices are rising far beyond historical experience or relative to rents. The “soft” warning signs are all around me, like the explosion of cheap credit, the popularity of credit terms predicated on ever-rising prices, and the talk of a new era in real estate. Based on my perceptions, I anticipate a collapse in this market. What can I do?

If I am an investor, I can short housing in some fashion. My problem is that I have no idea how long the bubble will go on, and if I take this position too soon I could lose a bundle. In fact, anyone who went short in 2005 and passed on the following two years are price frothery grossly underperformed relative to the market as a whole. Indeed, you might not have the liquidity to hold your position for two long years and could end up losing everything. Of course, it is also possible that the bubble could have burst a year or two early and your bets could have paid off. What the EMH tells us is that, as an investor, not even your prescient analysis of the fundamentals of the housing market would enable you to outperform more myopic investors or even a trading algorithm based on a random number generator.

The logical error lies in confusing the purposes of an investor with those of a policy analyst. Suppose I work for the Fed, and my goal is not to amass a personal stash but to formulate economic policies that will promote prosperity for the country as a whole. In that case, it doesn’t much matter whether the bubble bursts in 2006, 2007 or 2010. In fact, the longer the bubble goes on, the more damage will result from its deflation. At the policy level, the relevant question is whether trained analysts, assembling data and drawing on centuries of experience in financial manias, can outperform, say, tarot cards in identifying bubbles. The EMH does not defend tarot.

To profit from one’s knowledge of a market condition one needs to be able to outperform the mass of investors in predicting market turns, which the EMH says you can’t do. Good policy may have almost nothing to do with the timing of market turns, however.

19 comments:

trucker said...

Mr. Dorman:

Perhaps it is legitimate to rephrase somewhat by saying that if the market is God then the market is always "right", by definition. And if the "investors" are the saints and the angels and Wall Street are the apostles then who are we (the shepherds) to complain. All is going according to God's plan and the losers lose and the winners win. It is not "rational" to believe that "God" meant the rich people to be rich and the shepherds to be poor. But that is the essence of EMH defense.

And _YES_ the bubble and the cure were both evident in 2004 but there was no way to do anything about it. What happened was that monopoly took over where competing enterprises had checked and balanced one another, and greed ruled the financial sector such that Satan took the hindmost.

I can't help but feel that the key policy to control this sort of crap is a highly progressive corporate income tax or the outright nationalization of the credit system. Indigenous money failed because of monopoly and greed.

"Too big to fail" can be managed by a highly progressive corporate tax. It is, after all, the government's dollars enforced by government.

Barkley Rosser said...

Peter,

The old argument that at any point one cannot prove econometrically that what one sees is a bubble because one is unable to determine what the fundamenal value is holds irrespective of EMH, although there are some cases such as closed-end funds where one may be able to identify the fundamental.

Noah said...

One subtle (tangential) point here is that if all you use is time-series analysis with exogenous (even stochastic) lag structures, then policymakers and investors face the same problem. For bubbles to be predictable under the weak EMH, you need a model that is not subject to standard time-series analysis.

Brenda Rosser said...

"The old argument that at any point one cannot prove econometrically that what one sees is a bubble because one is unable to determine what the fundamenal value is holds irrespective of EMH.."

Neither can 'the market' determine what the fundamental value is. Only a monetary price.

"To profit from one’s knowledge of a market condition one needs to be able to outperform the mass of investors in predicting market turns, which the EMH says you can’t do."

What is a 'market condition'??

href="http://dailybail.com/home/if-these-allegations-are-correct-it-appears-to-have-been-a-d.html">Goldman Sachs can outperform the mass of investors with the cooperation of the US Treasury.

Brenda Rosser said...

Sigh.

Goldman Sachs can outperform the mass of investors with the cooperation of the US Treasury.

The link is:
http://dailybail.com/home/if-these-allegations-are-correct-it-appears-to-have-been-a-d.html

Peter Dorman said...

Barkley,

You've added two restrictions to the policy-maker's task that don't have to be accepted. (1) It isn't necessary to have anything more than a range estimate for fundamentals. You've got a bubble if you're outside the range. (2) Why does the assessment have to be based solely on econometrics? I mentioned soft evidence on purpose -- I believe pretty strongly in utilizing all available information.

trucker said...

Mr. Dorman

IMHO you are right in your proposition concerning the recognition of a bubble. But the oil price was the bubble that broke the camel's back and not the ridiculous home values. Both of these commodities were sending the same signals.

But Minsky got it right concerning the irrational exuberance. It has little to do with numbers and models. The problem really isn't the recognition of the condition but the policy actions required to prevent the condition and/or to correct it. There were quite a few that saw it coming. But what to do???? Once you _KNOW_ you have a bubble, then whatever you do will pop it. So how do you rescue the non participants?

The bubbles are prevented by progressive income taxation and confiscatory inheritance taxes that keep money from piling up in large hoards that then cause bubbles. But the Hayekian proposition is that the economy advances _BECAUSE_ the rich and resourceful have all the money and _BECAUSE_ the only way they can get more money is by providing what others want to consume. It is an ideological problem. So accounting the metrics is irrelevant. What is the definition of the word "good" in the phrase "good economy"?

Barkley Rosser said...

Peter,

In a very public speech in Nov. 2008 I called for efforts by policymakers to restrain or pop bubbles, but had to admit that it is very hard to identify them definitively. However, I agree that any effort to do so must go well beyond just econometric analyses (although they should certainly be included) to include psychological surveys and a variety of other methods.

Tom Hickey said...

As someone who was on the ground in CA during this period, there were not only economic signals that the market was severely overheating and would soon become unsustainable based on ability to service, but also it was obvious that a lot of the deals involved either negligence in due diligence or fraud. It was quite clear for some time that the housing market was not "frothy" but Ponzi. The people charged with overseeing the market were either stupid, on extended vacation, or complicit. If I could see this plainly as a bystander, this should have been a no-brainer for professional regulators.

Brenda Rosser said...

Is capitalism equivalent to 'the market'? Many do not believe so. I question the relevance of the EMH to our reality.

Fruminous Bandersnatch said...

Indeed, you might not have the liquidity to hold your position for two long years and could end up losing everything

That was the fundamental argument of Shleifer's The Limits of Arbitrage, not to mention the famous line "the market can remain irrational longer than you can remain solvent.

trucker said...

Tom Hickey said... "The people charged with overseeing the market were either stupid, on extended vacation, or complicit".

No.

The people overseeing the market were helpless.

Republican deregulation destroyed any ability of government OR THE MARKET to do its job. Removing the walls between commercial and investment banking and insurance underwriting allowed a "dark" banking arena in which there was no data that could be used by private or public agents to account and track the creation of credit and risk.

Before the repeal of Glass Steagall the major players were adversarial and competitive and very wary of one another. When the walls came down then it was "how do we take market share from one of the other big banking conglomerates?". The creation of credit and the taking of "interest" on that credit was the obvious choice.

Fiat money cannot be endogenous within the private sector because there is no force of government within the private sector. When financial institutions can create credit money at will and receive "interest" on that money, they MUST do so in spite of risk or they will be absorbed. The "competition" between would be monopolies drives them to more and more risk. Interest rates set by the Fed are not sufficient to control securitization bubbles.

It may be that government, due to its seeming inability to tax, is no longer a real player.

juan said...

mid '00s, credit spreads [risk premium] had tightened considerably until by early '07 many catagories [junk corps, etc] were at record lows.

global reflationary efforts, rising earnings, use of CDS, greater number of hedge funds, developing mkts' increased strength/fiscal conditions, etc, all contributed to notions of a strong, nearly risk free recoovery.

[as an aside, earnings numbers were substantially inflated but this had begun nearly 25 years earlier. Same period, reliance upon quants and econometrics had moved beyond comprehension of many in upper management - why would most economists be aware of such unless financial economists, and even then...]

from the later 1980s, there had been a nearly complete restructuring of credit mkts while, from 1970, decade by decade, the real global econ slowed. The credit bubble was a process of substitution articulated with/driven by a particular classs segment.


More to follow but it's too late to continue at this moment.

L. said...

Interresting. Here's my take

http://orionorbit.blogspot.com/2011/02/econospeak-why-efficient-market.html

(No, I don't intentionally try to spam but at the same time I don't think a 2 page comment is a good idea)

Brenda Rosser said...

Peter Dorman wrote: ".. At every moment, prices reflect all the forecasts of all the market participants who, between them, have access to all potential information and ways of utilizing it. A price moves only when new [that is, UNPREDICTABLE] information arises. ...Because the information is unpredictable, so is its effect on prices. The randomness of price movements in turn implies that no one can outperform the market in betting on where they will go. I have no problem with this. "

Okay, you say that no one can predict the unpredictable. This sounds reasonable.

An unmanipulated system of exchange, if it exists/if it is 'real', therefore is likely to be totally unpredictable. This is logical.

I'm uncomfortable with this sentence: "...no one can outperform the market in betting on where they will go. I have no problem with this."

I have a problem with the above statement. What makes 'the market' the equivalent to a system of randomness and unpredictability in price movements?? Surely 'markets', as you say, can be either manipulated (predictable in price movements) and some 'markets' can experience unpredictable changes in price movements.

There are markets and there are markets. But the word 'market' is not synonymous with unpredictability.

Why would one assume that prices move only when 'new' (ie, unpredictable) information becomes available?? The knowledge of the eventual running down of global reserves of certain metals can be long-standing and 'predictable' but consumers may take a very long time to change their purchasing habits due to cultural, personal, human factors.

Brenda Rosser said...

"At every moment, prices reflect all the forecasts of all the market participants...

On what basis is this assertion made? Do all 'market participants' engage in the activity of 'forecasting'?

Brenda Rosser said...

Hmmm... the capitalist 'market' and how it depends on 'collective cognitive dissonance':

A good description from 'Bobby':
"[My family} still don’t really get why we do what we do, and when my wife and I try to explain a new project and the reasons for doing it, the eyes of our family members collectively glaze over until they look almost zombie-like. What follows is silence, which I presume is some rather uncomfortable thoughts rolling through their heads, and then the sweeping proclamations that everything will be okay in the end, really, the nice government and the businesses that finance it will fix everything so that We The People can continue to consume poisoned food, plastic crap from the far ends of the world, and oh yes, the ever popular American land yacht ... It is not just my family either; I see it all the time with co-workers and friends. The Force of market economics is strong, so much so in fact that it seems to cloud people's better judgment even though I know that deep down most realize something is seriously amiss and that the culture of consumption that is so common in the industrialized world cannot continue unabated forever. ... they are fed the myth of progress on an almost daily basis...the State of the Union address to the myriad of advertisements ... if thoughts stray far from the goals of progress, even for a second, then there is always something or someone their just in time to sing a lullaby and place those ideas to rest.

Worried about the environment? Buy this and that "green" product, fresh off the boat from Taiwan. Think peak oil is a problem? Buy an electric car. .... It is the line of thinking that we can buy and spend our way out of anything ....

Perhaps it is fear of the unknown, fear of hard work, or fear that the "things" of their existence, which they think means so much, will disappear forever causing a vacuum of sorts as far as personal worth is concerned. When I think of how most people in today's industrialized world define themselves, which is usually based upon jobs and possessions, I cannot help but notice that if these elements of their existence were removed then, in their own minds anyway, any idea od self-worth that they had as a human being would be removed as well. They would essentially have no locus of control and I wonder if this isn’t at least part of the reason why, in the face of such overwhelming data, many go on living as if the earth can provide a burgeoning population base forever without any consequence or contraction. I believe that the urge to hang onto the comforts of industrial life is strong enough that even highly intelligent people will neglect data that contradicts their preconceived notion of the future, even though they know that the data does not lie and will not simply disappear.

I believe this is why so many cling to the idea that there will be more gadgets and gizmos in the future that will power industrial civilization forever. The mysterious cult known as "they" in modern parlance will come up with some solution because "they" always have.

With this level of collective cognitive dissonance in mind, I have to wholeheartedly agree with Cathy's point that we cannot teach those that do not want to learn, but we can do our best to preserve the skills and information that will be needed for the future so that when the time comes, we can help those who are in desperate need of assistance. While my family continues to insist that the world can be saved by simply shopping for "green" products at WalMart, we will continue to tend the gardens, clean the coops, and prepare.2/10/11 10:00 AM

Don Levit said...

Brenda wrote (from Bobby):
When I think of how most people in today's industrialized world define themselves, which is usually based upon jobs and possessions,I cannot help but notice that if these elements of their existence were removed, then, in their own minds anyway, any idea of self-worth that they had as as a human being would be removed as well.

This is so beautifully written, that to add anmy words would detract from their meaning.
I can say only that I have been thinking of a similar concept the last few days. I am speaking at a Unitarian Universalist congregation in May, and I want to cover this subject, how to have some sense of security amidst a very insecure environment.
I think of Rudyard Kipling's poem, "If," which says, to the effect, If you can keep your heads about you when everyone else is losing theirs.
It is so important to be able to do so, and still retain our integrity and dignity, as well as the integrity and dignity of others. But, how can one be a decent fellow (a mentsch), when it seems like he is surrounded by predators.
Anything you, Brenda or Bobby, would like to add, would be appreciated.
Don Levit

Brenda Rosser said...

"how can one be a decent fellow (a mentsch), when it seems like he is surrounded by predators..."

A simple straight forward question. I wish the answer to it could be so.

Perhaps by meeting one's basic psychological needs? To be capable and successful at something. To live in company that cares for you and allows you to belong amongst them. To find a path in life that provides one with enough power and control (for example, to have the ability to chose the life roles we take). To give to and help others. To accept the truth and to focus on 'being', not simply 'doing'.

But we don't have to get all this right the first time, or the second or third time ;-)

(But when we do get it right, what will happen to capitalism and market-oriented socieities?)

"We must rapidly begin the shift from a "thing-oriented" society to a "person-oriented" society….[compassion] comes to see that an edifice which produces beggars needs restructuring. A true revolution of values will soon look uneasily on the glaring contrast of poverty and wealth. [Compassionate people] see individual capitalists of the West investing huge sums of money in Asia, Africa and South America, only to take the profits out with no concern for the social betterment of the countries, and say: "This is not just."

Martin Luther King calling for a Radical Revolution of Values in 1967