My Argument in Favor of the Efficient Capital Market Hypothesis

Graphically summarized:

Link.

Trumping Nothing with Something

People have said--I think I have said, though I can't find it--that the Efficient Capital Markets Hypothesis will survive because there is no good counter theory and you can't trump something with nothing.

I've just started Wall Street Revalued: Imperfect Markets and Inept Central Banks, by the estimable Andrew Smithers where he claims to do just that--no, to have done just that back in 2000. Smithers graciously credits Robert Shiller with achieving the same goal by a parallel route. I'll keep you posted.

I guess the main reason I still hew to ECMH is the counsel-of-prudence aspect. When I teach basic finance to law students, I take it that at least half my job is to convince them that they aren't smart enough to outthink the market--okay, that they may be smart enough, but they are unlikely to be well enough trained, and very unlikely to be willing to give it the sitzfleisch that the job requires. So I think I'll stick to that part of ECMH, even if Smithers shows me how he can knock it in the head.

Two ECMHs: What Thaler Said

The Economist's postmortem on the place of academic economics in the late uproar is crisp and intelligent, not least for this account of Richard Thaler, expressing a point I've tried to make here before (link, link):

The [Efficient Capital Market] hypothesis has two parts, he says: the “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented.

Afterthought: I'm sure that Thaler has long since noticed that his craft-appropriate surname is the root of the word "dollar."

Semi-Appreciation: The Myth of the Rational Market

Justin Fox says his new book, "The Myth of the Rational Market" "is a work of journalism." He's right on that, and in this case, it is nothing to brag about. He's put together a highly entertaining collage of anecdote and apt quotation (there, thought ought to make a nice jacket blurb). But if you are looking to get your hands on the history of modern finance, you're going to look someplace else. He may offer the illusion that he is conveying knowledge but there is really no place in this porridge where he offers anything into which you can sink your teeth.

Start with the title: "The Myth of the Rational Market." Nowhere does he specify what he means by "rational" or "market" or "rational market" (nor, for that matter, "myth"--a word he quits using after the first chapter). At times he seems to be trying to build his story around the "Efficient Capital Market Hypothesis"--, ECMH, Eugene Fama's proposal (since rejected by Fama) that securities prices impound information that might affect securities prices. But from the get-go Fox seems to be treating "efficient" as synonymous with "rational." It isn't clear whether he sees no distinction, or figures that the reader will not see a distinction and so it's not worth sweating.

Either way, it is pretty clear that he wants to extend the definition far beyond the realm of securities prices; he seems to extend it at times to the behavior of all markets; to the principles of social organization in general; to the motivational scheme of politicians; to classic economic modelling; to modern macro theory, and perhaps to other realms that I haven't kept track of.

All these cannot possibly belong in the same bin. As an example, he seems to associate ECMH with the anti-state pro-market bias we associate with "Chicago School" economics. As an empirical matter, his own evidence defeats him. He points out that Fama himself is almost perversely apolitical and that other major players (e.g., Franco Modigliani) were avowedly leftish. Beyond that, the association seems untenable on its own terms: there is absolutely nothing about ECMH that requires or presupposes any particular form of state-market relationship (unless the mere existence of a market is thought somehow to be a political choice).

Beyond: the arguments in favor of the superiority of the marketplace over the state--some of those arguments are empirical ("markets work better"); and some are unreservedly moral ("markets are right"). But ECMH offers no parallel. Except insofar as it may seem to privilege the exercise of individual critical judgment, I should say that ECMH has absolutely no moral content whatever. It's just an observation, true or not true as the facts me dictate.

Beyond ECMH per se, Fox does canvass a broad range of material from critics or challengers of ECMH, although his presentation is not well organized. He needs to sort out, for example (a) structural distortions, like agent misbehavior, that serve the agent while disserving efficiency; from (b) "human limitations" as we see in Tversky and Thaler; and from (c) the analysis of bubbles, as in the work of Shiller or Minsky (indeed, Minsky seems to have been slapped on as an afterthought--perhaps Fox, like so many finance academics, had not really noticed him until the current uproar began).

But then for some reason he feels he has to go on and try to tackle virtually every other topic in modern finance theory (diversification pricing, beta; also rational expectations, public choice, valuation theory and a whole lot more). And not just to tackle them; to maintain the pretense that they all assimilate to a single intelligible theme. No, actually it may be they all assimilate to a single theme, but Fox has not shown that he has found it. And there is an ironic side-problem: by trying to attend to so many issues, he ends up giving short shrift to the one issue--option pricing theory--that may be more important than all others, including ECMH itself.

The result, then, reads like a career's worth of reporting notes, readable in themselves but far too diverse and scattered to offer much real insight. Fox said that it's journalism and I said it shows. But that is uncharitable. A lot of really helpful and instructive analysis begins as journalism. This book begins as journalism and pretty much stays where it is.

Effficient Markets:A Eulogy for the Undead

Seems that everybody and his Aunt Maude are declaring the Efficient Capital Market Hypothesis to be dead, at least for the time being--another one of many casualties of the late meltdown. I think the conventional wisdom is probably right on this one (wisdom of crowds, again!) although I'm not sure I've seen anybody do a satisfactory job of explaining just exactly what it is that is dead, and/or what it is dead about it.

Let me offer this chicken-scratch first draft.

First, as to what is ECMH: there is a lot of loose talk out there about how "we" used to believe that "markets" were "right" (i.e., and guess what--markets are not always right).

I think this is a vast, crude, even a grotesque, oversimplification. Say rather: the market "impounds" at any given time any information that may influence a market price. This is a much narrower claim, armored up with any number of potential qualifications that may limit its falsifiability. In particular, as cast here it makes no important claim to "rightness" at all(contrast, e.g., the trivial claim that the claim itself is "right"). Rather, it is entirely consistent with the claim that the market is vastly, crudely, grotesquely wrong about the future--adding that it will change its mind when it knows better.

Taken at least as a counsel of prudence, I think this take on ECMH is a vastly important insight. It is a reminder, first, that all the charlatanism of the ragtag army of seers, hucksters and assorted conmen who tell you that you can out think the market--all these are worth nothing more than the gas they exhale.

Some will say this is axiomatically self-evident, but it is amazing how often the point is lost on my students. Quite a goodly number--indeed, of those who have given any thought to the matter, almost all--show up serene in their assurance that they are able to beat the market or (what comes close to the same thing) that they will be after undertaking the relatively modest effort necessary to compete my course. I'm not at all clear from whence this cheery optimism arises; my best guess is that it has something to do withe their past in what Dierdre McCloskey calls the benign Christian socialism of the American family: the conviction that the world is a well-governed place calibrated to confer bounties upon them, and that it will continue to do so.

I have always regarded as my post important public function to knock the stuffing out of this belief and to convince them that there is nothing, absolutely nothing,that can guarantee them wealth except a large inheritance, unexampled good luck and, oh yes, perhaps diligent and relentless hard work. I should add that in this, as in most other endeavors, I am rarely successful.

But there is another way of looking at ECMH in which it appears as not so anodyne. That is: even if ECMH makes no claim that the market is "always right"--still the question remains: how could it be so spectacularly crashingly catastrophically wrong? It's one thing to tell us we are all sheep chewing on the same stubble. Why couldn't it have warned us that we are all lemmings charging off the same cliff?

I suppose the proponents of ECMH would say--well, never said you weren't lemmings. We only said you couldn't find it in the data. True enough, perhaps, but lame and evasive, in the manner of "no controlling legal authority." Somebody--Paul Kedrosky?--has remarked that ECMH seems to be interesting only when it is of no use. More or less on the order of Kafka's Messiah, who will come only when he is no longer necessary.

It's talk like this, of course, which brings us to the next round--the attempt to identify and anticipate lemming-like behavior. It's sending the theorists back to their (uncut) copies of Hyman Minsky. It's pushing this book up to #296 on the Amazon chart. It's motivating a large body of literature whose main theme seems to be--oh, we forgot to tell you, folks.... Whether anyone will succeed in locking this particular barn now that this particular horse is stolen is a quesetion that remains to be answered. Meanwhile ECMH is down there at the end of the bar, looking lonely and a little shopworn and frazzled, but alive and just as true as it was all along. Which is to say, sadly, not true enough.