What’s Fundamentally Wrong With EMH

Scott Sumner is a terrific economist, a creative thinker and a formidable debater.  He not only knows a lot about economic theory and history, he has an uncanny knack for knowing how to draw interesting and useful empirical inferences from the theory.  Plus, he’s funny and writes really well.  No wonder he is just about the best and most prolifiic blogger there is.  He is also a very nice guy, and has the added virtue of agreeing with me about 97 percent of the time.  So why am I about to start an argument with him?

Well, for a couple of years, Scott has been using his blog periodically (here is the latest) to take on critics of the efficient markets hypothesis (EMH), and doing an excellent job, pointing out many of the lapses in the reasoning of EMH critics, for example that supposed anomalies in pricing that prove that pricing is inefficient may simply be statistical flukes incapable of providing a basis for profitable trading, which is what a true exception to EMH would provide.   And Scott very effectively asks why all those people who were so convinced that there was a real estate bubble before 2007 weren’t out there shorting the market.

So let me give Scott his due and say that I don’t know of a more effective defender of EMH than he is, but I still can’t accept EMH.  What’s the problem?  Well, the most important empirical claim of EMH, the one that Scott uses relentlessly to bludgeon EMH critics, is that future prices cannot be predicted from past prices.  The best predictor of the price tomorrow is the price today.  That powerful empirical regularity seems to imply that today’s market price has already processed all the available information about the price tomorrow, so that, given the information today, the price tomorrow is already where it should be.  The price tomorrow will be different from today’s if and only if some new information not now available will cause it to change.  But new information, by its nature, can’t be anticipated, so even though new information causing us to revise the estimate of tomorrow’s price incorporated in today’s price might arrive, that possibility provides no basis for revising today’s price before the new information reaches us.  If you could predict when new information would arrive and how it would affect tomorrow’s price, that information, insofar as it really was predictable, would not be new.

This view of how asset markets operate is related to the idea that market prices are ultimately determined by fundamentals, demand, supply, cost, taxes, etc., objective magnitudes that can be ascertained, or at least estimated, by doing enough research into the asset that one is trying to evaluate.  Markets reflect the central tendency of all the various judgments about an asset being made at any time.  That explains why the current market  price is more likely to predict tomorrow’s price than is any single person, no matter how knowledgeable or astute, and why it so hard for any individual to outguess the market consistently.

In a famous discussion in Chapter 12 of the General Theory, Keynes offered a different view of how the stock market operates, comparing the stock market to a newspaper competition

in which competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice corresponds to the average preferences of the competitors as  a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.  It is not a case of choosing those which, to the best of one’s own judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest.  We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. (p. 156)

When I first read this chapter as a graduate student already trained to think of markets as efficient processors of information, I thought it quite remarkable that an economist as great as Keynes could have entertained such a primitive notion of how the stock market operates.  Sadly, I can no longer indulge myself with feelings of superiority when reading that chapter, because I am no longer convinced that Keynes was totally misguided in his characterization,  indeed, caricature – but caricatures are effective by identifying and emphasizing some salient feature of reality — of how the stock market works.

I would note parenthetically that on Keynes’s view, asset markets are no less unpredictable than they are under EMH.  So,  despite the identification in the EMH literature of efficiency with unpredictability, the two concepts are not necessarily equivalent.

So why do I think that Keynes was on to something in describing the stock market as a kind of beauty contest?  The key point, it seems to me, is that it is misleading to believe that there is a clear distinction between fundamentals and opinions.  In Keynes’s beauty contest, the fundamental question is which are the prettiest pictures.  Working with the fundamentals, you would compete in the contest by doing fundamental research on the pictures.  The contest would be efficient if the winner selected the prettiest pictures.  Keynes said that whether the prettiest pictures are chosen is irrelevant, because to win the contest what you have to do is to guess who the other competitors will think are (or will select as) the prettiest pictures.

The problem that I see with Keynes’s analogy is that he implicitly admits a dichotomy between fundamentals and opinions, between the prettiest pictures and pictures selected by those trying to guess who will be selected.  I take Keynes a step further; beauty is in the eye of the beholder, so the pictures selected as prettiest have as much claim as any others to be the prettiest, and there are no fundamentals by which to determine which pictures are the prettiest apart from the process that has chosen them.

Let’s try to bring the argument back from beauty contests to  markets.  We all know that expectations sometimes can be self-fulfilling.  That’s what network effects teach us.  The market goes where it is expected to go.  Sure there can be exceptions; expectations can be disappointed. But when expectations point toward a particular outcome,  it can be very difficult to avoid that outcome, especially when network effects are strong.  When expectations determine the outcome, the distinction between the expectations of traders and fundamentals starts to disappear.  If depositors expect a bank to go insolvent, it goes insolvent.  If traders expect the price of oil to go up, it goes up.  If they are pessimistic about the economy, the stock market goes down and the economy may follow.  So Keynes was right, traders in the stock market are trying to figure out where everyone else thinks that stocks are headed.  That’s not the whole story, but it is part of the story, and a part of the story that is left out of EMH.

Let me cite a specific example.  An important milestone on the way to the development of EMH was Milton Friedman’s paper “The Case for Flexible Exchange Rates” in which he argued that currency speculation would be stabilizing rather than destabilizing.  Friedman’s reason was that in order for speculators to earn profits, they would have to buy low and sell high, but buying at low prices tends to make the prices higher than they would have been and selling at high prices tends to make them lower than they would have been. So speculators are smoothing out the fluctuations in exchange rates, raising the lows and bringing down the highs.  The argument presumes that speculators on average are earning profits, which may or may not be true, but leave that aside.  I want to address another unstated presumption of Friedman’s argument:  that there is in fact an exchange rate consistent with the fundamentals and that sooner or later the exchange rate always comes back to the equilibrium level determined by fundamentals.  The fundamentals consist of the real exchange rate determined by real factors and the monetary policy of the government and the monetary authority.  Suppose speculators believe that the monetary policy will become more lax and drive the value of the currency down.  The government and the monetary authority are now confronted with a choice:  accept the depreciation or tighten money, raising interest rates, perhaps risking a recession to restore the old exchange rate.  The government might decide that it is just not worth it to take the actions required to restore the old exchange rate even though it had no intention of loosening monetary policy in the first place.  Thus, it was the expectations of speculators that created the change in fundamentals.  And their expectations were both destabilizing and profitable.

So when Scott defends EMH against its critics and points out that it is very hard to find a way to make profits systematically by exploiting inefficiencies in the asset prices, I agree with him, sort of.  But I can’t figure out what this has to do with efficiency.

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23 Responses to “What’s Fundamentally Wrong With EMH”


  1. 1 Lars Christensen July 19, 2011 at 5:21 pm

    Being on a trading floor on a daily basis I often find myself questioning why I still think EMH is a useful model – I would not insults our dealers too much by saying that they are not always fully rational. On the other hand it has often struck me how bad we (market participants: Analysts and traders alike…) are in terms of “beating the market”. In fact building models on FX and fixed income market pricing I have often gotten the feeling that the more information we put into the models the closer they get to market pricing – and not the other way around.

    Clearly there is a lot of value in the simple “wisdom of crowds”. Just have a look – how many analysts can you find that systematically (over years) beat the “consensus expectations” on for example US macro data? I think “Mr. Consensus” is doing a pretty good job – and yes, he and the market is often wrong, but very few traders and analysts are systematically better…

    So yes, EMH might be a very bad approximation of how financial markets work, but in my view no other model is better…

  2. 2 Cantillon Blog July 19, 2011 at 6:58 pm

    David,

    One’s manners are shaped very much by the habitual sorts of interaction one has with peers. I fear that mine are shaped more by the martial virtues developed by a practitioner who makes a living betting against markets rather than the more courtly virtues developed by an academic or policy economist.

    In that context, I hope you will not perceive it as rude of me to raise the relevance of the Dunning-Kruger effect for this discussion.

    The Dunning-Kruger effect describes a cognitive bias whereby “unskilled people make poor decisions and reach erroneous conclusions, but their incompetence denies them the metacognitive ability to appreciate their mistakes”.

    Now it is certainly not my intention to suggest that economists are not on the whole people of exceptional ability who, having pursued a long period of study and apprenticeship, are anything less than highly skilled and highly competent at pursuing their chosen metier.

    In understanding the nature of choice, we have learnt to focus on revealed preference rather than depending upon peoples’ expressed opinion about preferences. Similarly, perhaps in the domain of financial markets we should consider what exactly economists do for a living and in which areas in particular they can legitimately claim to have practical expertise (incorporating tacit and inarticulate knowledge rather than mere theory).

    I suggest then that economists on the whole have very little expertise in making calls about financial markets and _because_ they mostly lack expertise they rationalize away the dissonance between their prior of clear intellectual superiority and the observed inability to actually make money by putting forth the fictitious claim that it is the market that is inefficient.

    How does an economist progress in his career? It isn’t on the whole by making successful calls about financial markets, or even about the economy. An academic economist specializing in whatever you consider to be the relevant field is evaluated on the basis of his journal output (and perhaps various other measures of influence) – his job is to be thought of highly by other economists. Getting the economy right is really almost neither here nor there. In fact I do not suppose a very high media profile would contribute towards a perception of seriousness as a scholar amongst tenure committees.

    An economist also does not progress by being able to identify investment talent. There are people who do that for a living, and possibly this is as difficult a job to do consistently well as it is to make money in the market in the first place. But because it is difficult does not mean it is impossible.

    Scott asks why those people convinced there was a bubble in the US before 2007 weren’t out putting on bearish trades. (Note that I disagree strongly with his suggestion that the bubble was in real estate as such – I think the centre of the bubble was in the credit market – and also with the idea that it was a US-centric phenomenon. Perhaps the worst of it will turn out to have been sovereign and private credit in Europe).

    Well, Paulson, Lippman, Burry and Cornwall Capital were not the only ones of us to be involved in bearish trades (what was notable about Paulson and Burry is the degree of research, their recognition of the magnitude of the opportunity, their ability to market the idea and raise substantial funds for a dedicated strategy and their courage and focus in establishing a large ABX position).

    In general though the kind of person who bets on these things for a living does not yet have the time or the motivation to engage in academic discourse. What does it matter what the academic world thinks? One has better things to worry about managing the risk of the portfolio and keeping investors happy!

    More concretely, I certainly agree that the fundamentals are not given. How could they be? One doesn’t need to be a nihilist in the mould of Lachmann to recognize the importance of perception and expectations in shaping the decisions taken by market participants and their influence on prices. Italy has been clearly doomed to experience some discomfort in its funding markets for some time now (by which I mean a few years). But the media only awoke to this in the past week. Why are people so slow to catch on and why did they catch on now rather than a year ago? Well, I do have some thoughts, but for now would emphasize that a phenomenon that seems to be a puzzle is not grounds for dismissing the existence of such a phenomenon.

    And of course the market is not a clockwork, and the future is not given. Human choice is open-ended and creative. But to say that there is sometimes scope for expectations to shape outcomes is different from the nihilist view that there is no reasonable basis for forming expectations.

    I think there are a couple of problems with the following statement:- ” The market goes where it is expected to go. Sure there can be exceptions; expectations can be disappointed. But when expectations point toward a particular outcome, it can be very difficult to avoid that outcome, especially when network effects are strong”.

    Firstly, there are two different kinds of markets: those that converge to some price whose fair value can be known with certainty at expiration (such as futures on LIBOR) and those whose underlying fair value cannot be objectively determined (such as stocks or commodities). Yet one tends to see similar kinds of speculative behaviour in both kinds of markets. I assert that a theory of expectations and of speculation should be able to account for this commonality rather than having particular ad hoc stories for each kind of market.

    Secondly, perhaps the rally in crude from late 2007 into summer 2008 can be construed as an example of self-fulfilling expectations. But the fact remains that in summer 2008 a tremendous majority of market participants was very bullish of crude and yet it was tremendously profitable to take the other side of that trade; it was easy to identify the overshoot, and yet very few did. (I say the latter speaking as somebody who has some knowledge of speculative positioning over this episode).

    So we have another puzzle of the apparent shortage of stabilizing speculation. Perhaps this problem ought to be the seed of a new inquiry.

    This statement also, I find curious:- “If they are pessimistic about the economy, the stock market goes down and the economy may follow.”

    It may follow, but what grounds do you have for asserting that it was traders depressing the price of stocks that led to the economy slowing. For there have been many episodes of violent upheaval in the equity market universally expected to foreshadow difficult economic times that turned out to be buying opportunities and were not followed by a downturn. The 1987 crash being the most prominent example.

    This is probably already too long for a blog comment, but I would be curious to hear responses.

  3. 3 Cantillon Blog July 19, 2011 at 7:25 pm

    “I want to address another unstated presumption of Friedman’s argument: that there is in fact an exchange rate consistent with the fundamentals and that sooner or later the exchange rate always comes back to the equilibrium level determined by fundamentals. The fundamentals consist of the real exchange rate determined by real factors and the monetary policy of the government and the monetary authority. Suppose speculators believe that the monetary policy will become more lax and drive the value of the currency down. The government and the monetary authority are now confronted with a choice: accept the depreciation or tighten money, raising interest rates, perhaps risking a recession to restore the old exchange rate. The government might decide that it is just not worth it to take the actions required to restore the old exchange rate even though it had no intention of loosening monetary policy in the first place. Thus, it was the expectations of speculators that created the change in fundamentals. And their expectations were both destabilizing and profitable.”

    In theory many things are possible. In the real world one observes some phenomena rarely or never.

    So as a student of financial markets, I would be very curious to know which real-world episodes it is that you might have in mind in your story. I think you also left many important details out. Why do speculators think that monetary policy might become more lax? On what basis do they hold that expectation. Market participants often hold beliefs that turn out to be very mistaken, but almost always there is a reasonable-seeming reason for such beliefs.

    I can certainly imagine that the monetary authority had no intention to loosen monetary policy, just as with for example poor Norman Lamont in 1992. But in practice the speculators were right that the authorities did not in fact have the courage and resolution to pursue a monetary policy consistent with the maintenance of the ERM regime, and the authorities were mistaken about both the eventual price that would be involved in joining the ERM (they had not considered that a shock of the magnitude of the German unification boom might occur), and their ability to bluff markets into thinking that they would maintain membership at all costs.

    If speculators had not held the expectation that policy would be eased and ERM membership had been credible then the terms of trade between Germany and Britain would have had to adjust some other way. Either this would have taken place via more accommodating price setting and wage bargaining behaviour in Britain; or Britain would have experienced much higher and more persistent unemployment (until the unification boom turned to bust). But the fact is with the institutions of the time, there is no way that it would have been politically feasible to tolerate such pain for such a period and Britain would have had to leave later anyway. So the speculators were in fact correct in this instance – their view of loosening policy ahead was not just pulled out of thin air.

    Of course just because I gave you one example that does not refute your argument does not mean your version of things can not take place. But I should like to know which examples you have in mind, as I think my example is more representative of the typical currency crisis. What is the meaning of a peg if the government is going to possibly decide it is going to be “just not worth it” to maintain the peg?!

  4. 4 Cantillon Blog July 19, 2011 at 7:28 pm

    “Of course just because I gave you one example that does not refute your argument does not mean your version of things can not take place. ”

    I meant “Of course my giving you one example at variance with your account of the influence of speculation does not fit refute your argument”

  5. 5 Greg Ransom July 19, 2011 at 10:55 pm

    The EMH & the related RE conceptions are in fact a cluster of related but different empirical discoveries and model construction stipulations.

    One primary reason these discussions are so confused and go in endless circles is simply a result of the fact that all of these different results and model construction stipulations are not laid out on the table, and their differences and similarities never get effectively fleshed out and exposed.

    This is one reason why the survey articles and history of economic thought are non-optional for healthy theoretical and empirical advance in economic science — empirical economics and explanatory economics are HUGELY complex, and it is across the course of many papers and discussions and across time that the “adaptive space” containing all of the various distinctions and insights is limned. No one has all of this in his head at one time, and no single paper covers the territory.

    The background different empirical results and theoretical stipulations and considerations is simple massive.

    Only good history of contemporary and older economic science can begin to capture the “battle space” of ideas gestured at by economists hoping to lay claim to permanent and universally accepted results.

    To popular books that cover just a part of the complex story are _The Quants_ by Scott Patterson & _The Myth of Rational Markets_ by Justin Fox.

  6. 6 David Glasner July 20, 2011 at 11:34 am

    Lars, I don’t disagree with you and I think that the problem with EMH is in thinking that it has anything very informative to tell us about how markets work rather than about how difficult it is to predict where they are going. I hope that makes sense to you, because I think our views are pretty close. However, the further point that I was trying to make is that observers of the market through their expectations actually determine where the market is headed. It is not as if the market is what it is and we are just trying to guess its direction which is determined by fundamentals. Our expectatins are the fundamentals.

    Cantillon, Thank you for some very insightful comments and for some very thoughtful questions.

    You wrote:

    “Firstly, there are two different kinds of markets: those that converge to some price whose fair value can be known with certainty at expiration (such as futures on LIBOR) and those whose underlying fair value cannot be objectively determined (such as stocks or commodities). Yet one tends to see similar kinds of speculative behaviour in both kinds of markets. I assert that a theory of expectations and of speculation should be able to account for this commonality rather than having particular ad hoc stories for each kind of market.”

    I think that this is a key distinction. It doesn’t mean that the two kinds of markets always behave differently, but there is the potential for markets that are not tied down by spot market that determines the final value of the instrument at a particular future time to move off in some direction without creating a clear opportunity for earning arbitrage profits.

    “Secondly, perhaps the rally in crude from late 2007 into summer 2008 can be construed as an example of self-fulfilling expectations. But the fact remains that in summer 2008 a tremendous majority of market participants was very bullish of crude and yet it was tremendously profitable to take the other side of that trade; it was easy to identify the overshoot, and yet very few did. (I say the latter speaking as somebody who has some knowledge of speculative positioning over this episode).”

    Well, my own intuition was also that the rally in crude was way overdone in 2008. But the debacle was the result of the financial crisis (largely caused by tight monetary policy) not an imbalance in the market for crude. Short run demand and short run supply are so inelastic that the market can tolerate huge swings in price before supply disruptions or the limits of storage capacity force the spot price to change.

    My statement about expectations causing movements in stock prices causing movements in the economy was deliberately couched in vague terms, because I realize that movements in stock prices need not produce any real effects on the economy. What I meant was that the stock market can respond to public mood (either by consumers or investors or both) and that mood can itself trigger real changes in the level of economic activity. The stock market may even amplify the initial change in mood.

    On my exchange rate story, I am sorry but I don’t have a particular story in mind, I was engaging in the same kind of arm-chair theorizing that Friedman was engaging in in his seminal essay on exchange rates. My point is that speculation against a currency changes the odds that the currency will be devalued, and I don’t think that Friedman acknowledged that relationship in his essay. And to the extent that the argument in his essay was the inspiration for the subsequent development of EMH, an important element of the problem was left out of the argument. That speculation against a currency only speeds up the inevitable is undoubtedly true in many cases. My point is that it may not be true in all cases, and Friedman did not acknowledge that possibility. Empirically which cases are which would make for an interesting study, but I have nothing really to offer on that question.

    Greg, You put your finger on a really important problem for economics, which is that too many economists know so little about the history of the subject. But the subject is so vast now, that no one can really claim to be a master of the entire corpus of the subject. Perhaps the last person to be in that position was Harry Johnson. Of course the same would be true of Paul Samuelson who outlived Johnson by over 30 years, but Johnson was at least 10 years younger than Samuelson. I read and enjoyed Justin Fox’s book, I don’t recall seeing anything about Patterson’s book. I will try to have a look at it.

  7. 7 Benjamin Cole July 20, 2011 at 12:54 pm

    Well, sure, markets can be manipulated for a while…I wonder constantly about global oil markets, and the NYMEX, and mysterious oil blogs that constantly fearmonger Peak Oil, and the power of sovereign wealth funds. Of course, OPEC too.
    (Is it not in Putin’s interest to game the NYMEX or Brent upwards, and would it not be patriotic for Putin to do that? He has the money, he can cloak his identity–so why would he not try to game the NYMEX-Brent oil market up?)
    So, we could have a “bubble” in oil prices, and we did in 2009.
    But, in the end, you get oil tankers full and docked in Malta with nowhere to offload. So the EMH comes back.
    I guess it depends on your definition of bubble, too.

  8. 8 JP Koning July 20, 2011 at 1:16 pm

    David, have you read George Soros’s Alchemy of Finance? Your point about the self-fulfilling nature of expectations is much like his theory of reflexivity. Donald Mackenzie, an economic sociologist, has called this process “performativity”. These are all important ideas.

    EMH assumes that all participants are price takers, so it rules out the sort of reflexive processes by which participants become price makers and create self-fulfilling moves in markets. This is a naive assumption to make, it removes much of the richness of real financial markets.

    My guess is that Scott Sumner would really like the EMH to be true. If it isn’t, his GDP futures market plan looks far less appealing.

  9. 9 Scott Sumner July 20, 2011 at 2:37 pm

    JPKoning, I don’t see the EMH as being all that important to my NGDP future targetng scheme. I happen to think that if the Fed targeted its internal NGDP forecast, and did level targeting, you’d get 95% of the benefitts of the NGDP futures scheme. For that same reason, you could have a fairly large amount of market inefficiency without seriously damaging the NGDP futures target plan. Markets just need to be roughly efficient.

    David, Thanks for the very kind (and undeserved) comments in your intro. Let’s start with a typical market forecast—people might expect Apple profits to rise 32% in 2012. That expectation (when it forms) moves Apple stock prices. Is it self-fulfilling? No, if profits come in up only 5%, the stock prices will immediately fall sharply. I think that’s how almost all markets work, even in macro. If people expect inflation, it’s true that prices start to rise. But if the central bank doesn’t actually plan to deliver inflation, it very quickly takes actions that nip those expectation sin the bud. And those who speculated on that basis lose. The fixed exchange rate regime might be your strongest argument. But if the country abandons fixed rates because they don’t like the recession (caused by speculators forcing up rates), doesn’t that imply they shouldn’t have been doing fixed rates all along? They should have NGDP targeted?

    I’m not saying that expectations can never be self-fulfilling, I jsut don’t see that as very common.

  10. 10 Wonks Anonymous July 20, 2011 at 3:05 pm

    Robin Hanson on Dunning-Kruger.

    Will Ambrosini suggests the EMH is “a subsidiary hypothesis, like in cosmology the assumption that the physical constants are in fact constant, that makes it possible to test other hypothesis”.

  11. 11 Greg Ransom July 20, 2011 at 3:09 pm

    Read these two Wiki entries for just a hint of how many different empirical findings and how many different model building stipulations are smuggled in under the EMH & RE banners:

    http://en.wikipedia.org/wiki/Efficient-market_hypothesis

    http://en.wikipedia.org/wiki/Rational_expectations

    And these only touch on the background understanding behind any particular use of the words EMH or RE.

    So a lot of BSing is going on when someone claims to be dealing with all of that or “proving” one thing or another definitively with a blog posting dashed off between classes or while sitting in one’s pajamas.

  12. 12 Jay Jeffers July 20, 2011 at 3:58 pm

    David Glasnor, Scott Sumner, or Greg Ransom, (your post with the Wikipedia links prompted this one) or anyone else…

    I can’t resist the opportunity to ask a question I haven’t been able to get anyone to tackle head on (perhaps because I get too long-winded when I ask).

    So to try to keep it as succinct as possible,

    What is the difference between Rational Expectations and the EMH? Can you have one without the other? Is EMH a super-duper version of rational expectations? Do you have to accept at least some modest version of Rational Expectations in order to get the Intro Econ 101 models off the ground? If so, how does one principally draw the line between rational expectations and EMH?

    I hope these questions don’t expose my ignorance too much; I’m a philosophically oriented thinker, and these issues seem fundamental to me, but I can’t get people who seem informed about economics to engage on the topic. I would appreciate any help.

    Jay Jeffers

  13. 13 mcmikep July 20, 2011 at 9:04 pm

    I don’t believe anything in this post contradicts the views of Sumner.

    It’s an irrelevant point since I’m not defending EMH, but, in your exchange rate example, why do the speculators believe monetary policy will become more lax? Why does the monetary authority have no intention of loosening? Why the disconnect between their intentions and the markets expectation of their intentions?
    I think you can disprove any assertion if you start with a set of assumptions that contradict the assertion. It’s like saying ‘what if the majority of dogs suddenly attacked and killed their owners?’ Yes, that would certainly call into question man’s best friend hypothesis.
    Also, nobody expects the resulting balance of payments surplus to cause the currency to appreciate and therefore takes long positions in foreign currency, offsetting the positions of the original speculators?

  14. 14 David Glasner July 20, 2011 at 10:35 pm

    Benjamin, I wasn’t trying to suggest that anyone is trying to rig oil markets or any markets. My point is that the equilibrium that markets tend towards is affected by what people expect. The basic EMH model assumes that the equilibrium is what it is and the market uses all the available information to generate a prediction (the current price) of what the equilibrium will be.

    JP, I have not read The Alchemy of Finance, but I did read his more recent book The New Paradigm for Financial Markets which covers much of the same ground I think. In a sense I think that I have taken a more extreme position than Soros, because he also believes that there is an equilibrium that the market tends towards in the long run, but in the short run there can be movements away from equilibrium because of reflexivity. I think that reflexivity can change the equilibrium. I am afraid that I don’t know anything about Donald McKenzie, so I will have to try to read up about him. I don’t think that market power is a necessary condition for expectations to be self-fulfilling. Insofar as network effects can be a source of market power there may be some correlation between the two, but otherwise I don’t seen any logical nexus between them.

    Scott, Not all expectations are self-fulfilling, and certainly there is no reason to believe that an expectation about Apple’s profit next quarter is not going to be self-fulfilling. But the expectation that VHS would be more popular than Betamax was self-fulfilling (sorry, I am dating myself with that example). In network markets, where the expansion of demand for one product depends on the availability of another product, expectations about future demand are critical to the evolution of the market. I was not taking a position on Friedman’s argument for flexible exchange rates, so you may well be right that even if I am right in my criticism, flexible exchange rates may be the better choice. Finally, I would also take issue with your statement that my introductory comments about you were undeserved. I think that they were fully deserved. They also were in accord with the Talmudic dictum that only a fraction of the praise due to a person should be stated in his presence and all of it in his absence.

    Jay, Obviously EMH and RE are closely related. In my view, EMH is a vaguely empirical proposition about the behavior of asset prices, in particular that they change randomly. However, as I suggested, random changes in asset prices could be rationalized in different ways. RE is a methodological principle which says that an economic model must have the property that its equilibrium solution can be derived if agents expect the equilibrium to be attained. If expecting the equilibrium doesn’t ensure that the equilibrium is attained, the model is internally inconsistent.

    Mcmikep, I don’t think that I am necessarily contradicting Scott, I just have a different way of thinking about how asset markets function. My exchange rate example is simply a hypothetical; it didn’t strike me as inherently unrealistic, but if you think it is implausible, I am not sure that I can convince you otherwise.

  15. 15 mcmikep July 21, 2011 at 4:01 am

    It’s certainly not inherently unrealistic. There are lots of different ways such a scenario could come about. But, it assumes the monetary authority lacks credibility. If there is credibility, some other speculators would increase their holdings of the currency and the exchange rate wouldn’t change. If they lack credibility, what would make speculators incorrectly expect a lax policy? Is the economic data getting worse? If so, their causing the currency to depreciate is more likely to be stabilizing than destabilizing (from an NGDP point of view, not necessarily from the point of view of the monetary authority.)
    If this isn’t what you had in mind, what other set of assumptions could bring about the scenario without violating what we believe to be true of speculators, central banks, and exchange rates?

  16. 16 Jay Jeffers July 21, 2011 at 12:16 pm

    David Glasner,

    Thank you for your reply. I think I may be off-topic, if so, forgive me.

    But in the two Econ classes I’ve taken, there’s been very little coverage of these kinds of big-picture conceptual issues, and I find I actually can get a grip on them in dialogue with informed people.

    So, there’s all kinds of controversy about the way rationality is treated in mainstream economics. It’s tempting, then, to impose the same controversy onto each discussion in economics when it involves the word “rational.” But I have the sneaking suspicion that there are actually several controversies, but then again, I’m not sure if they’re all tied together.

    For example, does not marginal utility (supply and demand) posit rational actors? If so, is this tied to rational expectations? Is one a micro issue, the other macro? Can I doubt RE without doubting marginal utility? (after all, isn’t some bare-boned assumption of rationality needed to state that I would want more of something at a cheaper price, and that my desires are well-ordered?)

    Obviously, each one of my questions need not be addressed; I would settle for a gloss. Or, in lieu of that, I realize the original post was about EMH, so to stay on topic, is there a book/resource you could point me toward, that explains (from a philosophical and/or historical perspective) the development of marginal utility, and then goes into rational expectations and onto the EMH, and how they’re all related, or if not, how to bracket marginal utility off from RE and EMH?

    (that goes for anyone else in the know)

  17. 17 John Hawkins July 21, 2011 at 2:26 pm

    David,

    Your brief comment about how your model of self-fulfilling expectations applied to VHS vs. Betamax (we might say Blu-ray vs. HD in my generation) seemed to have plenty of interesting ideas under the surface. Perhaps the model applies best depending on the degree to which a certain transaction is a (pardon the game theory speak) “coordination game”. Considering some economists see the whole entirety of the market as a coordination game (the one whose recent fame brings him to my mind easiliest is Hayek) the model could be very far reaching indeed.

    On a sidenote, it would be very interesting to be able to use the theories of free-marketers like Hayek in conjunction with self-fulfilling expectations for certain prices and markets to explain how markets can act in extremely pro-cyclical and exaggerated manners, rather than anti-cyclically.

  18. 18 Kenneth Schulz July 21, 2011 at 11:44 pm

    The problem that I see with Keynes’s analogy is that he implicitly admits a dichotomy between fundamentals and opinions, between the prettiest pictures and pictures selected by those trying to guess who will be selected. I take Keynes a step further; beauty is in the eye of the beholder, so the pictures selected as prettiest have as much claim as any others to be the prettiest, and there are no fundamentals by which to determine which pictures are the prettiest apart from the process that has chosen them.

    The question is, does a person choose differently if he is asked to “pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors” than if he is asked to express his own preferences. It is an empirical question about human behavior, not a philosophical issue of a ‘dichotomy between fundamentals and opinions’. Your ‘step further’ is not relevant to the behavioral question.

    Here is an amusing, if not particularly rigorous, investigation:

    Keynes’ intuited psychology is correct.

    Full disclosure: I am a psychologist, not an economist. But it looks like I would do well to read some Keynes.

  19. 19 Kenneth Schulz July 21, 2011 at 11:51 pm

    sorry, tag fell off…

    Planet Money

  20. 20 David Glasner July 22, 2011 at 1:54 pm

    mcmikep, I don’t think that credibility is a binary variable. To me it seems closer to a continuum, but perhaps it is discontinuous. At any rate, I certainly agree that if a monetary authority has sufficient credibility, no one will speculate against it, and if it has no credibility, well, it is doomed. The interesting cases are somewhere in between.

    Jay, You are indeed asking some very questions, which are rarely treated in standard economics courses, and I am not sure that I can clear any of them up for you. But here are a few quick thoughts off the cuff. My understanding of rationality in economics is basically that it means that preferences, whatever they may be, are consistent i.e., people will choose consistently across a range of options. The concept of marginal utility is essentially equivalent to the consistency assumption when a slight additional assumption is made about marginal rates of substitution between two or more objects of preference. As I said earlier, my understanding of rational expectations is that it is a restriction imposed by the theorist on his model, requiring the model to have the property that if the agents in the model expect the equilibrium of the model the model will in fact imply that equilibrium will result. So I don’t view rational expectations as an axiom about individual rationality in the way that consistency (or, if you like, declining marginal utility) is. Steve Sheffrin wrote a very good book on rational expectations about 20 years ago, later revised in a second edition. That might be a good place to start.

    John, Thanks very much for your interesting comment and for filling in my generational gap. You are right that Hayek figures very heavily in my thinking on this point, especially his incredibly important 1937 paper “Economics and Knowledge.” I spent a short time as a visiting professor at NYU in the early 1980s and got to know slightly the late Ludwig Lachmann, who studied under Hayek at LSE in the 1930s. Nearly alone among the Austrians, he understood that Hayek’s argument implied, in a way very analogous to Keynes, that there is no theoretical basis for assuming that if expectations are incorrect, so that the conditions for intertemporal equilibrium are not satisfied, that there is any market mechanism that tends to bring expectations back into mutual correspondence so that there is any tendency toward equilibrium. I think that is precisely the scenario that you have in mind.

    Kenneth, Thanks for the link. I am not sure that Keynes was trying to make a deep psychological point with his example. The beauty contest is just what the newspapers made it. Whether the stock market behaves in that fashion depends not so much on psychology, but on what governs the valuation of stocks. Psychology may have something to do with that, but I don’t think that psychology is the ultimate determinant.

  21. 21 Kenneth Schulz July 23, 2011 at 1:23 am

    David,

    Thank you for taking the time to reply. I read several pages of context of the ‘beauty contest’ illustration. Keynes first makes what sounds to me like a statement of the EMH:

    We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge…

    He then raises a number of considerations which cause real markets to depart from the ideal. Keynes uses the term ‘psychology’ quite frequently in his discussion, most often in reference to the behavior of the majority of (nonprofessional) investors. The beauty contest illustration appears in the course of an extensive discussion of the behavior of knowledgable, professional investors:

    …the professional investor and speculator … are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence….
    Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced….he … tries to guess better than the crowd how the crowd will behave.

    After further arguing that several factors constrain the professional to adopt this strategy, he relents a bit:

    If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise.

    Keynes means his references to psychology quite seriously, as I read him (and granted, I read him as a psychologist).
    Regards,

  22. 22 David Glasner July 23, 2011 at 11:11 pm

    Kenneth, I probably wrote my earlier reply too soon without checking how Keynes was using the term “psychology” in that passage. I obviously haven’t learned my lesson and am again going to speculate about what Keynes meant without rereading the passage, but I am sure that you will correct me if I say something that contradicts the text. I think by “psychology” Keynes simply means guessing what other traders will be thinking and he is therefore contrasting “psychology,” i.e., anticipating what other traders will be thinking, with enterprise, i.e., identifying fundamental shifts in valuation. I am suggesting that the dichotomy is not always as clear cut as Keynes thought.


  1. 1 Browsing Catharsis – 07.24.11 « Increasing Marginal Utility Trackback on July 24, 2011 at 8:09 am

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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