Excess Volatility Strikes Again

Both David Henderson and Scott Sumner had some fun with this declaration of victory on behalf of Austrian Business Cycle Theory by Robert Murphy after the recent mini-stock-market crash.

As shocking as these developments [drops in stock prices and increased volatility] may be to some analysts, those versed in the writings of economist Ludwig von Mises have been warning for years that the Federal Reserve was setting us up for another crash.

While it’s always tempting to join in the fun of mocking ABCT, I am going to try to be virtuous and resist temptation, and instead comment on a different lesson that I would draw from the recent stock market fluctuations.

To do so, let me quote from Scott’s post:

Austrians aren’t the only ones who think they have something useful to say about future trends in asset prices. Keynesians and others also like to talk about “bubbles”, which I take as an implied prediction that the asset will do poorly over an extended period of time. If not, what exactly does “bubble” mean? I think this is all foolish; assume the Efficient Markets Hypothesis is roughly accurate, and look for what markets are telling us about policy.

I agree with Scott that it is nearly impossible to define “bubble” in an operational ex ante way. And I also agree that there is much truth in the Efficient Market Hypothesis and that it can be a useful tool in making inferences about the effects of policies as I tried to show a few years back in this paper. But I also think that there are some conceptual problems with EMH that Scott and others don’t take as seriously as they should. Scott believes that there is powerful empirical evidence that supports EMH. Responding to Murphy’s charge that EMH is no more falsifiable than ABCT, Scott replied:

The EMH is most certainly “falsifiable.”  It’s been tested in many ways.  Some people even claim that it has been falsified, although I’m not convinced.  In the tests that I think are the most relevant the EMH comes out ahead.  (Stocks respond immediately to news, stocks follow roughly a random walk, indexed funds outperformed managed funds, excess returns are not serially correlated, or not enough to profit from, etc., etc.)

A few comments come to mind.

First, Nobel laureate Robert Shiller was awarded the prize largely for work showing that stock prices exhibit excess volatility. The recent sharp fall in stock prices followed by a sharp rebound raise the possibility that stock prices have been fluctuating for reasons other than the flow of new publicly available information, which, according to EMH, is what determines stock prices. Shiller’s work is not necessarily definitive, so it’s possible to reconcile EMH with observed volatility, but I think that there are good reasons for skepticism.

Second, there are theories other than EMH that predict or are at least consistent with stock prices following a random walk. A good example is Keynes’s discussion of the stock exchange in chapter 12 of the General Theory in which Keynes actually formulated a version of EMH, but rejected it based on his intuition that investors focused on “fundamentals” would not have the capital resources to finance their positions when, for whatever reason, market sentiment turns against them. According to Keynes, picking stocks is like guessing who will win a beauty contest. You can guess either by forming an opinion about the most beautiful contestant or by guessing who the judges will think is the most beautiful. Forming an opinion about who is the most beautiful is like picking stocks based on fundamentals or EMH, guessing who the judges will think is most beautiful is like picking stocks based on predicting market sentiment (Keynesian theory). EMH and the Keynesian theory are totally contrary to each other, but it’s not clear to me that any of the tests mentioned by Scott (random fluctuations in stock prices, index funds outperforming managed funds, excess returns not serially correlated) is inconsistent with the Keynesian theory.

Third, EMH presumes that there is a direct line of causation running from “fundamentals” to “expectations,” and that expectations are rationally inferred from “fundamentals.” That neat conceptual dichotomy between objective fundamentals and rational expectations based on fundamentals presumes that fundamentals are independent of expectations. But that is clearly false. The state of expectations is itself fundamental. Expectations can be and often are self-fulfilling. That is a commonplace observation about social interactions. The nature and character of many social interactions depends on the expectations with which people enter into those interactions.

I may hold a very optimistic view about the state of the economy today. But suppose that I wake up tomorrow and hear that the Shanghai stock market crashes, going down by 30% in one day. Will my expectations be completely independent of my observation of falling asset prices in China? Maybe, but what if I hear that S&P futures are down by 10%? If other people start revising their expectations, will it not become rational for me to change my own expectations at some point? How can it not be rational for me to change my expectations if I see that everyone else is changing theirs? If people are becoming more pessimistic they will reduce their spending, and my income and my wealth, directly or indirectly, depend on how much other people are planning to spend. So my plans have to take into account the expectations of others.

An equilibrium requires consistent expectations among individuals. If you posit an exogenous change in the expectations of some people, unless there is only one set of expectations that is consistent with equilibrium, the exogenous change in the expectations of some may very well imply a movement toward another equilibrium with a set of expectations from the set characterizing the previous equilibrium. There may be cases in which the shock to expectations is ephemeral, expectations reverting to what they were previously. Perhaps that was what happened last week. But it is also possible that expectations are volatile, and will continue to fluctuate. If so, who knows where we will wind up? EMH provides no insight into that question.

I started out by saying that I was going to resist the temptation to mock ABCT, but I’m afraid that I must acknowledge that temptation has got the better of me. Here are two charts: the first shows the movement of gold prices from August 2005 to August 2015, the second shows the movement of the S&P 500 from August 2005 to August 2015. I leave it to readers to decide which chart is displaying the more bubble-like price behavior.gold_price_2005-15



11 Responses to “Excess Volatility Strikes Again”

  1. 1 Major.Freedom August 30, 2015 at 4:33 pm


    ABCT is not a prediction of either gold prices or stock prices.

    It is an a priori theory for what causes the kinds of business cycles that have occurred since “modern” banking arose. In other words, it is a theory about how non-market intervention in money, particularly, but not exclusively, interest rates, destroys the information needed by investors in a division of labor economy to coordinate productive activity, which brings about systematic economic calculation errors.

    It is not a theory that states “The Fed printed $X trillion dollars, therefore the price of gold will rise by Y% and never go back down again.”

    You should have resisted the temptation.


  2. 2 Thomas Aubrey August 30, 2015 at 11:28 pm


    There is quite a lot of evidence that markets are micro efficient but not macro efficient, as per Samuelson’s dictum. (See Jung & Shiller 2006)

    Moreover, it is possible to identify bubbles ex ante. When stock prices rise as profits fall, this is strong evidence that asset prices have become decoupled from fundamentals (falling Wicksellian Differential). Indeed, China’s profit rate has been falling for some time as highlighted here http://alphanow.thomsonreuters.com/2014/01/investors-concerned-chinas-falling-rate-profit/

    I think the challenge for many investors is they spend far too much time obsessing about growth rates (China’s growth rate is still pretty good as is the US). Many investors assume that there should be a relationship between growth and stock returns. There isn’t. See (Dimson, Marsh, Staunton – Triumph of the Optimists 2002)

    The reason why the US market caught cold after China’s market collapse is that its rate of profit growth (Wicksellian Differential) has just started to fall. See here: http://alphanow.thomsonreuters.com/2015/08/investors-continue-to-ignore-falling-profit-rates-at-their-peril/


  3. 3 JKH August 31, 2015 at 3:06 am

    I experienced EMH decades ago in the finance stream, and found myself very sceptical of there being true meaning and usefulness to be found in a haystack of statistical technique. But at the same time, quite impressed by the scale of the laborious statistical exercise. Later on I found myself thinking something similar in a debate with a new boss about whether risk was the same thing as statistically measured volatility (statistically measured volatility being the germ that morphed into the dreaded ‘value at risk’ plague that ultimately permeated investment banking/trading risk management – often in the absence of common sense in the face of uncertainty.). One financial crisis later (including one AIG ‘value at risk’ cataclysm), I felt full confirmation that I was on the right side of that debate.

    Since then, every time I see ‘EMH’, I’m mired between recognizing it as tautological, vacuous, irrelevant, or wrong. Which is a useless exercise in itself, so I quickly move on. Usually.

    “But it is also possible that expectations are volatile, and will continue to fluctuate. If so, who knows where we will wind up? EMH provides no insight into that question.”

    Well, if your first sentence is true (and I think it is stunningly, obviously, massively true) and if it is also true that EMH provides no insight into that question (which I think must almost certainly be the case), then it seems to follow that EMH is pretty useless (which I tend to think is quite likely – along the lines of tautological, vacuous, irrelevant, or just plain wrong). And that line of conceptual reasoning doesn’t even require reference to statistical method.

    Whereas chapter 12 has great conceptual meaning. There is no doubt of that.


  4. 4 Miguel Navascués August 31, 2015 at 10:25 am

    David, thanks for your interpretation of the Keynes’ theory versus Fama’s. I knew it, but I see now much cleared! Thanks also for the interesting the step between “fundamentals” and “expectations”. Very clever article.


  5. 5 David Glasner September 1, 2015 at 9:09 am

    M.F, Thanks for the primer on ABCT.

    Just wondering, do you believe that ABCT theory implies any quantifiable relationship between Fed money printing and the S&P 500? If so, does that relationship differ from the relationship between Fed money printing and the price of gold? If the relationship between between Fed money printing and the S&P 500 differs from the relationship between Fed money printing and the price of gold, can you explain how and why they differ? If you don’t believe that there is a quantifiable relationship between Fed money printing and the S&P 500, do you believe that Bob Murphy should have resisted the temptation to declare victory for ABCT based on the recent decline in the S&P 500?

    Thomas, What you call Samuelson’s dictum seems reasonable to me.

    Stock prices could rise as profits fall if future profits are being discounted at a reduced rate. There is nothing a priori irrational about that.

    JKH, I am the proverbial two-handed economist. On the one hand, I am skeptical of EMH, but on the other hand, I think it does have a kernel of truth, which, if you read chapter 12 carefully you will find that Keynes actually recognizes. New information does get processed by traders in markets and does affect market valuations. That’s obvious, but not entirely vacuous or tautological, and it can often be helpful in thinking about what is happening in markets. The challenge is distinguish those sorts of situations from situations in which markets are responding in pathological ways.

    Miguel, Thanks, glad you found it helpful.


  6. 6 Thomas Aubrey September 1, 2015 at 10:18 am

    I agree that stock prices could rise as profits fall if future profits are being discounted at a reduced rate. However, this is less likely if the rate of profit falls year after year, implying a greater uncertainty that those cash flows will be generated. Hence this is more likely to signal a bubble.


  7. 7 JKH September 1, 2015 at 12:43 pm


    “New information does get processed by traders in markets and does affect market valuations. That’s obvious, but not entirely vacuous or tautological..”

    I guess that’s right. Obvious is a better word.


  8. 8 sumnerbentley September 1, 2015 at 3:54 pm

    David, I notice that when you mentioned Robert Shiller you also cited the fact that he won a Nobel Prize for his views on the EMH. But it seems like you forget to mention that Eugene Fama won a Nobel price in exactly the same year for exactly the opposite view. Perhaps the committee figured that one of the two had to be right, and by giving awards to both they were pretty sure that one award would be deserving.

    Seriously, I’m not at all a fan of Keynes’s beauty pageant analogy, and explain why in this post:


    If I wake up in the morning to a stock crash, and immediately become more pessimistic, that is certainly consistent with Ratex and the EMH. And that’s because the stock prices already reflect my expected reaction.

    Here’s an analogy. People guess the number of jellybeans in the jar. But they are actually supposed to guess the number that will be there one day later. They are also told that if they guess a number over 100, Scott Sumner will immediately eat 10 of the jelly beans, leaving 10 less at the end of 24 hours. Now suppose they believe there are 235 jelly beans. Then they would rationally guess 225, expecting 10 to be eaten.

    Suppose stock investors see a scary fall in AD on the horizon. They will forecast the effect on stock valuations (and future AD) taking into account both the Fed’s likely reaction to a stock price crash, and the reaction of consumers to a stock price crash.


  9. 9 David Glasner September 1, 2015 at 5:30 pm

    Scott, You’re right I did forget that they won the prize in the same year. It’s not the only time that the Nobel was awarded to very unlike-minded recipients. Hayek won it with Myrdal in 1974, but they also shared common interests and approaches even though they wound up on opposite sides of most issues. I think the Nobel Committee is making a judgment not about who is right and wrong, but about the quality of the work, though I suspect that there may be less lofty considerations involved as well. Thanks for sharing your post about Keynes and the beauty contest. I notice that at the end of the post you promised to write another post about Keynes’s statement that the market can stay irrational longer than a trader can stay solvent. If you got around to writing it, can you provide a link. Let me just clarify that I did not mean to endorse Keynes’s beauty contest theory. The reason I referred to it was that it seems to me that his theory also implies or at least is consistent with random fluctuations in stock prices, and that excess returns are not serially correlated, which you cite as evidence in favor of EMH. I would say that there is a fair amount of truth in EMH, but I can also imagine that there are times when Keynesian forces are more dominant.

    I don’t know what you mean by stock prices after a crash already reflecting your expected reaction. That sounds to me more like a Keynesian description in which you are basing your expectation on what other people are expecting. Once you allow interdependence of expectations, you are creating the possibility for network effects and tipping points that allow small disturbances to result in very large effects.


  10. 10 sumnerbentley September 2, 2015 at 9:19 am

    David, Here’s the post you asked for:


    I also have a new post at Econlog, where I try to better explain how I see the rational expectations hypothesis working when views about the economy are shaped by asset price movements.


  1. 1 Scott Sumner Defends EMH | Uneasy Money Trackback on September 7, 2015 at 7:54 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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