“Bubbles,” cognitive illusions, and the peso problem

Let’s suppose that every once and a while an asset comes along that is extremely difficult to value.  It might have an extraordinarily high value, or much more likely it will soon be worthless.  One example might be a dotcom company (or mobile apps, if that’s the 21at century equivalent.)  Another example might be Bitcoin.

How should Bitcoin be priced?  If there is a 95% chance that it will soon be worthless and a 5% chance that it will soon hit $1000, then $30 seems like a relatively fair price.  That allows for a substantial expected gain ($50 minus interest costs would be the risk-neutral price.)  But Bitcoin is very risky, so investors need to be compensated with an above average expected rate of return.

Now consider a point in time where the asset is selling at $30, and investors have not yet discovered whether it will eventually reach $1000.  Should you predict that the price is a bubble?  Yes and no.  It is likely to eventually look like it was a bubble at $30.  Indeed 95% of such assets will eventually see their price collapse.  That’s “statistically significant.”  It’s also significant in a sociological sense.  Those that call “bubble” when the price is at $30 will be right 95% of the time, and hence will be seen as having the “correct model” of bubbles by the vast majority of people.  Those who denied bubble will be wrong 95% of the time, and will be seen as being hopelessly naive by the average person.  And this is despite the fact that in all these cases there is no bubble, as by construction I assumed the EMH was exactly true.

This post is motivated by earlier predictions that suggested Bitcoins were a bubble at $30, and hinted it might be a bubble at $2.  I predict that eventually the price of Bitcoins will fall sharply (from some level of which I am not able to predict) and people will vaguely recall:

“Wasn’t Scott Sumner the guy who denied Bitcoins was a bubble?  What an idiot.”

Defending the EMH is a lonely crusade that can only end in tears and ridicule, unless you are Eugene Fama, in which case it ends in a Nobel Prize and ridicule.  And I’m not Fama.

And yet the EMH is true . . . er, truish in the Richard Rorty sense.

PS.  The hidden agenda of this post is that spectacular price increases after incorrect bubble calls should count heavily against the bubble model, indeed roughly 20 times as heavily as a correct call in the case above.  Don’t look for reputations to be adjusted according to this metric.  Markets may be rational, but the assignment of scientific prestige in bubble theory is highly irrational.

PPS.  Of course many bubble proponents like Cowen and Krugman and Shiller deserve their high academic reputation, but for reasons unrelated to bubble analysis.

PPPS.  Bitcoin hit $1000 today.


Tags:

 
 
 

48 Responses to ““Bubbles,” cognitive illusions, and the peso problem”

  1. Gravatar of Saturos Saturos
    29. November 2013 at 10:04

    Yes but if the (stronger) EMH is true by construction, then doesn’t that mean that “If there is a 95% chance that it will soon be worthless and a 5% change that it will soon hit $1000″, then those changes are driven by fundamental changes in the dispersed social knowledge of the value of holding Bitcoins? So can’t we dismiss cases where the asset is just a currency, and the return to holding currency based on its fundamental value is… well, it really just depends on its value later on, doesn’t it? And the expected future network effects contributing value to transacting in *this* currency instead of others. But even with non-currency assets – surely if the price skyrockets 7000% in a year, with no obvious change in what society thinks its expected future usefulness or scarcity could be – then can’t we conclude that an “uncertainty” of the asset’s true value which includes such wild gyrations – because such gyrations would have to be driven by fundamentals, and there are no fundamentals which could drive such a rapid revaluation – makes it a bubble?

  2. Gravatar of SG SG
    29. November 2013 at 11:23

    Saturos,

    I was taught that the “fundamental” value of a country’s currency is a function of demand for that country’s goods and services. If you think of the “country” that bitcoin represents as all those who want to engage in anonymous, secure transactions outside the purview of government, then the fundamental value of bitcoin is a function of demand for online black markets.

  3. Gravatar of Gordon Gordon
    29. November 2013 at 11:45

    Isn’t part of the problem in the whole bubble debate that different people have different definitions of the word? For some, it means that when there is sufficient information for the market to correctly judge the value of something, the price goes well above that value. For others, a bubble means that the less information there is to correctly judge the value, then psychological factors come into play. And then there are the people who engage in looking for patterns. For them, a bubble really is anything in which the price has gone up significantly.

    Look at Lars Christensen’s recent attempt to test the wisdom of the crowd by having an audience guess his weight. People were able to correctly judge it. He originally thought people had overestimated it which would be a bit of a knock against the EMH but it turned out they were correct. But let’s suppose he had done this same test while wearing a loose fitting robe (kind of like those evangelical ministers wear sometimes). And further suppose Lars planted someone in the crowd to give an over estimate of his weight and speak this estimate out loud so that many would hear it. Then it’s likely that many of the people would use the plant’s estimate as a basis for their own estimate. This is how I reconcile what seems to be differing views between the EMH advocates and the behavioral finance advocates.

    Though if I’m way off base here it wouldn’t surprise me as I have yet to read enough to make certain I have a good grasp of the differing viewpoints.

  4. Gravatar of ssumner ssumner
    29. November 2013 at 11:57

    Saturos, I’m not sure I follow. Suppose everyone agrees that Bitcoin is worth $1000 if it becomes a major established alternative currency, widely used whether other currencies are not convenient, and $0 if it eventually fails, and is abandoned.

    And also suppose there is great uncertainty today as to whether or not the currency will become established, but “time will tell.” Isn’t all that completely consistent with the EMH?

    Gordon, Your first definition is the only useful definition of bubble, and is the one used by academics.

  5. Gravatar of Philo Philo
    29. November 2013 at 12:08

    @ Saturos:
    If there is “no obvious change in what society thinks its expected future usefulness or scarcity” will be, why shouldn’t we conclude that there has been an *unobvious* change?

  6. Gravatar of Al Al
    29. November 2013 at 13:18

    Couldn’t the same story be construed as an argument against the usefulness of EMH? You could have a hero, Dr. Iff Aun Lee, who consistently points out that volatility of spot prices is explained by changing view on tail event probabilities. You ask him to prove it, and he screams back “You prove it!” before jumping off the roof, shouting something about double joints.

  7. Gravatar of Gordon Gordon
    29. November 2013 at 13:19

    “Gordon, Your first definition is the only useful definition of bubble, and is the one used by academics.”

    So then is it that people like Cowen and Shiller say bubbles happen even though there is sufficient information for the market to judge the value correctly? I had been operating under the assumption that they were using the term only for conditions when there wasn’t sufficient information for the market to judge the value with any certainty.

    BTW, I just wanted to say thanks for taking the time to answer things here for those of us who haven’t had any formal economics education. I find myself wishing I had taken some courses way back when I was in college.

  8. Gravatar of bill bill
    29. November 2013 at 14:00

    I believe that Shiller started talking about the US stock market being in a bubble in 1995. So essentially, he was wrong no matter what the definition of a bubble. The market kept going up so eventually he wrote a book that ended up being perfectly timed. Better to be lucky than smart (even for a guy as smart as Shiller).

  9. Gravatar of Geoff Geoff
    29. November 2013 at 15:26

    “And this is despite the fact that in all these cases there is no bubble, as by construction I assumed the EMH was exactly true.”

    In all those cases there was a bubble, as by construction I assumed the EMH is exactly false.

    Tell me, anyone, why the first sentence should be accepted as true and the second as false, given that it’s just asserted like that.

  10. Gravatar of Geoff Geoff
    29. November 2013 at 15:40

    Rorty’s philosophy self-contradicts.

    Rorty claims that no objective, common ground foundation for truth exists. He believes Rationalism to be an illusion; an artificial constraint. Truth, to Rorty, is relative. He advanced “Hermenautics”. He writes:

    “Hermeneutics sees the relations between various discourses as those of strands in a possible conversation, a conversation which presupposes no disciplinary matrix which unites the speakers, but where the hope of agreement is never lost so long as the conversation lasts. This hope is not a hope for the discovery of antecedently existing common ground, but simply hope for agreement, or, at least, exciting and fruitful disagreement. Epistemology sees the hope of agreement as a token of the existence of common ground which, perhaps unbeknown to the speakers, unites them in common rationality. For hermeneutics, to be rational is to be willing to refrain from epistemology—from thinking that there is a special set of terms in which all contributions to the conversation should be put—and to be willing to pick up the jargon of the interlocutor rather than translating it into one’s own. For epistemology, to be rational is to find the proper set of terms into which all contributions should be translated if agreement is to become possible. For epistemology, conversation is implicit inquiry. For hermeneutics, inquiry is routine conversation” – Rorty, Philosophy and the Mirror of Nature, pg 318.

    After one reads this, I am confident that the reader will agree that it is quite reasonable to ask: “OK, what then of Rorty’s arguments?” If Rorty is correct, that there is no such thing as truth based on common, objective ground, then all of his statements cannot be presented as true! It seems Rorty is seeking to claim for himself, as all relativists inevitably do, an objective foundation for one’s own pronouncements, while at the same time denying that any such foundation exists for others.

    It’s very telling that Sumner would favorably cite Rorty. If Rorty is the philosophical foundation for Sumner’s beliefs, that explains a lot of why Sumner is confused so often.

  11. Gravatar of benjamin cole benjamin cole
    29. November 2013 at 16:47

    1. Do I sense that QE did not cause inflation, so the fallback position is bubble-talk?
    2. Even if there is such a thing as a bubble, should macro-monetary policy have Fed play Mommy and “protect” investors from making bad decisions based on low interest rates?
    3. Why do the bubble-hysterics never mention gold? Gold is never in a bubble.
    4. Art prices are nuts to the moon—we are talking $100 million+ for a canvas. The Fed is to blame? Or perhaps incredible explosions and concentrations of wealth?

    If there is a global capital glut or at least abundant capital (I think so) then we should see competition for investable assets. Looks like a bubble?
    The solution is greater consumption and a reduction in capital floating around—-QE, no?

    Curiously, the bubble-hysterics are saying free markets do not work and are prone to wssting trillions of dollars on misallocations…funny, I thought that was the job of governmdnt.

  12. Gravatar of Don Geddis Don Geddis
    29. November 2013 at 17:16

    Geoff: “by construction … why the first sentence should be accepted as true and the second as false

    What I love, is how often you dismiss insightful economics on this blog, claiming that your own contrary economic analysis is based on “logic”. But look! You can’t even do actual logic, either! LOL. It appears that you’ve never seen the phrase “by construction” before. Here’s an idea: before you base your whole worldview on “logic”, you might want to first study up on just how logic actually works…

  13. Gravatar of JohnB JohnB
    29. November 2013 at 17:17

    The more I’ve learned, the more I think that the EMH is a useful framework for looking at the world and talking about bubbles is a road to contradiction and confusion.

  14. Gravatar of Don Geddis Don Geddis
    29. November 2013 at 17:18

    Sumner: you get through the entire post, laying out a hypothetical example … and then bury the $1000 lede in a PPPS, almost as an afterthought. Too awesome.

  15. Gravatar of Lorenzo from Oz Lorenzo from Oz
    29. November 2013 at 17:27

    Talking of “asset price instability” is just not as catchy as “bubble”. It also lacks the implication of being so much cleverer than those poor schmucks actually buying said assets.

  16. Gravatar of Lorenzo from Oz Lorenzo from Oz
    29. November 2013 at 17:50

    With gold, new production is a small proportion of existing supply. Bitcoins work in a fairly similar way. So, as an asset, bitcoins are online gold. And gold jumps around a lot too.

    On SG’s lovely point that “the fundamental value of bitcoin is a function of demand for online black markets”, the Silk Road website went down on October 2 2013. Bitcoin dropped from around US$400 to around US$30 in two days. It has since recovered.

    On the Silk Road website:
    http://en.wikipedia.org/wiki/Silk_Road_(marketplace)

    Bitcoin exchange rates:
    http://bitcoincharts.com/charts/mtgoxUSD#rg60ztgSzm1g10zm2g25zv

  17. Gravatar of xtophr xtophr
    29. November 2013 at 18:23

    What job are people hiring Bitcoin to do that currency can’t do?

  18. Gravatar of paul Einzig paul Einzig
    29. November 2013 at 19:17

    Scott

    “Defending the EMH is a lonely crusade that can only end in tears and ridicule, unless you are Eugene Fama, in which case it ends in a Nobel Prize and ridicule”

    This is really funny…like Lenny Bruce funny!

  19. Gravatar of Anon Anon
    29. November 2013 at 20:51

    Scott, this is unrelated. But, I just wanted to say thank you for this post from a few years ago:

    http://www.econlib.org/library/Columns/y2010/Sumnerneoliberalism.html

    The research you offered was invaluable in my post on neoliberalism:

    http://theanonymouscommentator.blogspot.com/2013/11/what-do-50s-and-60s-teach-us-about.html

  20. Gravatar of ChrisA ChrisA
    29. November 2013 at 21:03

    Rather than a bubble, I thought of Bitcoin as a rather silly fashionable trend, basically irrelevant in a real world sense, but which got a lot of publicity in certain areas because it fit a certain narrative. Rather like quantum fluctuations in physics, where matter and energy is fluctuating in and out of existence breaking the iron law of conservation of energy, but only in a trivial non-exploitable way. I am revising my view however, because of the silk road thing. There really does seem to be a need for a non-traceable currency like instrument like Bitcoin. Maybe we are seeing something with Bitcoin like the early inflation which some think created the universe out of quantum fluctuations. Sorry for the long winded metaphor.

  21. Gravatar of Scott Freeland Scott Freeland
    29. November 2013 at 21:04

    Scott,

    Despite your bubble skepticism, you once wrote that the collapse of the NASDAQ index in the early 2000s looked “fishy”. Do you mind expanding on that?

  22. Gravatar of Saturos Saturos
    29. November 2013 at 23:09

    “Suppose everyone agrees that Bitcoin is worth $1000 if it becomes a major established alternative currency”

    Then surely you’d actually find a bunch of people in the market who’d be willing to say that Bitcoin’s success value is around $1000. And then you’d be willing to predict at least that Bitcoin’s value couldn’t continue to shoot past $1000…

  23. Gravatar of Saturos Saturos
    29. November 2013 at 23:12

    If the current value is a weighted average of two potential outcomes, then sure the price could shoot up as the weights shift rapidly, but then you’d have to show that it’s more plausible that there are “market fundamentals” driving the revaluation of those weights, than a standard bubble mechanism such as behavioral economists study. And you still wouldn’t get a price going above a pre-established upper bound, without new info on that fundamental bound value.

  24. Gravatar of Saturos Saturos
    29. November 2013 at 23:14

    *assuming strong-form EMH, which is what this blog favors.*

  25. Gravatar of sdfc sdfc
    30. November 2013 at 04:25

    You might say people are speculating in bitcoin. Just who are the hedgers in that market?

  26. Gravatar of mikef mikef
    30. November 2013 at 06:37

    It seems to me that Bitcoin is a pretty good illustration of the Quantity Theory of money….

    It is a flawed currency in that there is a limit to amount that can be in circulation..can you imagine if our economy was based on Bitcoin…the #30K car that I bought last year would now only be worth $100…hyper deflation….80% unemployment overnight…for me this makes me understand how peaple can go hungry while crops rot in the fields…the stuff you heard about that happened in the depression…

    THe use of Bitcoin has increased some..but I think that the velocity is what has decreased…everyone is holding on to them for speculation purposes…as the price increases the velocity decreases even more…causing the price to increase more…

  27. Gravatar of mikef mikef
    30. November 2013 at 06:45

    That should read the car I bought last year for 30,000 bitcoins..is now only worth 30 bitcoins

  28. Gravatar of Morgan Warstler Morgan Warstler
    30. November 2013 at 06:56

    That should read the car I bought last year for 30,000 bitcoins..is now only worth 30 bitcoins.

    So?

    If you sell the car and get 30BTC, it buys you the equivalent of what 30KBTC bought you last year.

  29. Gravatar of Dan W. Dan W.
    30. November 2013 at 07:23

    The good news is that anyone walking behind Scott still has a chance at picking up the $20 bill lying on the ground because Scott certainly is not going to do it!

  30. Gravatar of Saturos Saturos
    30. November 2013 at 08:48

    OK, well at least we know that everyone agrees that the true value of Bitcoin if it’s established is something like $1200. That’s the market consensus based on traders’ rational beliefs. No way it’s going much past that.
    http://blogs.wsj.com/moneybeat/2013/11/29/bitcoin-now-tops-1200/

  31. Gravatar of Saturos Saturos
    30. November 2013 at 08:50

    Or at least, something tangible occurred since this post went up that caused traders to revalue the weighted probability of success by a fifth.

  32. Gravatar of mikef mikef
    30. November 2013 at 09:16

    “If you sell the car and get 30BTC, it buys you the equivalent of what 30KBTC bought you last year.”

    If I can find a dealer that is still in business…I guess that is where the sticky wages come into play…if the salesmen are working just on commission then..maybe it doesn;t matter…

  33. Gravatar of ssumner ssumner
    30. November 2013 at 09:39

    Al, The usefulness of the EMH here is that you are warned not to sell Bitcoins short when bubble advocates yell “bubble.”

    Gordon, You asked:

    “So then is it that people like Cowen and Shiller say bubbles happen even though there is sufficient information for the market to judge the value correctly? I had been operating under the assumption that they were using the term only for conditions when there wasn’t sufficient information for the market to judge the value with any certainty.”

    There is never certainty. They claim that the information available suggests the price is too high, relative to the rational expectation of future payoffs. (monetary and nonmonetary.)

    Bill, Yes, I’ve made that argument as well.

    Ben, Yup, it’s the fallback position (for some, not all.) The 3 names I mentioned did not predict high inflation.

    xtophr, Evade currency controls, make anonymous transactions, etc.

    anon, Glad to be of help.

    Scott. In the past I’ve claimed that the 1987 stock crash is clearly not consistent with the EMH. The 2000 dotcom bubble is “fishy,” meaning that it might be consistent, but is more likely inconsistent.

    Saturos, First of all I don’t claim to support the strong form of the EMH. Second, the $1000 figure was just a hypothetical. Third, the fundamentals of Bitcoin are very hard to identify because so much depends on network effects.
    As I read the EMH it says nothing about how much uncertainty there is in the world. The models deal with risk, not uncertainty, because it’s more mathematically tractable. But the underly logic of the EMH is 100% consistent with incredibly large amounts of uncertainty.

    Dan, I once lost $1000s of dollars in a single day because I believed in the EMH. There was a lag in the pricing of Asian mutual funds (time zone difference) which made profits easy to earn. I assumed no arbitrage opportunities because I couldn’t imagine fund companies were that dumb. But they were. The issue was fixed after it was exposed in the press.

    Saturos, Here is the bottom line. If you were offered Bitcoin today at a price of $30, on the condition that you could not sell for at least 5 years, do you buy? The implication of Tyler’s post is that you should not buy. But that seems crazy to me, I’d buy a lot at $30, even if I was forced to lock it up for 5 years.

  34. Gravatar of Geoff Geoff
    30. November 2013 at 11:27

    Don Geddis:

    “What I love, is how often you dismiss insightful economics on this blog, claiming that your own contrary economic analysis is based on “logic”. But look! You can’t even do actual logic, either! LOL. It appears that you’ve never seen the phrase “by construction” before. Here’s an idea: before you base your whole worldview on “logic”, you might want to first study up on just how logic actually works…”

    You still sound mad. Tell me how anything you said constitutes an informed or substantive argument.

    I notice that you seem not to have an answer to my insightful rebuttals. Try again. Your posts are getting rather stale.

  35. Gravatar of Dan W. Dan W.
    30. November 2013 at 11:31

    Scott,

    I agree with you that the term “bubble” is meaningless as a scientific term. Not because “bubbles” don’t happen but because of the vagueness of interpretation, how they should be measured and how policy should respond to them.

    But it is possible and practical for policymakers to reveal the statistical assumptions at the foundation of their models. If it turns out that valuations are at 3 sigma levels, or even more extreme, there should be scrutiny of those models. Put another way, if policymakers want to deny the existence of bubbles then I suggest they confess that economic outcomes do not fit a Gaussian distribution and are in fact much less predictable then they so often claim.

    As for EMH I believe the concept is perfectly illustrated by the turkey. Each day is just like the one before. Until November when the turkey experiences the day unlike all the others. In other words, EMH supports the human desire to believe the world makes sense but the philosophy promotes complacency and creates a false sense of security, that makes exploitation by others all the easier.

  36. Gravatar of Geoff Geoff
    30. November 2013 at 11:42

    Benjamin Cole:

    “Curiously, the bubble-hysterics are saying free markets do not work and are prone to wssting trillions of dollars on misallocations…funny, I thought that was the job of governmdnt.”

    Benjamin, please understand that when you say things like this, you are really just communicating your own agenda. Your intellectual investment in the “efficacy” of central banking has lead to a bias in your mind that encourages you to believe that the market should be able to completely absorb non-market activity such as central banking, if the “free market” is to be “protected”. For if it was negatively affected by such non-market activity, then to you that would mean the free market is weak, too weak to exist as a useful method of cooperation.

    As a result of this, the “bubble hysterics” must be minimized, and attacked as non-believers. After all, if they believe non-market activity such as central banking makes “the economy” fail, then they are saying the market is too weak to exist.

    What is actually in the minds of those you attack is this:

    Free market economists who are “bubble-hysterics” are not saying the free market “doesn’t work” when there is a non-market banking system. They are telling you that the market has to exist if markets are to work. We don’t have a free market. Therefore, if “the economy” fails, it isn’t the free market that is failing, it is the hampered market that is failing.

    The free market isn’t omnipotent. You don’t have to believe or insist it is omnipotent in order for you to defend it against anti-capitalists. You can say hampered markets fail and still be pro-free market.

    Remember, the free market is based on peace. On private property rights. On voluntary exchange. If there are individuals who go around shooting people, or threatening them with violence, or kidnapping and imprisoning them if they don’t accept a particular means of exchange a portion of which must go to the violence initiators, such that “money” becomes monopolized by the state, all this is not in any way a “failure” of the free market. It is a failure of individuals to practise free markets. Humans have choice. They can choose peace or violence. If some people choose violence, it doesn’t mean peace failed. It means peace wasn’t given a chance.

  37. Gravatar of Geoff Geoff
    30. November 2013 at 12:00

    Benjamin Cole:

    Another way of saying the above is that peace cannot absorb violence. They are mutually incompatible. Free market activity cannot absorb non-free market activity. They are mutually incompatible.

    It is not the job of peace (free markets) to successfully absorb violence (central banking). It’s the job of people to choose one or the other, and whichever means they choose, will have necessary consequences, such as bubbles in a central bank hampered market.

  38. Gravatar of Morgan Warstler Morgan Warstler
    30. November 2013 at 13:37

    mikef,

    As long as we’re comfy with a new class of billionaire haves, given their supportive toppling of the banks and bankers as we know them, and we are, there’s no sticky wage issue.

  39. Gravatar of Michael Michael
    30. November 2013 at 15:15

    Geoff wrote:

    “Free market activity cannot absorb non-free market activity. They are mutually incompatible.”

    I guess we cannot attribute the relative success of the US during the past century to free-market activity, then. We know that there has been considerable non-free market activity in the US since 1913, including (but not limited to) the Fed.

  40. Gravatar of Steve Steve
    30. November 2013 at 15:53

    The problem for Bitcoin’s EMH defenders is that the same logic could equally well apply to Bernie Madoff.

    How so? Suppose you are were an early investor in Madoff, and you suspected he was running a Ponzi scheme. But he is really really good at it, gosh darn it. Rational expectations (plus plausible deniability) suggest you should invest more in Madoff! Why? Any initial economic losses will quickly be diluted into profits by new investors adding more and more capital at higher and higher ‘valuations’.

    What’s actually going on at Bitcoin is that a group of early investors are running around promoting the idea that for Bitcoin to be a useful currency, it needs a valuation of $2 trillion, just like the totality of USD currency. With a cap of 20 million Bitcoins, that would imply that each Bitcoin needs to rise to $100,000.

    So when Bitcoin trades it $1,200, the market is not saying Bitcoin is a success, but rather that people believe 1.2% of the world can be convinced to ‘diversify’ its cash into Bitcoin.

    Bitcoin could rise to $5,000 it people believe 5% of the world can be fooled into moving its cash into Bitcoin.

    Note that this is the same argument goldbugs used to promote the idea that gold could go to $10,000 per ounce. Never mind replacement cost or intrinsic value.

    And that’s the genius of Bitcoin. It’s the world’s first Multi Level Social Media Marketed Ponzi Scheme.

  41. Gravatar of Geoff Geoff
    30. November 2013 at 16:27

    “I guess we cannot attribute the relative success of the US during the past century to free-market activity, then. We know that there has been considerable non-free market activity in the US since 1913, including (but not limited to) the Fed.”

    Oh you can certainly attribute the relative success of the US to free market activity. You just have to realize that the success was due to the extent to which free market activity took place, and that the prevalence of non-market activity reduced the level of success from what it otherwise would have been. If non-market activity, i.e. violence, were zero, then success would have been the highest it could have possibly been. The country grew despite, not because of, non-market activity.

  42. Gravatar of zepplin zepplin
    30. November 2013 at 18:44

    Steve wrote:

    “The problem for Bitcoin’s EMH defenders is that the same logic could equally well apply to Bernie Madoff. … Rational expectations (plus plausible deniability) suggest you should invest more in Madoff”

    No, if you believed in EMH as an early investor in Madoff, you would neither invest more nor less due to, well, EMH.

  43. Gravatar of Erik Erik
    1. December 2013 at 02:49

    Scott, have you heard about attempts to predict bubbles with high probabilityin real-time? His results seem to be a contradiction to the EMH

    http://www.ted.com/talks/didier_sornette_how_we_can_predict_the_next_financial_crisis.html

  44. Gravatar of Erik Erik
    1. December 2013 at 02:50

    Forgot to say: attempts by physicist Didier Sornette

  45. Gravatar of ssumner ssumner
    1. December 2013 at 06:51

    Dan, You said;

    “Put another way, if policymakers want to deny the existence of bubbles then I suggest they confess that economic outcomes do not fit a Gaussian distribution and are in fact much less predictable then they so often claim.”

    I don’t think this is at all controversial, fat tails are widely understood today.

    Steve, You said;

    “The problem for Bitcoin’s EMH defenders is that the same logic could equally well apply to Bernie Madoff.”

    Just to be clear, I’m not “Bitcoin defender.” As I said, the odds are it will fail.

    BTW, belief in the EMH would have prevented investors from getting fleeced by Madoff. In addition, if the SEC had understood the EMH they would have shut down Madoff before he did so much damage. The Madoff affair is a perfect example of why the EMH is so useful.

    Erik, Haven’t seen that one, but “anomaly studies” are testing the wrong theory. They are little more than an exercise in data mining. The proper test is not to see if you can find a procedure that beats the market, but rather whether there is statistical evidence that others have done so. Thus are excess returns serially correlated?

  46. Gravatar of Geoff Geoff
    1. December 2013 at 08:20

    Equilibrium thinking unfortunately dominates macroeconomics.

    EMH is, I believe, the result of a cognitive illusion that stems from systematic conflation of the concept of equilibrium with the concept of movement towards equilibrium.

    We are never “at” equilibrium. Equilibrium is a mental concept that we introduce to serve as a guidepost of where everything is moving towards. In ancient times eschatology had us reabsorbing into the One. In modern times, economists translated this eschatology to have us moving towards no further learning or action: equilibrium.

    EMH can be rather easily shown as incorrect and/or not useful, by realizing that not all information is actually “contained” in the cross section of prevailing prices.

    Current prices never encapsulate the information known and subsequently revealed through purchases from potential buyers. If all prices encapsulated known information, then trading would cease to exist, as no price would be judged as under- or over-priced.

    Given the empirical fact that buying and selling continues to take place, we can conclude that at any given moment in time, before an asset is purchased by future buyers, the information revealed by that act of purchasing the asset is not yet encapsulated in the prevailing price. But this “not yet encapsulated information” is the every day state of affairs for all assets!

    Every asset that is being bought and sold is an asset that is continually adjusting in an environment where not all known information is actually represented by the existing price of the asset. Hence, EMH is an a priori flawed theory of markets. For EMH implies that all prevailing prices encapsulate all known information, including information known by potential buyers. But that’s impossible. Existing prices can only ever contain information revealed by past exchangers of that asset. They can never contain information known today by potential buyers.

    The cognitive illusion, as noted above, stems from understanding the concept of equilibrium as actually taking place in the empirical world. The illusion is the belief that the thought of equilibrium exists in the empirical world of learning and action.

    It is not a refutation of the above to argue that if an asset is currently viewed as under-priced that it would quickly be purchased, thus raising its price such that all known information is indeed encapsulated as EMH holds. Such a response would actually be a concession that EMH is not an accurate description of the present, but some near future instead.

    Since there are buyers of stocks every minute of every day, it means “the market” has not actually priced in all information known in the present.

    The best way to dispel the cognitive illusion of EMH is to understand that the concept of equilibrium is a mental concept only. It is not an empirical concept.

  47. Gravatar of question question
    3. December 2013 at 11:41

    Scott, can you give a definition of EMH you are using (or point to a piece that describes it in full)? I feel like a lot of the argument stems from semantics (using different definitions for ‘bubble,’ ‘EMH’ and what they imply). I’d guess there’d be very little disagreement once the definitions are fully specified and all empirical evidence is presented.

  48. Gravatar of Ad Bo Ad Bo
    3. December 2013 at 16:08

    To understand the price behavior of bitcoin, use the quantity theory of money; M·V = P·Q.

    Sudden price surge and hoarding is to be expected, not deflation: http://zeroprofits.blogspot.com/

Leave a Reply