Great minds think alike
This is me back in 2010:
The EMH is approximately true; indeed it’s almost impossible for me to imagine any other model of financial markets. But it’s not precisely true, again, just as you’d expect. After all, if the EMH were perfectly true then no one would have any incentive to estimate fundamental values. We know people are imperfect and hence that any real world human institution, including markets, will be at least slightly imperfect.
A smart person like Eugene Fama should have been able to come up with both the EMH, and its limits, by just sitting in a room and thinking. Much as David Hume got the QTM by imagining what would happen if everyone in England woke up one morning with twice as much gold in their purses. Or Fisher’s theory of inflation and nominal interest rates. Or Cassel’s purchasing power parity. Or Friedman/Phelps’ natural rate hypothesis. Or Muth and rational expectations. Certain ideas are simply logical, and that’s why I have no doubt that despite all those economists on the left arguing the EMH has been discredited, it will still be taught in every top econ/finance grad program 100 years from now, whereas fiscal stimulus will be long gone from macro textbooks.
PS. Why will fiscal stimulus be gone? Because even Krugman admits it only makes sense at the zero bound. And we are rushing headlong into a world of all electronic money-probably within 50 years. There is no zero lower bound with electronic money, and hence the Taylor Rule is all you need. Old Keynesian economics will vanish, leaving only new Keynesianism.
And here’s my doppelganger Noah Smith 4 years later:
Now, the analogy between the EMH and Newton’s Laws is far from perfect. Newton’s Laws are wrong in a finite set of ways, under conditions that are predictable and well-known. The EMH, in contrast, is wrong in an infinite number of ways, and the set of the most important ways in which it’s wrong is constantly changing, as old anomalies are traded away and new ones crop up. Also, the EMH is actually a family of hypotheses, since you need a model of risk to specify it properly.
But like Newton’s Laws, the EMH is deep and fundamental. If you went through a wormhole and visited an advanced alien civilization, what would they think about financial markets? Chances are, they wouldn’t use the Capital Asset Pricing Model, or the Fama-French 3-Factor Model, or the Shiller CAPE. But I bet they would have some version of the Efficient Market Hypothesis.
This is because the EMH doesn’t emerge from any peculiarity of the way our market system is set up, or the way human beings behave. The EMH comes from something much deeper than that, something that probably has to do with information theory. It comes from the fact that when you exploit information to make a profit in a financial market, you decrease the amount that others can exploit that information. In other words, the financial value of information gets used up. That sounds simple and obvious, but so are the principles that give rise to Newton’s Laws.
In any case, the anomalies that make the EMH not quite right may also have deep explanations, but we don’t know what those are yet. When we do, that will be a big advance in finance theory. But the EMH will still be the jumping-off point for any theory of financial markets, on this planet or any other. It will always be wrong, but never useless.
Noah reached this insight 4 years after I did. But don’t be fooled, he’s much more than 4 years younger than me. He reached enlightenment at a younger age because he’s also much smarter than me.
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10. October 2014 at 08:16
I think there’s a major problem with terminology. EMH is not the same thing as excess volatility, but the existence of the latter is often used as evidence of the former’s incorrectness, probably because of that troublesome word “efficient” thrown in there.
If I had my way we would call EMH something like the “information exhaustion hypothesis” and excess volatility the “excess volatility hypothesis.” And then you wouldn’t have people saying “you think the stock market is efficient? lol ur so dumb haven’t you seen the way it jumps up and down?”
10. October 2014 at 08:25
Great post Scott.
Dan S, how about “efficientish’?
10. October 2014 at 08:43
Brian, ha I’m sure the econ profession will eat that up.
I should also add that sometimes the equity premium puzzle gets thrown in there too. I recall Dan Davies tweeting that EMH is disproven by the fact that equal-weighted portfolios outperform market-weighted ones. https://twitter.com/dsquareddigest/status/518497983768174593
10. October 2014 at 09:12
There are at least three different definitions of EMH with very different implications:
Strong: prices = fundamental value. Markets are economically efficient. This one is obviously false.
Semi-strong: prices reflect all the available information. More plausible.
Weak: prices reflect the publicly available information.
What’s your definition of EMH? The two last mean that markets are informationally efficient, not economically…
10. October 2014 at 09:20
Hi Scott,
Noah seems to be coming around to information theory as well …
“The EMH comes from something much deeper than that, something that probably has to do with information theory. It comes from the fact that when you exploit information to make a profit in a financial market, you decrease the amount that others can exploit that information. In other words, the financial value of information gets used up.”
I’ve not only said this but used it to derive supply and demand and the quantity theory of money. Here’s me:
“The EMH (put one way) is the idea that price data is maximally uninformative. Note: that is maximally uninformative, not completely uninformative [ed. the trends etc] … Economic agents intercept entropy (information) flows: they convert low entropy money into high entropy goods and services. … The information in the market (e.g. prices of goods) is converted in to quantities of goods where the prices they were bought at no longer matter (according to the EMH). This information is consumed by the market in the same way free energy is consumed by organisms.”
http://informationtransfereconomics.blogspot.com/2014/02/ii-entropy-and-microfoundations.html
10. October 2014 at 10:00
Then there’s Paul Krugman and me;
http://hisstoryisbunk.blogspot.com/2014/10/nobel-prize-for-bad-economics.html
I await Paul’s ‘In Prize of cheap labor being denied opportunities’. All he has to do is recycle one old Slate column for the latest laureate;
‘Satyarthi and others from his organization conducted raids on poorly lit and cramped workshops where dozens of children were illegally forced to weave carpets or saris. He would ask reporters and photographers to accompany his volunteers on the raids.
‘Dozens of scared and confused children would pour out of factories and sweatshops that his group raided.’
Wondering where there next meal was going to come from now that they’d lost their only source of income. Give that man a Nobel Peace Prize!
10. October 2014 at 11:39
“In other words, the financial value of information gets used up. ”
Scott, my boy, I think we finally have a way to move the ball a little bit from a previous discussion.
Your view of capital gains, is that in the whole, they are the same income being taxed twice because given EMH, investments generally grow at rate of inflation, so it is deferred consumption, nothing else.
I have always said “sure, but in the world of startups, where a $1K investment generates a $1M return in 1 year, that money hasn’t be taxed.”
So this is my point / question: Perhaps we could say that the startup world is full of “first movers” people who have information before everyone else, and they parlay that into outsized investments – money that hasn’t been taxed.
On the whole though, if you combine and average ALL the startups – then you are back to Scott’s EMH.
It’s not a big move of the ball, but maybe the tax rate is higher on people further down the information trail, similar to Cantillon Effects?
10. October 2014 at 12:31
“The EMH comes from something much deeper than that, something that probably has to do with information theory. It comes from the fact that when you exploit information to make a profit in a financial market, you decrease the amount that others can exploit that information. In other words, the financial value of information gets used up.”
I didn’t think that this was controversial.
10. October 2014 at 12:32
“After all, if the EMH were perfectly true then no one would have any incentive to estimate fundamental values.”
Maybe the EMH is true because the individual participants are irrationally putting too much effort into “beating the market”. It’s a behavioural explanation of the EMH.
10. October 2014 at 14:35
Doc, Noah might be smarter than you. But you transformed the world. He is helping making it better which is also good.
You are visionary, much more important than IQ.
I think Keynessian stimulus will not be taught because under NGDPLT there would be nothing to stimulate.
Just a quick question. Have you thought about a negative conquense of NGDPLT.
If the central Bank announces NGDPLT, firms will fall for the money illusion and will increase output at increasing rates. After several years of high output > 6%, and deflation– something close to paradise– resources will be scarce, a negative supply shock. That would last for long with high inflation > 3% and low or negative output.
As a consequence, we would have long periods of high and low growth and inflation. A very unpopular and difficult situation to explain to politicians and the general public. They will star making silly policies and creating more problems than solutions.
Sounds convoluted but I do see it happening in the long run. Do you have any thoughts on ‘NGDPLT Over-Use Syndrome’?
10. October 2014 at 14:57
Scott,
I’m not an economist and I’m probably being very dumb but I’ve never understood precisely what the EMH is trying to tell me. According to Wikipedia:
‘the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”. In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made’
Suppose a market has a fixed number of shares.
Suppose that at time T0 the total value of those shares is V0.
Suppose that at a later time T1 the total value of those shares is V1.
Suppose that between T0 and T1 the shares pay a total dividend of D1.
Between T0 and T1 the investors in this market make a total profit of (V1 – V0) + D1.
Suppose there are N investors.
The average investor makes a profit of ((V1 – V0) + D1) / N.
The above is just arithmetic and is true for any values of these variables. In particular, it would be true if the values V0, V1 and D1 are generated:
a) In an “informationally efficient” way, or
b) Using a random number generator, or
c) Any other way.
It would also be true irrespective of the number of trades made between the N investors (ignoring spreads and costs).
It would also be true for any distribution of the total profit between the N investors.
So what precisely is the EMH telling me? “Informational efficiency” seems to be an assumption rather than a conclusion. What have I missed?
10. October 2014 at 16:46
Jaime,
What does the EMH say…It says that prices quickly incorporate new information.
Suppose the shares of XYZ are currently trading at $20 dollars per share.
Further suppose that you are watching CNBC, and across the ticker comes the headline, PDQ offers to purchase XYZ at $30 dollars / share pending board approval.
The EMH says, that by the time you get you can pick up the phone, (or log into your brokerage account) XYZ will be trading at $29 dollars per share. Why 29? Because, there is a chance that the deal will fall apart.
But, the price instantaneously reflects the new information. There was never a time that you could have been fast enough to catch the shares at any price between 20 and 29. There are theorists out there that insist that price changes are, in fact, continuous. But, that would be in contradiction to the EMH.
The strong form of the EMH says that the rumors of the take over offer will always be leaked, and the shares should be bid up to 29 before the news actually hits the tape. Most people don’t believe in the strong-form.
Some of the implications of the EMH: Any method to evaluate what share prices should be based on historical price movements (e.g. charting) is BS.
A careful analysis of financial records is unlikely to give an investor any information to outperform the market. It is possible to glean information regarding the risk of the name, though.
It may be possible to outperform by taking on additional risk.
It may be possible to outperform via informational asymmetry. If you are analyzing patterns that no one else is, you may be able to find an edge. Eventually, other people will discover your patterns, and your edge will evaporate.
The EMH says nothing about the possibility of market risk to radically change.
In your example above, if V1 and D1 are known, the market price will reflect the future value less the time value of money. V0 is irrelevant.
10. October 2014 at 17:39
Dan, Yes, the problem is that very few people understand what it implies. They think it implies “no anomalies.”
MB, Those aren’t the definitions I’m familiar with. I believe markets reflect publicly available information. Some markets are efficient, some are not. It depends on many factors.
Luis, I’ve wondered about that too.
tesc, I’m not too worried about that, because I believe economies are naturally stable. But anything is possible.
Jamie, In response to any new information the price should adjust immediately, so that the expected rate of return on this asset continues to equal the risk-adjusted equilibrium return.
10. October 2014 at 17:42
Jason, That’s good to hear.
Patrick, Great post!
10. October 2014 at 18:21
Thanks doc
10. October 2014 at 19:12
But at zero lower bound, why the Taylor rule as opposed to Market Monitarism NGDPLT targeting?
Excellent blogging, btw.
10. October 2014 at 20:59
I think the more precise definition is that you can’t beat the market on a risk-adjusted basis. It’s like with index funds, which have a higher return overall in exchange for higher short term risk.
11. October 2014 at 03:00
Patrick, India still has a large problem with actual slavery, many of the people that Kailash freed were kidnapped and/or held against their will. Unfortunately, the non issue of sweat shops too often gets commingled with the very real problem of modern slavery (there are still about 27 million people enslaved on earth). While I also praise “cheap labor” the same cannot be said of forced labor. Kailash is guilty of sometimes conflating the two, but has largely helped those who are actually enslaved.
As for EMH, I always teach it as something that must be the baseline truth given that you have many people and information that can be used to make a profit. Of course it is also false, but it is never false in a way that you can formalize, the reason for this being the same as to why it is true.
11. October 2014 at 03:13
Doug M and Scott,
Thanks for your replies.
Doug: “What does the EMH say…It says that prices quickly incorporate new information”
Yes. That is what I thought. However, that seems rather obvious. In his original post Scott said:
“Noah reached this insight 4 years after I did. But don’t be fooled, he’s much more than 4 years younger than me. He reached enlightenment at a younger age because he’s also much smarter than me”
This quote suggests that the EMH is something profound and needs extensive thought to reach “enlightenment”
Left to my own common sense I would have concluded something like:
Markets incorporate new information quickly
The average investor is unlikely to outperform the market (any more than the average person is likely to outperform the average in any other field)
Nevertheless, a few people like Warren Buffett can consistently outperform the market over an extended period so they must have some sort of skill which lesser investors do not possess (just as experts outperform everyone else in any other field)
Based on the above, Buffett’s skill must rely on something other than the rapid incorporation of new information.
I might even have talked about “edge” and the fact that edges will be lost when other people discover them. That is common knowledge even amongst people who bet on trivial sports events.
What I don’t understand is what the EMH is saying that is different from my common sense. Why is it something that requires “enlightenment”? What would be the alternative? Doug does mention one alternative when he says “There are theorists out there that insist that price changes are, in fact, continuous. But, that would be in contradiction to the EMH”. However, I would have thought that that point could be proved / disproved by empirical observation so that doesn’t answer what is profound about the EMH.
Perhaps a better question would be to ask what Scott and Noah believed before they reached enlightenment?
11. October 2014 at 04:40
I also wrote something along these lines on Econlog some time back.
In any case, any of us is free to invest, and ehm… *act* like we please. 🙂
11. October 2014 at 05:16
Ben, Good question.
Jamie. No, the fact that Buffett outperformed the market does not tell us that he has any special skill, even if the odds of him doing so though luck were 100 million to one.
The EMH also implies that bubbles don’t exist.
Don’t assume it is easy to understand the EMH.
Ari, Another great mind.
11. October 2014 at 05:58
Morgan Warstler,
Steve Randy Waldman just complimented you!
And his two latest posts seem to have some interesting conversations going with various influential wonks……
http://www.interfluidity.com/v2/5642.html
http://www.interfluidity.com/v2/5675.html
11. October 2014 at 06:38
Should the H in EMH stand for Heuristic?
11. October 2014 at 06:39
Opinions from a thoughtful liberal, amateur economist. I like Keynes’s comparison of financial markets with a beauty contest. Are beauty contests “efficient?”
DeLong has made a good point that it is up to government to make sure that markets work and aren’t subject to excessive volatility like massive bubbles and epic panics. Smith mentions Davies who I agree with:
“Market prices are… a weighted average of the views of a large group of well-resourced and intelligent people with an incentive to get things right. But nobody would build a theory of politics around the infallibility of opinion polls…. “
11. October 2014 at 07:11
‘Patrick, India still has a large problem with actual slavery….’
Yes, but that’s gotten short, or no, shrift in all the news articles announcing the Peace Prize. Even the quotes from Satyarthi pretty much ignore slavery and decry market labor for the children.
I doubt, even with all his faults, that Krugman favors kidnapping and child slavery.
11. October 2014 at 07:17
‘http://delong.typepad.com/sdj/2014/06/department-of-huh-i-dont-understand-more-and-more-of-pikettys-critics-per-krusall-and-tony-smith.html’
Funny, I don’t remember DeLong warning us about HUD creating a housing bubble, nor pointing a finger at his former boss, Bill Clinton’s Housing Initiative when it all blew up.
11. October 2014 at 07:20
Oops, that url from DeLong’s blog has nothing to do with my comment above. It was left over from an e-mail I’d sent to a friend who was having lunch with Krussell yesterday. Sorry.
11. October 2014 at 07:30
Let’s see what the Nobel Committee thinks is the reason for Satyarthi’s honor;
———-quote———-
Showing great personal courage, Kailash Satyarthi, maintaining Gandhi’s tradition, has headed various forms of protests and demonstrations, all peaceful, focusing on the grave exploitation of children for financial gain. He has also contributed to the development of important international conventions on children’s rights.
Despite her youth, Malala Yousafzay has already fought for several years for the right of girls to education, and has shown by example that children and young people, too, can contribute to improving their own situations. This she has done under the most dangerous circumstances. Through her heroic struggle she has become a leading spokesperson for girls’ rights to education.
The Nobel Committee regards it as an important point for a Hindu and a Muslim, an Indian and a Pakistani, to join in a common struggle for education and against extremism. Many other individuals and institutions in the international community have also contributed. It has been calculated that there are 168 million child labourers around the world today. In 2000 the figure was 78 million higher. The world has come closer to the goal of eliminating child labour.
—————endquote————–
No mention of ‘slavery’. Even when Satyarthi mentions child slavery himself, he seems to conflate it with child labor.
11. October 2014 at 08:05
Lincoln apparently faced a similar problem. Does that mean the slaves should not have been emancipated? Would Lincoln have gotten the Nobel Peace Prize?
http://www.theguardian.com/world/2012/jun/16/slavery-starvation-civil-war
In thinking about this problem, I’ve got a hard time drawing a bright line between child labor in these underdeveloped and developing countries and “slavery”. Many world famous historians such as Quentin Terrantino (!) have wondered why American slaves didn’t rise up against their masters. That was likely more difficult than a kid walking away from a sweat shop, but in either case, it’s a real Hobson’s choice at the very least. These sorts of transitions are always pretty messy. I guess we can blame Satyarthi, Lincoln and Bush II and many others for not adequately considering and planning for the aftermath of their liberation campaigns.
11. October 2014 at 08:50
http://www.nytimes.com/2014/10/11/world/asia/kailash-satyarthis-nobel-peace-prize-caps-decades-of-fighting-child-slavery-in-india.html
This NYT article mentions it, and I was not accusing Krugman or anyone else of being in favor of slavery, it is just a topic that seems to get almost no mention, which always bewilders me. India actually has the biggest problem with slavery in the modern world, Kailash has worked to help ameliorate the situation, though admittedly he tends to conflate all child labor with slavery.
“I would like to dedicate this award to the people of India and all children in slavery.”
and
“Each time I have freed a child, the child who has lost the parents and the parents who have lost all the hope that the child would ever come back, and when I hand this boy or girl over to the mother and the mother embraces him or tries to put him in her lap, I cannot explain what kind of joy one can have.”
This article is also focused on the child slavery aspect.
http://zeenews.india.com/news/india/nobel-peace-prize-it-is-indias-victory-over-child-slavery-says-kailash-satyarthi_1482819.html
11. October 2014 at 08:59
A specific case Kailash’s organization helped with
http://www.theguardian.com/global-development/2014/mar/02/tea-workers-sold-into-slavery
Ted Talks about slavery for the interested
https://www.ted.com/talks/lisa_kristine_glimpses_of_modern_day_slavery
http://www.ted.com/talks/kevin_bales_how_to_combat_modern_slavery?language=en
11. October 2014 at 11:18
Well Rob, if you read your sources carefully, or this one;
http://www.theguardian.com/world/2013/jul/20/poverty-tea-pickers-india-child-slavery
you’ll see that the children are in fact being offered better wages by the ‘traffickers’ (itself a morally loaded term, that could be replaced with ‘recruiters’) than they can earn on the tea plantations. Some of the stories are actually blaming the tea companies for paying such low wages.
So Paul and I stand by our analyses. The self-righteous indignation is undeserved.
Now, if the Nobel Committee wants to give a prize for uncovering fraud committed by recruiters–i.e., not following through on the contracts offered–that’s another story. But it’s not the one the official announcement gives.
11. October 2014 at 11:43
‘…wondered why American slaves didn’t rise up against their masters.’
Actually, they did. This was a major concern in America, and not only in the South. Tocqueville mentioned a race war as a real possibility in the event of a mass emancipation. William Lloyd Garrison was almost lynched by a mob in Boston for advocating it.
But that’s not what is at issue with the Indian child-laborers. Presumably the people who are holding the children against their will don’t have the government’s police and military power at their disposal. So why aren’t there stories in the press of escapees from the bondage? Especially if there are hundreds of thousands of kids who want to return to their old, and better lives.
11. October 2014 at 14:34
“Market prices are… a weighted average of the views of a large group of well-resourced and intelligent people with an incentive to get things right. But nobody would build a theory of politics around the infallibility of opinion polls…. “
There are BIG differences between markets and opinion polls.
11. October 2014 at 16:11
….Patrick if you had bothered to actually read the sources you would see that while they offered them higher wages it was a ruse to get them to come. For a real job people can leave, also you don’t need threats, and they won’t be glad to be rescued, also the people typically get paid and cannot be sold to other employers… You do have some cases of snatching, but often it is easier if you can initially get the person to come with you voluntarily by lying. If a child goes into a stranger’s van because the stranger offers the child candy, does that make anything that happens afterward consensual?(clearly not)
11. October 2014 at 16:26
Patrick there are stories, just because you don’t hear about them does not mean they don’t exist, http://en.wikipedia.org/wiki/Iqbal_Masih a “famous” case, also the corrupt police in these areas usually are working with the slavers. They are quite a few resources out there if you bother to look that tell of children running away. They are often uneducated people taken far away from their homes and threatened with both harm to themselves and to their families if they try to escape.
11. October 2014 at 17:29
Pietro, Perhaps in the sense of being an approximation.
Peter, Opinion polls are nothing like markets. I put very little weight on opinion polls on policy questions. Market forecasts are more reliable than policymaker forecasts.
Regarding beauty contests, I think it makes more sense to view markets as predicting future fundamentals.
11. October 2014 at 19:05
OT question for Scott Sumner or anybody:
1. Okay, suppose North Dakota was an independent nation. The economy is booming, booming. No unemployment. If Charles Plosser were the King Central Banker of North Dakota, how would he obtain minor deflation in North Dakota, his stated preference? Would the results be healthy?
What makes it a bad idea to seek minor deflation in North Dakota?
2. Okay, right now the US Government spends about $15 billion net (federal outlays minus federal taxes) in North Dakota, about $20,688 per resident. Is this monetary policy in drag, when thought of in his way?
11. October 2014 at 19:46
‘Patrick if you had bothered to actually read the sources you would see that while they offered them higher wages it was a ruse to get them to come.’
And Rob, had you bothered to actually read my comment you would have seen me say;
‘Now, if the Nobel Committee wants to give a prize for uncovering fraud committed by recruiters-i.e., not following through on the contracts offered-that’s another story. But it’s not the one the official announcement gives.’
11. October 2014 at 19:53
‘Patrick there are stories, just because you don’t hear about them does not mean they don’t exist, http://en.wikipedia.org/wiki/Iqbal_Masih a “famous” case….’
Yes, that’s the problem; one famous case isn’t proof of anything. Even if you concede that every story given in the Guardian articles is accurate, it’s still way too small a sample to give us an idea of the overall consequences of what Satyarthi has done.
And, frankly I’m suspicious of the facts presented in those articles. But still, we’d need a lot more evidence to know that the do-gooders are, in fact, doing more good than harm.
12. October 2014 at 00:17
“‘…wondered why American slaves didn’t rise up against their masters.’
Actually, they did. This was a major concern in America, and not only in the South. Tocqueville mentioned a race war as a real possibility in the event of a mass emancipation. William Lloyd Garrison was almost lynched by a mob in Boston for advocating it.”
Patrick, your reply isn’t in response to the quote. The issue is whether *slaves* rose up against their masters prior to emancipation (240 years of slavery in America preceded it), not whether there was a “major concern” about the effects of emancipation or the effects of advocating it or even a “major concern” about pre-emancipation revolt. You are conflating “concerns” with actions.
Here, another world-famous historian makes the case that slaves did rise up:
http://www.theroot.com/articles/history/2013/04/did_africanamerican_slaves_rebel.4.html
Read the whole thing and ask yourself whether a few limited and isolated accounts, when considered in the context of the scope and history of the entire slave industry, makes that case that *they* did. One need not accept the idea that slaves where “content” or “docile” to explain why there was not greater resistance. My inclination would be that a major reason was that they just could not foresee where they would go and how they would live if a mass revolt would succeed. They faced, I think, the same dilemma as those child laborers do today.
12. October 2014 at 06:48
Slaves *did* rise up against their masters. Nat Turner’s bloody rebellion in 1831 being the most famous. There were also such in the Caribbean. The concerns of even Northerners in the USA were founded in fact.
The reason why there weren’t more rebellions is that the large plantation owners took military/police preemptive actions. Slaves being docile or content had nothing to do with, nor did I ever even suggest, that.
But, again, that has nothing to do with the situation in India.
12. October 2014 at 07:11
Patrick,
Again, please put this in the context of 240 years of slavery in America— and how many million slaves over that period of time? I’m sure you could point out examples of uprisings among members of the Teamsters Union over a much shorter period of time.
As far as “docile, etc”, I agree that had nothing to do with it and I said so in my comment. You probably read the article I linked to—if not, the idea was one that Gates mentions in para 2 of the article I linked to and objected to. My comment was in direct reference to that.
The point, again, is that the slaves didn’t really have any viable options for almost all of that history, Neither do many child laborers.
12. October 2014 at 08:24
“whereas fiscal stimulus will be long gone from macro textbooks.” [in 100 years]
I doubt this.
Unless institutional arrangements have changed so much in 100 years that interest rates at which governments can borrow no longer plunge during recessions, governments still should (and most will) increase investment during recessions because that is what prudent project analysis rules call for. And if faced by monetary authorities that during recessions are willing to buy additional government paper but not private paper (whether at zero interest rates or not), governments ought to go beyond the amounts of deficit financed expenditures implied by project analysis.
But in either case an increase in fiscal deficits will still be optimal during recessions 100 years from now.
12. October 2014 at 08:58
“Unless institutional arrangements have changed so much in 100 years that interest rates at which governments can borrow no longer plunge during recessions, governments still should (and most will) increase investment during recessions because that is what prudent project analysis rules call for.”
Perhaps you can explain this to me from an overall finance and governmental perspective. I’ve always been puzzled by this as it assumes a number of things I don’t think are necessarily true:
1. It appears to assume that the amounts borrowed at low interest rates will be repaid within the term of the loan. Experience shows that’s not the case and every proposal for fiscal stimulus I’ve encountered never claims that will be done (a multiplier of GDP, even if true, is not a multiplier of tax revenue). The real financing costs are generally hidden by pushing them outside an arbitrary budget window. Companies generally repay their debts within the useful lives of the assets they acquire; governments don’t. Therefore, the amounts borrowed will inevitably need to be financed. If one thinks current rates are a”bargain”, that means at higher rates.
2. It assumes that the government knows more about future interest rates than the public does. Are they assuming that those folks who buy up that debt are ignorant suckers and/or that the bond market is inefficient? Or, is it a set up for future financial repression? Is that what prudent government is about?
3. If interest rates on longer term loans are really a “bargain”, don’t those who purchase that debt (generally, the citizenry) stand to lose as much as the government gains? I can see why this is a strategy for private businesses (they don’t owe any special duties to bond holders other than to repay the debt and I doubt they have a better crystal ball), but if this is successful as a borrowing strategy, isn’t it just a form of future taxation? Or, is it just another way to stick it to the Chinese?
Perhaps the more valid argument here is not really about interest rates and “cheap financing” at all, but about cheaper labor (or what would be cheaper labor were it not for Davis Bacon, minimum wages, extended unemployment insurance, etc). For this, interest rates may be a rough proxy, but is that what you should be focused on? If it’s a cheaper supply of labor we’re talking about, why not just say so? That would make much more sense to me. It seems to me that all these arguments for cheaper financing costs ignore the opportunities for cheaper labor. Why is that?
12. October 2014 at 09:58
The EMH is not even approximately true. It has zero truth. It is not even a useful guide to investing. Look at Sumner. Trying to start an NGDP futures market instead of just investing in a plain old index linked mutual fund.
This approach of recognizing the deep, fundamental errors of EMH, but nevertheless clinging to it and calling it “approximately true” or “useful but not precisely true” is really just a refusal to admit one cannot explain the market using a succinct argument.
Aliens would likely not be adhering to any form of EMH either.
EMH is not even logical. It logically contradicts the very act of using logic, because it contradicts the concept of human action as such. Sumner came close to getting to that when he mentioned EMH is not perfectly true because humans are not perfect.
Smith believes EMH probably comes from information theory: The tradeable value of information declines (to the average) the more that particular information is utilized. Well that statement is in itself true. If every investor had the same information, the same thoughts, they would then make the same investment decisions. This would of course imply every investor would make the same amount of profit (where the precise amount of profit is determined by the specific information->thoughts->actions in question). But is this really all EMH can ultimately tell us? That the same information and same actions leads to the same (and thus average) profits?
The reality of human action is not consistent with such rigid information. At all times, information is dispersed, thoughts are heterogeneous, and actions within the population are divergent. But even more important then this, information/thoughts/actions for one and the same individual changes and is thus different over time. EMH is not even approximately true. It is a fundamentally, deeply, profoundly wrong theory of markets.
What EMH really is, is an idea that seems to logically arise from certain narrow assumptions. IF x is true, and IF y is true, and IF z is true, THEN the EMH is (approximately) true. As far as the deduction goes, I think it is reasonable, but the problem is the contradictory-to-human-action assumptions. They are just flat wrong.
EMH is not wrong due to humans being imperfect. Perfect human action is a logical impossibility. Action and perfection are mutually exclusive. It is therefore not even correct to argue that if humans were perfect then finally EMH would be a perfect explanation of markets. EMH is founded on absolutely false assumptions.
12. October 2014 at 10:42
Scott said:
“Jamie. No, the fact that Buffett outperformed the market does not tell us that he has any special skill, even if the odds of him doing so though luck were 100 million to one.”
This makes no sense to me. I find it hard to believe that anyone can support the argument that “…Buffett outperformed the market does not tell us that he has any special skill…” Did he not outperform the market in a serial manner over many market cycles?
13. October 2014 at 00:35
Sumner:
The fact that Buffet eventually made losses does not tell us that he lacked any specual skill.
The fact that Barry Bonds is no longer the home run champion does not tell us that his whole career was based on luck, or something other than skill.
The fact that Bob Dylan is no longer releasing songs of the sae level of genius as in the 60s, does not tell us that he just got lucky back then.
The fact that many economists who have won Nobel prizes no longer write such brilliant papers, does not tell us that they lacked superior intelligence and analytical skills and were merely lucky.
To outperform others based on skill does not require or imply any permanent ability to do so.
Geez EMH is a mind killer. So absurd!
13. October 2014 at 05:04
Bob O’Brien wrote:
“This makes no sense to me. I find it hard to believe that anyone can support the argument that “…Buffett outperformed the market does not tell us that he has any special skill…” Did he not outperform the market in a serial manner over many market cycles?”
Buffett is not merely a picker of winners and losers and Berkshire Hathaway is not just a big mutual fund. Perhaps the companies he buys tend to be more successful than they otherwise would have been had they not been bought by Buffett.
13. October 2014 at 05:11
Major, Buffet’s success might be because one or more of the following:
1) he personally can beat markets over time through special skill,
2) he was lucky,
3) he has hidden some high-cost low-probability dowsnide risks somewhere in his investments (consiously or otherwise) that haven’t hit,
4) as Michael points out, he adds value to companies he controls through superior management talent, or
5) a possibility I’ve overlooked.
It’s very hard to tell which of those are true.
13. October 2014 at 06:03
This Buffet discussion is slightly off point. Benchmarking berkshires performance to the s+p as though it were a domestic stock mutual fund is incorrect. It is not one. Their balance sheet is complicated and they can easily access ‘alternatives’ like buying all the outstanding asbestos insurance risk in the US. The question is really why they have so consistently managed the risks and rewards associated with an insurance company’s balance sheet so much better than their competitors. Few others have seen their core business as essentially a hedging opportunity for long term stock investment … But it’s a really good idea.
Anyway,
You can easily beat the s+p by going long the s+p with 1.2x leverage and a little bit of cash management. Buffet himself has acknowledged that he could have bested his own performance by taking on a bit more leverage, and that there was good reason to think this all along. This does not ‘disprove’ the EMH, it just highlights the way the equity risk premium is an integral part of our understanding of the EMH.
13. October 2014 at 09:13
I don’t think Buffett disproves the EMH at all. I’ve seen some analysis recently that shows his so-called “alpha” came from making levered investments in low-volatility stocks. His genius was in coming up with the idea of using an insurance company as a source of cheap funding to buy stocks. Oh, here’s the link: http://www.econ.yale.edu/~af227/pdf/Buffett's%20Alpha%20-%20Frazzini,%20Kabiller%20and%20Pedersen.pdf
13. October 2014 at 14:38
Patrick, this is actually an issue I have spent considerable time on. I did not believe it at first either, but if you are curious and look into the matter yourself I am relatively certain you will be convinced (given that you are impartially seeking the truth). Also please don’t call slavery recruitment fraud, I think that is fairly unreasonable.
Anyway according to this
http://www.globalslaveryindex.org/findings/#rankings
India has over 10 million people currently enslaved, you can also read the CIA page on human trafficking and see that most countries they discuss either import or export slaves with India. While these numbers are rough and hard to come by, this is the nature of the beast. If you care to look there are quite a few anecdotal stories as well as attempts to come to reasonably good estimates.
http://nlrd.org/wp-content/uploads/2012/02/ReportonTrafficking.pdf
This paper in particular takes pains to try to be as conservative on the issue as possible.
An excerpt
“During the course of the Action Research, the researchers interviewed a large number of children rescued from different types of exploitative situations. Locating the rescued children was a difficult and daunting task. It was found that many rescued children had been repatriated to their native places and hence, could not be contacted. The researchers also interviewed only those child victims who had been trafficked. Finally, 510 children trafficked for non-sex-based exploitative purposes, spread over 12 states, could be interviewed. Ample care was taken by the researchers to keep the sample broad-based by including children rescued from different forms of servitude in different parts of the country. Analysis of the rich harvest of primary data thus collected throws revealing light on the socio-economic background of the trafficked children, the nature of their exploitation after being trafficked and the factors and forces that pushed them to this abyss.”
From the US department of state
INDIA (Tier 2)
“India is a source, destination, and transit country for men,
women, and children subjected to forced labor and sex
trafficking. The forced labor of an estimated 20 to 65 million
citizens constitutes India’s largest trafficking problem”
13. October 2014 at 14:51
Thomas, You said:
“Unless institutional arrangements have changed so much in 100 years that interest rates at which governments can borrow no longer plunge during recessions, governments still should (and most will) increase investment during recessions because that is what prudent project analysis rules call for.”
Sure, but that’s not what I mean by fiscal policy. I’m talking about stimulus aimed at boosting AD. If done for valid cost/benefit reasons that’s different.
Bob, Think about what you are saying. Suppose person X wins the Megabucks lottery. 100 million to one odds. Your claim is person X could not have won though luck, as the odds were against him. But SOMEONE had to win.
Nick and dbeach, I agree.
14. October 2014 at 00:00
Being able to model a Major League Baseball season, say, using probability statistics, and then making statements like “The St Louis Cardinals making it to 2 of the last 3 world series does not tell us the team had skill, as my model predicts at least two teams must make it”, does not prove or reveal that baseball is a game where teams and players succeed based on pure luck.
14. October 2014 at 08:16
Scott: “No, the fact that Buffett outperformed the market does not tell us that he has any special skill, even if the odds of him doing so though luck were 100 million to one. The EMH also implies that bubbles don’t exist. Don’t assume it is easy to understand the EMH”
OK. I understand what you are saying. However, I’m not clear how we would tell the difference between Buffett (or anyone else) winning due to skill or luck. What criteria would we use to determine whether skill or luck or a combination of the two was involved?
The same question arises regarding whether bubbles exist. Someone else mentioned Keynes and beauty contests. At one time, tall and thin may be considered beautiful. At another time, short and full-bodied is preferred. Which is “correct” or “efficient”? Surely, we are just talking about collective opinion, rather than an objective truth, in beauty contests and in markets.
Scott: “Bob, Think about what you are saying. Suppose person X wins the Megabucks lottery. 100 million to one odds. Your claim is person X could not have won though luck, as the odds were against him. But SOMEONE had to win”
There is no skill involved in playing a lottery. There is no prior information which a market could use to determine the “correct” numbers to play.
14. October 2014 at 08:56
Scott said:
“Bob, Think about what you are saying. Suppose person X wins the Megabucks lottery. 100 million to one odds. Your claim is person X could not have won though luck, as the odds were against him. But SOMEONE had to win.”
Buffett appears to have won about ten lotteries in a row. Can this be luck?
15. October 2014 at 18:39
Jamie, It’s never possible to tell whether any individual investor was successful through luck or skill, so you look for indirect signs of skill, like serial correlation in excess returns of managed mutual funds.
Bob, Ten lotteries in a row? Is that a joke, or are you just bad at math?
15. October 2014 at 22:41
Scott,
I have recently starting taking the advice of an investment service that I think has a track record that looks very good historically. When I read your comments about EMH (I do not claim to really understand EMH) it calls into question the wisdom of following the advice of an investment advisor.
I looked up BRK-A vs S&P 500 index on yahoo and found the following:
1985 1490 vs 85
1990 7455 vs 329
1995 24600 vs 470
2000 51200 vs 1394
2005 89900 vs 1181
2010 114600 vs 1074
Today 203800 vs 1862
As an average investor I look at these numbers and it tells me that Buffett has consistently beat the market. Doesn’t this mean he is an exception to the EMH? And could’t my investment advisor also beat the EMH?
16. October 2014 at 08:38
Ok let’s look at it this way. Is there anything that you could see in market behaviour that could bring the EMH into question? I see that any anomaly that anyone points to proponents of EMH will just say far from questioning the EMH it further substantiates it.
What would you have to see to that you would admit it was brought into question?
16. October 2014 at 10:09
Bob, You said:
“I have recently starting taking the advice of an investment service that I think has a track record that looks very good historically.”
That’s a really foolish reason to trust investment advice. Studies show that excess returns are not serially correlated.
I once won 12 straight hands in blackjack, which is more consecutive successes than the Buffett numbers you cite. Did I cheat?
Mike, I’ve done at least a dozen posts explaining that point. One is the post I linked to here.