Defending the indefensible

I love to take a contrarian position.  The more contrarian the better.  But only if I truly think I am right.  This post will be a lot of fun because these days you can’t get much more contrarian than defending Eugene Fama on the EMH.  But I also happen to think Fama is right.  Really, I do.  Indeed I think I can show that he is right, or at least much more likely to be right than most people imagine. 

This was triggered by the barrage of criticism he has been receiving.  If you read posts like this one from Free Exchange, you’d think this giant of financial economics, this future Nobel laureate, is a complete fool.  Maybe he is, but if so then I am too.  Here’s the New Yorker’s Cassidy, then Fama, then Free Exchange:

(Cassidy) Are you saying that bubbles can’t exist?

(Fama)  They have to be predictable phenomena. I don’t think any of this was particularly predictable.

(Free Exchange)  This is truly remarkable. A bubble is an unsustainable increase in prices relative to underlying fundamentals. These fundamentals are more or less observable; those who called the housing bubble did so based on historically anomalous increases in the ratio of home prices to rents and incomes. And many people did correctly identify the bubble years before it imploded, including writers at The Economist who were worrying about rapid home price increases while the American economy was still limping out of the 2001 recession. This is the reality that Mr Fama seems unwilling to confront. How unwilling?

So that is the pro-bubble argument.  We can know the fundamental prices of assets.  We can know when asset prices move away from their fundamental value.  And when they do we can predict that at some point over a reasonable period of time (say a few years) they are likely to move back toward their fundamental values.  I hope that is what Free Exchange is claiming; if not I have no idea what the argument is.  But if that is the claim, it is wrong on all three counts.  I’ll come back to housing eventually, because his assertions are incorrect, but first I’d like to look at the Fidelity Latin America fund, as this perfectly illustrates my point. 

You are probably thinking “why the Fidelity Latin America Fund?”  Well first of all, if you are one of those people who believes in bubbles, and you haven’t been paying attention to the FLAF, you sure are missing the boat.  It certainly looks like a bubble.  But this is also what efficient markets look like.  They are erratic.  They have peaks and valleys.  It looks like they have bubbles, but that is a cognitive illusion.  No one really knows the fundamental value of Latin American stocks.  As a result the price can move around quite a bit, even when the so-called “fundamentals” haven’t changed very much.

Chart for Fidelity Latin America (FLATX)

Anyone who believes in bubbles should have been able to make a lot of money either shorting or going long on the FLAF.  (Maybe these stocks can’t be shorted, but my point will still hold up as there are plenty of stocks that can be shorted.  So please don’t bring up that objection.)  So let’s say The Economist magazine really knows the fundamental value of assets in the various countries it covers.  It does cover a lot of countries, and probably knows more about those countries than almost any other magazine.  Also suppose The Economist started a mutual fund that invested based on its ability to spot fundamental values and deviations from those values.  That mutual fund should outperform other funds.  And not just by a little bit, but massively outperform them.  Just look at the graph.  Did the fundamentals in Latin America (a slow growth area where RGDP grows about 4%) really increase 10-fold between the summer of 2002 and early 2008?  I am almost certain they’d say no.  So there are great profit opportunities.  And not just here, The Economist covers the whole world, and all sorts of assets.  They make predictions about real estate, about commodities, about all sorts of things.  There are always some markets that are “underpriced” and others that are “overpriced.” 

At this point I’m sure that people are saying “that’s not fair, they aren’t claiming to be able to beat the market.”  But unless I am mistaken, that is exactly Fama’s point.  Unless your Nostradamus-like ability to spot fundamental values does give useful predictions of where asset prices are going, with at least more than a 50/50 chance of success, then the theory of bubbles you have developed is essentially worthless.  It would have no utility, for investors and more importantly for regulators.  

Now let’s ask why people have this mistaken notion that bubbles are easy to spot, and that Fama is deluded.  I believe it is a cognitive illusion.  People think they see lots of bubbles.  Future price changes seem to confirm their views.  This reinforces their perception that they were right all along.  Sometimes they were right, as when The Economist predicted the NASDAQ bubble, or the US housing bubble.  But far more often people are wrong, but think they were right.  The most famous example is Shiller’s famous “irrational exuberance” call of early 1996.  Most people still think Shiller was right.  But he was wrong, or at least it is far from clear whether the prediction was at all useful.   (Over the last 14 years there are many times when he looked wrong, and many times he looked right.) 

Now suppose you were a bubble proponent and you starting watching the FLAF when it was down around 7 in late 2002.  You watch it double to 14, and say to yourself, hmm, a bit pricey, looks like a bubble might be forming.  Then it goes to 21, nearly tripling in value.  Now you are really starting to think bubble.  It’s mostly in Brazil.  But Brazil isn’t China, it grows at about 3%.  The joke is “Brazil’s the country of the future, and always will be.”  Now it goes to 28, up almost 4 times higher than the 2002 lows.  Surely no plausible amount of profit growth can justify that rise.  Now the bubble alarms are going full blast.  Sell, sell, sell.  Except anyone who took your advice would have been a fool.  It went to 35, then 42, then 49, then 56, then 63, then over 70. 

Now suppose I wrote this post in the spring of 2008.  A few months later I’d look like a complete idiot.  The FLAF crashed.  The bubble theorists would have had their worst fears realized.  They’d say “I told you so” even though they would have been wrong, even though the post crash price was still near 28.  And now it’s back to 52.  What is the fundamental value?  For a Rortian pragmatist like me that question is absurdity piled on absurdity.  Or what Bentham called “nonsense on stilts.”  There is no “fundamental value.”  There are only amounts people think it is worth.  Individual people, and the market consensus.  There are no outside referees like “God” to tell us who is right.  We are all alone.  All I can say is that the price will continue to fluctuate.  I have no idea which way.  And at times the bears will make money, and at other times the bulls will come out ahead.

But there is one thing I can predict with a high degree of confidence.  Whatever happens to the FLAF over the next 50 years, the price movements will be interpreted through this congnitive illusion, this confidence that we can see patterns in graphs, even where they don’t exist.  The “mountain peaks” will look like bubbles.  In fact, you can generate a “stock graph” by just flipping coins repeatedly.  And if you show the resulting graph to the average investor he will see patterns.  It is all a cognitive illusion.

But why is Fama’s theory now in such disrepute?  Because in the past ten years the world economy has seen two very important bubble-like patterns, indeed arguably the only two such market cycles in the US during my lifetime with macro significance.  And they were both predicted by lots of experts because they violated popular theories of fundamentals.  So start with the cognitive illusion that people have that makes them see bubbles even where there don’t exist.   People think they have made accurate predictions because an upswing is always EVENTUALLY followed by a downturn.  Then add in the fact that The Economist really did make accurate predictions in two of the most important events in modern history.  Do you think it will be possible to convince them that they just got lucky?  About as likely as a husband convincing an already suspicious wife that he is innocent after twice being caught in bed with two separate women.  So I feel sorry for Fama.  He’s probably right, but I don’t see how he could ever convince anyone in this environment.  It would be like trying to convince someone that neoliberalism was the right policy in 1933.  (Come to think of it, The Economist advocates neoliberalism.)

Now let’s return to housing, and the false claims made by Free Exchange.   In fact, it is not easy to predict the fundamental value of housing.  In a previous post I pointed out that many people screamed bubble when the tight American coastal markets began to diverge from “flatland” prices.  This occurred during my lifetime, and I know that it caught a lot of people off guard.  When I moved from the Midwest to Boston in 1982 house prices didn’t seem that high to me.  By 1987 they had doubled.  By 1990 they’d fallen 15% and I recall people in Boston saying; “see, I knew all along that house prices were completely out of whack in 1987.”  Except that there is just one problem, the prices starting rising again.  By a lot.  More recently they have fallen again in the coastal markets.  But it clear to me that in the tight coastal housing markets prices diverged from fundamentals (or Midwestern prices), and never really returned.   Free Exchange suggests you can get the “fundamental” values by looking at ratio of house prices to income.  Will that work in NYC?  How about San Francisco?  Actually, if I wanted to play that game I’d estimate the fundamental value as the cost of construction plus land prices.  And land prices really don’t have any fundamental value. 

Just to be clear, I’m not trying to model housing prices, I’d be the first to admit that the sharp run-ups in Vegas and Phoenix look irrational.  My point is that housing prices are usually hard to predict, because land prices are hard to predict.  Houses can become “unaffordable” in places like NYC and SF, and stay unaffordable for decades.  Of course they aren’t really unaffordable, as people are living in them.  But they appear unaffordable according to the sort of metrics used by the bubble proponents.  These bubble criers were wrong in 1990 when they thought they were right.  Housing prices in desirable coastal markets could well stay much higher than flatland markets for many decades to come.  Or they might not.

A lot of bubble proponents say that the bubble theory doesn’t allow investors to make abnormal returns.  I don’t buy that and I don’t think Fama does either.  I think you can sense Fama’s exasperation in his answers.  Reporters like anecdotes, they think in terms of specifics.  Academics like models, generalities, principles.  Fama wants to know what exactly the bubble proponents are saying.  I don’t want to put words in his mouth, but I think that he is sort of saying the following.

1.  Either you are claiming that a mutual fund run on The Economist’s predictions would reliably outperform index funds.

2.  Or you are saying something with no meaningful implications that I can understand, and you have drained the term ‘bubble’ of any useful meaning.

I think Fama would regard the first claim as delusional and absurd, and I’d agree.   So then what is the point of bubble theories, what are they suppose to tell us that is useful?  Here’s another Fama quote from Free Exchange, see if I have interpreted him correctly:

That’s what I would think it is [i.e. a bubble], but that means that somebody must have made a lot of money betting on that, if you could identify it. It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.

PS.  My “cognitive illusions” theory doesn’t explain why smart academics disagree with Fama.  Academics who have studies “proving the EMH wrong.”  These studies have even created models that can reliably beat the market, if run backward.  Sorry, I’m not impressed.  But that is another post.  Maybe I’ll call it “t-statistic illusion.”

PPS.  I just opened the link in the first quotation.  It is the funniest thing I have read in ages.  It is an ad for The Economist that brags about a spectacularly false housing price prediction made in 2003.  QED.

HT:  Dilip and rob


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83 Responses to “Defending the indefensible”

  1. Gravatar of OGT OGT
    14. January 2010 at 20:21

    OK, so you are arguing a very weak form of ‘efficiency’ that markets are hard to predict? Like a roulette wheel?

  2. Gravatar of Simon K Simon K
    14. January 2010 at 20:37

    Anyone who thinks you could make money off a mutual fund based on The Economist’s predictions should remember this one “Oil for $

  3. Gravatar of Simon K Simon K
    14. January 2010 at 20:38

    Sorry browser hiccup there – The most famously wrong headline was “Oil for $10 a barrel”.

  4. Gravatar of Simon K Simon K
    14. January 2010 at 20:46

    To be more serious – I actually thought Fama’s basic defense of the EMH was reasonably compelling, but I hated the rest of the interview. I get the impression he looks at the world backwards – the EMH must be true, therefore the recession really started in 2007 (actually he’d need to push that back to 2006, but the interviewer let him off easy), government regulation must have been the cause of low lending standards, , no-one could have known the credit rating agencies were wrong, and AIG must have been assuming they’d have been bailed out.

  5. Gravatar of Tom Hickey Tom Hickey
    14. January 2010 at 21:37

    I don’t buy into Fama’s after-the-fact rationale. You either get it or not, and if you are using a “system” and the system didn’t get it, then the system failed.

    I think a lot of folks that were predicting a bubble in housing were doing to for reasons only peripherally related to price and underlying value, although that was a factor. Several other factors were involved, however.

    The first was Minsky’s financial instability hypothesis. To those who bothered to look into the origination of many of these deals, it was clear that they were based on Ponzi finance and were dependent on constantly rising housing prices in order to refinance after the teaser ended. Additionally, a lot of documentation was loose, if not fraudulent, and there was little checking up going on. Mortgage brokers knew that banks were hungry for mortgages to securitize, and they made a lot of money obliging them.

    The second was unreasonable expectations about future appreciation, since income places a limit on meeting cash flow. At a certain point, the number of people who are capable of carrying the monthly at higher and higher median prices dwindles and when that happens demand drops. In the area I was living in CA in mid-2006, the median house price was twenty-five time median income.

    Third, a lot of buyers were speculators, who planned run for the door on the first whiff of a slow down. This was a tip off, too.

    Fourth, in many areas most of the loans being issued near the top were exotic. Another signal of weak hands.

    Fifth, traders know that asset prices are driven upwards by two factors, expectation of improving fundamentals and momentum. Momentum is much more significant at tops. When it becomes clear that expectation of improving fundamentals is virtually irrelevant and momentum is accelerating, creating an imbalance of greed and fear, then risk is under-appreciated.

    Traders define a top as an accelerating upward MOMO-driven trend that is becoming unsustainable in relation to the demand pool. All these factors were operative, and experienced traders were aware of this because this is their job, while the most “experts” were still in the dark.

    I don’t think that is necessarily contradicts REH and EMH from the trader’s perspective. From the trader’s perspective there are no market failures, only alternating opportunities when the market overshoots and corrects, upside or downside. Traders know that this where a lot of money can be made quickly by those who can correctly appraise risk better than the vast majority of market participants who are greedy when they should be fearful and fearful when they should be greedy.

    Soros admits that his stomach guides him in the final analysis. That’s the way it is. I don’t know that one can quantify the changing aggregate relationship of fear and greed, although technical analysis makes an attempt at it using various market indicators.

    BTW, we haven’t hit the bottom of housing yet in the US. There’s still a big debt overhang and considerable deleveraging still to come. There will be more shakeouts before the bottom is in. Demand is not yet recovering relative to supply. In fact, there are more foreclosures in store, and banks are not flooding the market with REO since they don’t want to drive prices down further. But at a certain point….

  6. Gravatar of Doc Merlin Doc Merlin
    14. January 2010 at 22:09

    Ok, I wouldn’t have shorted here or used bubble reasoning. It doesn’t do what I expect a bubble to do. There is no log periodic behavior that results whenever everyone is trying to buy the dips.

    Anyway my problem with EMH is thus:

    If EMH were true it would be because we are each making our own market choices ignoring EMH.
    if everyone takes EMH to be true, it becomes false, because it then becomes very easy to “look for deals.”

    Every time someone bets on EMH (and buys an index fund for the market) they make the market less efficient than if they had tried to look for good market positions to have. That means when people act on EMH, and use beta strategies (market following strategies), alpha strategies (strategies that try to beat the market) actually become easier.

    On a side note, the big indices typically beat the total economic growth rate, what is up with that?

    Weak EMH is undoubtedly true, in that on average market participants cannot beat the market, that alpha strategies are at best a zero sum game.

  7. Gravatar of Greg Ransom Greg Ransom
    14. January 2010 at 22:12

    Several people made hundreds of million dollars shorting the market on presumption there was a housing bubble.

    It’s just massive dishonesty or ignorance to suggest this didn’t happen.

  8. Gravatar of Doc Merlin Doc Merlin
    14. January 2010 at 22:14

    Woops, didn’t finish my last thought. The last paragraph should conclude with:

    But this is irrelevant, EMH is mostly true, but it becomes less true the more we believe it is true.

  9. Gravatar of David N David N
    14. January 2010 at 22:18

    I don’t know about Fama, but you’re off your rocker. Land prices have no fundamental value?

    “Anyone who believes in bubbles should have been able to make a lot of money either shorting or going long on the FLAF.” The classic “if you’re so smart why aren’t you rich?” argument.

    I think you’re beating a dead straw man. Maybe I am too contrarian the other way, but I don’t think I’ve spotted lots of bubbles. I think there’s been two or three in the last 20 years.

    For 80 years market P/E was 10-20. In 1998 it hits 32. A bubble spotter, even one who is too chicken to go short, might say “Something’s not right here. This is irrational. Did stocks get so much less risky that we’ll accept this poor earnings yield?” An EMH guy needs to have a different explanation, something “perfectly rational” that justifies the unheardof multiple. That’s where the bubble exists; in the justification.

    I don’t know the history or what people were saying about FLATX in the last decade, but it appears to be a highly focused fund. It’s certainly not an index fund. Maybe it was just a good run of stock picking by the managers. Maybe its valuation is perfectly compatible with EMH every step of the way. The chart alone can’t tell us that. Unlike you I don’t think there’s a lot of people going around calling every 10-bagger a bubble and seeing every correction as proof of same.

  10. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    14. January 2010 at 23:59

    Fama said a few things that I agreed with:

    http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-eugene-fama.html

    “Right, but is that credible? It’s very difficult to explain how A.I.G. issued all the credit default swaps it issued if people didn’t think the government was going to step in and bail them out.”

    “What is your view on regulating Wall Street? Do we need more of it?

    I think it is inevitable, if you accept the view that the government will bail out the biggest firms if they get into trouble. But I don’t think it will work. Private companies are very good at inventing ways around the regulations.”

    But in the rest of the interview he didn’t acquit himself well. This was especially iffy:

    “It’s a leap. I’m not saying you couldn’t do it, but I’m an empiricist. It’s got to be shown.”

    He sounded ( very inexactly, of course )more like Edmund Wilson descanting about the worth of various novels and the manner’s of their authors in this interview than someone averse to judgment until all of the facts are in.

    “For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down—I guess that is what they call a bubble.”

    Where I come from, that qualifies as exaggeration or even hyperbole.

  11. Gravatar of Giles Giles
    15. January 2010 at 01:48

    I agree with Simon K – reading the whole interview, and it seems staggering that this sort of reasoning can come from a Nobel-candidate, particularly the idea that because of his EMH views, the recession MUST have preceded the housing distress. This seems to be the very opposite of the empirical view that he claims to hold.

    Also, I think he fails to acknowledge the two different aspects of EMH – no free lunch, and the price is right. See his colleague Thaler’s column: http://www.ft.com/cms/s/0/efc0e92e-8121-11de-92e7-00144feabdc0.html

    I used to work in financial betting (literally). Most of our business was premised on people not being able to predict future markets, and I made a lot of money from that turning out to be true. But I don’t believe in EMH, particularly after the dotcom crash. You can know that a price is wrong, and have no useful safe way of speculating against it – that “market stays irrational longer than you can stay solvent” problem. I saw blatant arbitrages between majority owned subsidiaries of companies and their owners last for days.

    I also made markets in housing futures, and was very aware of how inefficient, high-transaction cost it was. Far from efficient.

    I don’t think laughing at the Economist along that old line of “if you’re so clever why ain’t you so rich” is an adequate defence of Fama here, at all. Plenty of people knew AOL, CSCO, QXL, GEO and all those other dotcoms were overvalued – but trading them downwards profitably is a very different thing.

  12. Gravatar of Mike Sandifer Mike Sandifer
    15. January 2010 at 02:16

    Dr. Sumner,

    I take issue with a few elements of your post and some of your perspetives on bubbles and EMH in general.

    First, how can a majority of a market (# of investors x $ invested) ever beat that market? There seems to be at least an implicit argument that if few enough people profitted from the identification of the potential bubbles mentioned, then EMH is not undermined.

    I think it’s prima facie untrue. Some investors will always be better than others. I thought the relevant claim attached to EMH here would be that markets simply can’t be beaten consistently above chance.

    Second, the potential bubbles you mention lack the essential features of those easier to identify in my mind. I don’t see positively accelerated growth in your graph there, for example.

    More generally, I agree that people tend to see patterns that don’t exist. There is plenty of experimental evidence to support this. But, it’s also well-known that people have a tendency to miss “obvious” patterns in other circumstances. It is just as easy to self-select the data you look at to fail to see predictive patterns as it is to see ones that aren’t there.

    Also, I’m puzzled about your previous claims that you subscribe to weak EMH. Perhaps this is my ignorance about the theory, but your position strikes me as semi-strong, at least. I’ve long considered myself accepting a weak version, but then you’ve pointed out areas of misunderstanding on my part before. Who wouldn’t accept a weak version?

    The real question in my mind is whether there is more money invested with above-market returns than chance can justify. I haven’t looked for evidence, but it seems that should be the next step.

  13. Gravatar of Mike Sandifer Mike Sandifer
    15. January 2010 at 02:26

    Dr. Sumner,

    Another previous claim you made just came to mind. You mentioned in an earlier post that the way some researchers define and identify bubbles, one would have to conclude that the stock market is usually undervalued. Is this really a problem? If about 80% of people are risk averse, is it so hard to imagine that the risks associated with stock investing are over-weighted?

  14. Gravatar of Marcus Nunes Marcus Nunes
    15. January 2010 at 03:46

    In 1998 The Economist popularized the “bubble” concept with two beautiful covers. The first was of a “bubble” sitting just above the torch held by the Statue of Liberty, ready to be “pricked”. Since nothing happened, a few months later the cover depicted Baron Munchausen flying on his coach, hands extended forward holding a sword in pursuit of The “bubble”.
    This was about the S&P and the Dow. NASDAQ wasn´t mentioned.Then you look at two things. Between 1998 and 2001 NGDP went from 5% growth to above 8% in early 2000 and then “dived” to 3% in 2001. This “instability” in NGDP is closely correlated with the move in stocks. The NASDAQ went up much more than the S&P because it was also driven by productivity “story” of the time.

  15. Gravatar of 123 123
    15. January 2010 at 03:53

    If editorial staff of the Economist doesn’t change, a mutual fund that avoids assets The Economist calls overvalued would strongly beat index funds over next 50 years, but with a large volatility.

  16. Gravatar of DanC DanC
    15. January 2010 at 05:32

    Very good blog.

    Fama is correct.

    A few things started this recession. A oil price shock occurred at the same time a massive, really record amount of variable rate mortgages were being reset. Many of these were subprime loans that the government had encouraged.

    In addition, there is no reason to expect governments or regulators to be any more rational then markets.

    However Fama andEMH could be wrong going forward as we move toward crony capitalism.

  17. Gravatar of Master of None Master of None
    15. January 2010 at 05:42

    I think there’s a difference between “predictable bubbles” (i.e. what Fama says is impossible) and “bubbles ex post”.

    In order for the Fed to regulate bubbles, for example, Bernanke has to believe that EMH is wrong, and that bubbles can be predicted. Why do you think the Fed has been so reluctant to embrace explicitly regulating asset prices? Perhaps because they tend to view the world from Fama’s point of view.

    For myself, I think that the more liquid and investment-oriented a market is, the more EMH applies. For markets where prices are “sticky” (e.g. labor, housing), I tend to think more from Schiller’s perspective. (That is, until the prices become “unstuck”).

    More here: http://master-of-none.tumblr.com/post/207991990/reprogram-the-reaganites

  18. Gravatar of TheMoneyIllusion » I told you so! . . . Um, no you didn’t. TheMoneyIllusion » I told you so! . . . Um, no you didn’t.
    15. January 2010 at 06:13

    [...] about burying the lede!  Last night I did a post discussing how the people who say “I told you so” after bubbles are often suffering [...]

  19. Gravatar of ssumner ssumner
    15. January 2010 at 06:54

    OGT, You can call it what you like. I am saying bubble theories are useless unless they can outpredict index funds. And I say they can’t, hence they are useless. I don’t care whether you call that weak, strong, or semi-strong. That is my argument.

    Simon K, Good point.

    Simon#3, I haven’t even read the interview yet. But yes, a recession didn’t cause housing prices to fall in 2007, more likely it was the immigration crackdown that occurred that year. I’m am not defending all of Fama’s opinions, just his defense of the EMH.

    Tom Hickey, You said;

    “Traders know that this where a lot of money can be made quickly by those who can correctly appraise risk better than the vast majority of market participants who are greedy when they should be fearful and fearful when they should be greedy.”

    I don’t think individual traders know very much. Sometimes they do have correct insights that the market doesn’t yet realize. But these insights aren’t reliable enough to make “bubbles” a useful concept for either investors of regulators.

    Doc Merlin, You said;

    If EMH were true it would be because we are each making our own market choices ignoring EMH.
    if everyone takes EMH to be true, it becomes false, because it then becomes very easy to “look for deals.”

    Good point. That’s why I always say the EMH is only approximately true.

    Greg, You said;

    “Several people made hundreds of million dollars shorting the market on presumption there was a housing bubble.

    It’s just massive dishonesty or ignorance to suggest this didn’t happen.”

    I completely agree. They did make money on that presumption, and it would be dishonest to deny that. If you think I did, then you need to re-read my post.

    David, You said;

    “I think you’re beating a dead straw man. Maybe I am too contrarian the other way, but I don’t think I’ve spotted lots of bubbles. I think there’s been two or three in the last 20 years.

    For 80 years market P/E was 10-20. In 1998 it hits 32.”

    I don’t follow this. Didn’t you get those sorts of valuation changes recently in Brazil, or China, or lots of other markets?

    It seems to me these things happen all the time.

    You said;

    “Unlike you I don’t think there’s a lot of people going around calling every 10-bagger a bubble and seeing every correction as proof of same.”

    Unlike you I do think there are lots of people making those sorts of claims, although admittedly an index fund would have been a better example. Fama’s right, people know throw around the term all the time. The Economist is now calling the current market a bubble. The S&P is down 25% in the past 9 3/4 years, but we are supposedly still in a bubble. Maybe stocks will fall this year, it wouldn’t surprise me, but isn’t that a pretty low threshold? The ratio of prices to expected 2010 earnings is not that high, is it?

    Don the libertarian democrat, I’ll do a post soon on regulation. We don’t need to regulate “Wall Street” only FDIC-insured banks and TBTF institutions. Require collateral on loans and derivitives. That’s probably the best we can do.

    Giles, I answer your stock shorting point in my new post. Regarding the price is right vs. prediction; if you can’t predict, you have no way of demonstrating that your “correct price” model is right. So why should I believe you?

    Mike, You said;

    “I think it’s prima facie untrue. Some investors will always be better than others. I thought the relevant claim attached to EMH here would be that markets simply can’t be beaten consistently above chance.”

    I completely agree.

    You said;

    “The real question in my mind is whether there is more money invested with above-market returns than chance can justify. I haven’t looked for evidence, but it seems that should be the next step.”

    Good point. BTW, I discuss weak and strong EMH in my first reply. You can make up your mind.

    Mike#2, I am not an expert on stock pricing. But the experts say stocks appear to have earned excess returns, although I think there is a very new study that denies this. So who knows. The original view was that the gap between stocks and bonds could not be explained by the risk difference. They must have empirical estimates of risk aversion.

  20. Gravatar of ssumner ssumner
    15. January 2010 at 06:59

    Marcus, Yes, I was much too kind to The Economist. But I made up for it in my newest post. :)

    123, I hope that is a joke.

    DanC, All good points. I had forgotten how high oil prices in 2007 hurt house prices in the exurbs, where commutes are long.

    Master on None, I agree the Fed can’t really forecast bubbles, and they know it. So they don’t try, and instead argue we need to regulate banks so that they don’t make so many risky loans. That makes sense to me.

  21. Gravatar of William William
    15. January 2010 at 07:26

    Speaking of risky loans…

    From 2000-2006 the annual number of new mortgages increased 60% (housing starts only increased 12% in the same time frame.) Wouldn’t it be valid for someone at the time to suggest that this increase in mortgages is dubious and probably transient, and that any price increase driven by this “phantom fundamental” is also transient? A bubble, in other words?

  22. Gravatar of 123 123
    15. January 2010 at 07:31

    No, this is not a joke. :(

    I saved a lot of money by reading Economist and avoiding assets that Economist said are overvalued.

    Their timing is not good enough for short selling, but if they say something is overvalued you can always look for some less expensive investments and in long run outperform the market.

  23. Gravatar of David N David N
    15. January 2010 at 08:20

    The run-up in Brazil’s indexes in the past 6 years appears to have occured at reasonable P/E ratios around 10-20. China’s P/E’s are high, no question about it. That alone is not enough to declare a bubble. If 15 is a reasonable P/E for a country expected to grow at 3%, then perhaps 40 is a reasonable P/E for a country expected to grow at 10%. Or maybe China is badly overvalued. I can’t say. But it doesn’t take different valuation philosophies to justify investment in Brazil, China, or the US.

  24. Gravatar of Rafael Rafael
    15. January 2010 at 08:31

    Scott,

    What do you think about sophisticated detractors of the EMH, like Shleifer and Andrew Lo?

    There´s a useful source on this issue, the article by Andrew Lo prepared to THE NEW PALGRAVE: A DICTIONARY OF ECONOMICS.

    link:
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=991509&rec=1&srcabs=470161

  25. Gravatar of More on bubble spotting – Economics - More on bubble spotting - Economics -
    15. January 2010 at 08:45

    [...] SUMNER has written a long post defending Eugene Fama and the efficient markets hypothesis. In a nutshell, he thinks that I'm [...]

  26. Gravatar of Tom Hickey Tom Hickey
    15. January 2010 at 08:58

    SS: “I don’t think individual traders know very much. Sometimes they do have correct insights that the market doesn’t yet realize. But these insights aren’t reliable enough to make “bubbles” a useful concept for either investors or regulators.’

    Scott, you are lumping traders together. I’m talking about the consistent winners. Yes, there are a few. I just don’t think that most economists are looking in the right direction in asset markets. Although apparently Keynes was a successful trader for his own account.

    It’s the day-to-day that a challenge, not so much the big turns. The short term is what’s hard to catch. It’s a matter of percentage of right calls to wrong, holding for profit, and closing out losing positions quickly enough. But here Goldman either has a bunch of very sharp traders with their daily prop trading record, or they are cheating. EMH rules them suspicious. No one is that good day after day over the span of a month, I don’t care how big their bonuses are.

    Sheila Blair disagrees with you about regulation in her recent dissing of Alan Greenspan. Elizabeth Warren has said that the consumer protection legislation would prevented a lot of the cause of the crisis from occurring if it was applied.

  27. Gravatar of Friday links: broken black boxes Abnormal Returns Friday links: broken black boxes Abnormal Returns
    15. January 2010 at 09:05

    [...] bubbles exist, and if they do can they be profitably exploited?  (TheMoneyIllusion, Free [...]

  28. Gravatar of Greg Ransom Greg Ransom
    15. January 2010 at 09:58

    The notion of “fundamental values” has all sorts of problems.

    Fortunately, the existence of unsustainable systematic distortions in the structure of relative prices across time doesn’t depend on the notion of specific, unique and individual “fundamental values” for specific items unrelated to the overall interconnected structure of prices and production processes across time.

    There is no Platonic realm of “actual” individual values for individual goods outside of the ever adjusting relational network of subjective evaluations and interconnected prices relations and production processes across time.

    But we have a good deal of insight into how price relation and production structures which are unsustainable are produced — and we know as a fact that subjective interconnect relational valuations change over time in response to changes in the relational interconnections of prices and production processes across time. This process works imperfectly, but it never stops taking place, and we know that via this process systematic distortions in the price and production process increase and decrease across time.

    To assert otherwise is equivalent to asserting that there is no proof that there is a desk in front of you, or that you can’t prove that there isn’t a pink elephant in the room, i.e. the counter claim depends on the worst sort of “philosophy”, a just plain stupid approach to epistemology and the philosophy of sciences that lost its legitimacy generations ago, if it every had any.

    Where am I wrong in suggesting that the”efficient markets” are simply making the mistake of failing to see that understanding the causal process of adjustments of the whole system is NOT THE SAME as “predicting’ the place of any single economic agent within it, or predicting how that agent can “maximize” his return at any specific point in time.

    Again, bad “philosophy” is driving out good economics — the false picture of knowledge and “science” as mere prediction and economics as mere explanation of individual “behavior” and success.

    It’s a stupid anti-scientific picture of entrepreneurial agency to imagine adjustments in entrepreneurial understanding across time using the “scientific” template of the ability to precisely predict what will happen when three bodies interact. We know that people coordinate their subjective relational valuations with changing price and production relations across time, via changes in understanding, but it’s utterly a false picture to force these alterations of understanding into the mold of “predicting” precise and exact numerical relations at every particular moment in time the way we can predict what will happen when three bodies interact (OK, I’m making a joke here. Scientists can’t do that. Let’s change that to two bodies interacting).

    It’s stunning that many economists don’t “get it” — they seem to have completely lost the capacity to be economists, lost the capacity to think in terms of entrepreneurs adjusting their subjective knowledge and understanding of valuational relations within a systematically changing interconnected system of relational prices and production processes across time — one that economic science has shown can easily be systematically distorted across time through the time structure of production and relative prices, via leverage, the time necessary to see production processes succeed or fail, systematic distortions in the channeling of money through the system, etc., etc.

    I.e. Econ 101 tells us that the “Efficient Markets” attack on the possibility of “bubbles” is bad science, bad economic thinking and just an embarrassment to science.

    Where am I wrong here?

  29. Gravatar of Tom Hickey Tom Hickey
    15. January 2010 at 10:42

    Greg Ransom, I don’t think you are wrong as much as looking in the wrong direction. Entrepreneurs and investors don’t determine current asset prices as much as traders do. It is true that they provide the bulk of financial market capital but they are followers, not leaders, in setting market prices. The price of an asset is established moment to moment by the last trade. Traders are responsible for most market volatility. Providing liquidity is their economic role, for which those who are correct more than other are well compensated. Traders also strengthen markets by flushing out weak hands. However, they also drive momentum in both directions. Traders do seek to find and exploit inefficiencies among markets (arbitrage). This makes markets more efficient.

    Financial markets are quite different from “real” wholesale and retail markets. They are actually the only “free” markets still in existence outside of bazaars where prices are negotiated, since they operate on the basis of bid and asked to discover current price, taking all available information into account and considering risk. Commodity spot markets bridge the gap between financial markets and real markets.

    I don’t think that there is yet any more efficient way of price discovery, but unless markets involve exploiting inefficiencies, there is a whole lot of either gambling on randomness or else cheating going on. I don’t know any market players that think regulated markets are casinos, although many think that regulations are often not efficient at preventing cheating. (Read Zero Hedge or The Market Ticker, for example.)

    So what I am saying is that REH and EMH as stated have problems, but the basic idea is correct within the limitations of social science. No social science is yet deterministic in its predictions, e.g., because of uncertainty and reflexivity. Statistics attempts to reduce uncertainty, but probability is based on data from the past. Taleb, Soros, and others have examined this in relation to markets.

  30. Gravatar of Greg Ransom Greg Ransom
    15. January 2010 at 11:48

    Tom, in the sense I’m using the term, every economic “actor” is an “entrepreneur”, someone adjusting his understanding and valuations to changing relative prices and production structures — see the work of Kirzner or Mises.

  31. Gravatar of tgrass tgrass
    15. January 2010 at 12:11

    Master of None (and Sumner), Sumner replies that the Fed can’t predict a Bubble. If we go back to the working definition here of a bubble as a price that exceeds some intrinsic value, we can conclude that the Fed could in fact identify a bubble merely by defining the intrinsic value of a home.

    On that: many note the recent departure in major cities from historical median income/median price multiples. That reveals how problematic an “intrinsic value measure” can be: income is not an accurate measure of buying power for a home among those with wealth. The major cities have had increasing down payment rates, possibly reflecting increases in capital gains, which are not expressed in income stats. So I agree with Fama, the term “bubble” is like “god” – it’s the expression we give to our ignorance.

  32. Gravatar of Matthew Yglesias » Efficient Markets Hypothesis Rhetoric Matthew Yglesias » Efficient Markets Hypothesis Rhetoric
    15. January 2010 at 12:15

    [...] Scott Sumner’s lengthy defense of Eugene Fama and the Efficient Markets Hypothesis makes me want to refine what I said already about Fama’s recent New Yorker interview. This [...]

  33. Gravatar of Tom Hickey Tom Hickey
    15. January 2010 at 12:35

    Greg Ransom: “Tom, in the sense I’m using the term, every economic “actor” is an “entrepreneur”, someone adjusting his understanding and valuations to changing relative prices and production structures — see the work of Kirzner or Mises.”

    OK. Agreed.

    The underlying principle in the real and financial sectors is market discipline. This allocates capital efficiently in the process of price discovery.

    A charge that many are now making is that market discipline broke down owing to moral hazard, causing markets to fail. I would add to that lax oversight, which allowed cheating. Efficient markets require a level playing for market discipline to operate.

    Like an organism, an economic system works efficiently only if the elements and subsystems function in coordination dynamically, as you point out. Non-economic distortions like privilege and cheating vitiate this.

    As economists like Steve Keen observe, static economic models don’t capture this adequately. Entrepreneurs in your sense know this, or they lose their capital quickly.

  34. Gravatar of Zosima Zosima
    15. January 2010 at 13:16

    The big problem I have with EMH defenders is that their evidence derives largely from human successes and failures. A la “If your theory is so good why don’t you go make a fortune off of it”.

    People are fundamentally stupid and irrational. This is a scientific fact that is well supported by research in cognitive science. The fact that people can’t model or predict a system doesn’t mean that it isn’t actually following a mechanistic and deterministic pattern.

    Take earthquakes. Plate tectonics is an excellent scientific explanation of why and how earthquakes occur. Yet we can’t predict where or when earthquakes will occur. Does that mean that plate tectonics is false or that we won’t be able to predict them one day? No. I can just imagine an alternate reality where Eugene Fama became a geologist and not an economist; telling other geologists “Well if your plate tectonics theory is so great, why don’t you go make your fortune in earthquake safety/prediction?”

    Human failures are not evidence for a theory.

    p.s. The same argument Fama makes could be made against purely deterministic, chaotic systems, like the equation y=2x mod 1.0, with x_0 = pi, without knowing the initial position, our inability to predict them does not make them intrinsically unpredictable or random, just apparently unpredictable and random. I’m not sure that Fama appreciates this distinction.

  35. Gravatar of Bill Woolsey Bill Woolsey
    15. January 2010 at 13:57

    Scott:

    I have no interest in developing any theory for investors to make money. I am an economist. I don’t think my role is to train someone to make money at anything.

    I also have little interest in developing theories that help regulators manipulate prices.

    Fama, on the other hand, may not be an economists as I understand it. Perhaps he does see his role as training entrepreneurs or managers or something. Or perhaps training regulators to overrule entrepreneurs or managers when they are making errors.

    I do have an interest in looking at alternative institutional frameworks and considering how the interactions of entrepreneurs will work out. And making judgements about which sort of institutional framework is better.

    So, for me, a theory of bubbles doesn’t require that I be able to show someone how they would make money by observing bubbles. I don’t need to be able to show a regulator how he could see a bubble and then intervene to stop it.

    If some institutional arrangements are more likely to result in bubbles than others, then go with the ones that are less likely to result in bubbles.

    However, I actually believe that bubbles result from errors and that economists should spend more time teaching people to avoid those errors. In particular, forecasting the trajectory of prices into the future is a mistake that can generate bubbles. I know people do this. I have met people who do this. I don’t know it can generate bubbles. I just have a theory about how it can happen. But I think it is a sound theory. And I can look at historical episodes where it is a plausible explanation.

    Does my theory allow someone to make money? I don’t know. I DON’T CARE!!!! Does my theory allow regulators do undertake some massive violation of individual rights to stop people from making this error? I don’t know. AND I DON’T CARE.

    I am happy teaching people not to project trajectories into the future. Emphasizing that there are fundamentals. And that maybe the fundamentals justify perpetual price increases–well and good. But past price increases don’t prove that.

    I am not sure that some institutional frameworks are less likely to create bubbles than others. But I would be interested in that.

  36. Gravatar of Simon K Simon K
    15. January 2010 at 14:02

    Greg – I strongly agree with your view of entrepreneurial activity. We’re always operating under conditions of great uncertainty. Any participation in any market is always an experiment to find out whether our beliefs and expectations are right, and almost every time we discover that there are relevant facts we don’t know. There is not, and never will be, a magic price prediction machine that tells use what prices should be.

    But isn’t that completely consistent with a fairly strong form of the EMH? It means no technical analysis of price data will ever produce excess returns on average. It means no straightforward analysis of “fundamentals” will ever produce excess returns. The only way to get excess returns it to have unusual information or insight. And even then you’ll be wrong a lot of the time. This is weaker than the strong EMH since it acknowledges that information takes time for the market to assimilate, but its stronger than the weak EMH, because it rules out not only Chartism but most kinds of Fundamentalism.

    So I don’t see this view as inconsistent with what Scott has been saying about bubbles – it can be possible to make money by betting against the market for individual participants, but still meaningless to say there’s a bubble in the market as a whole. This is just another form of the standard EMH paradox I was taught in school – you don’t find $10 bills lying on the sidewalk because someone would already have picked them up, but that does statistically imply that someone did in fact find them and pick them up. Its a difference between what the market as a whole does, and what individual market participants see.

    The people who made money shorting the housing bubble had very specific theories about what was wrong that they were speculating on – some people recognised that the synthetic CDO-squareds of REMIC MBS (etc) were overrated and shorted them, others recognised that house prices in their specific area made it cheaper to rent (for them). But quite a few people tried to short and were wrong because they didn’t understand the details well enough (for example, fully conforming pass-through MBS did not suffer that badly and not only because the Feds started buying them). And still other people (like me) remained long throughout all of 2001-8 and still made money because they recognised that their specific houses or their specific debt weren’t overvalued.

    I suppose that Mises would say that the macro view that shows the bubble as a whole in retrospect but doesn’t allow it to be predicted is itself meaningless and then go on to claim that the whole thing was predictable due to credit expansion. Seem like having your cake and eating it to me, and I don’t think anyone made money shorting dollars (at least not yet).

  37. Gravatar of More on bubble spotting « economics More on bubble spotting « economics
    15. January 2010 at 14:19

    [...] SUMNER has written a long post defending Eugene Fama and the efficient markets hypothesis. In a nutshell, he thinks that I’m [...]

  38. Gravatar of Dan Carroll Dan Carroll
    15. January 2010 at 14:29

    The EMH suffers from the problem in that it is a very broad generalization that is generally unprovable but explains everything. In explaining everything, it explains nothing.

    Your analysis suffers from an incorrect assumption: that the unpredictability of markets suggests that markets are “efficient”. I could make the same argument that the unpreditictability of markets makes them “inefficient”. No one in his right mind is arguing that one can accurately and consistently predict the future prices of assets and get rich. Likewise, asserting that the prices of housing in 2006 in CA & FL, of the Nasdaq in 2000, or of oil in 2008 were “efficient” defies logic. It was obvious to many who were not profiting off of the “bubble” that those prices were non-sensical.

  39. Gravatar of Mel Jay Mel Jay
    15. January 2010 at 15:00

    (1) You cannot infer whether the Fidelity Latin America Fund
    is in a bubble from it’s price; you need something like
    it’s P/E.

    (2) Knowing there is a bubble and being able to predict when
    the bubble will burst are two very different things. The
    first mainly depends on historical norms and the latter
    depends mostly on human psychology

  40. Gravatar of Simon K Simon K
    15. January 2010 at 15:13

    Dan – “Efficient” has a technical meaning that goes beyond “unpredictable”. It means that on average you can’t make money in the long run using publicly available information. It is possible to test this on certain markets eg. stocks, and it works out pretty well.

    The EMH doesn’t saying anything about specific prices being “efficient”. That doesn’t make any sense in terms of the technical meaning. As an aside, though, if you thought 2006 California house prices were “non-sensical”, can you explain why many are still at those values?

  41. Gravatar of Greg Ransom Greg Ransom
    15. January 2010 at 15:27

    What Bill Woolsey said.

  42. Gravatar of Greg Ransom Greg Ransom
    15. January 2010 at 15:38

    You are right about moral hazard and the rest, Tom, but you left something equally significant out here, Tom, the way that bandwagon effects, over optimism, and the whiting out of core price signals by the Federal Reserve,and the existence of leverage and non-neutral money can systematically distort the structure of prices and production across time, generating unsustainable structures of production, relative prices — along with unsustainable anticipatations of revenue, income, and profit.

    Tom wrote:

    “A charge that many are now making is that market discipline broke down owing to moral hazard, causing markets to fail. I would add to that lax oversight, which allowed cheating. Efficient markets require a level playing for market discipline to operate.”

  43. Gravatar of Greg Ransom Greg Ransom
    15. January 2010 at 15:46

    Simon, I get this:

    “Greg – I strongly agree with your view of entrepreneurial activity. We’re always operating under conditions of great uncertainty. Any participation in any market is always an experiment to find out whether our beliefs and expectations are right, and almost every time we discover that there are relevant facts we don’t know. There is not, and never will be, a magic price prediction machine that tells use what prices should be.

    But isn’t that completely consistent with a fairly strong form of the EMH? It means no technical analysis of price data will ever produce excess returns on average. It means no straightforward analysis of “fundamentals” will ever produce excess returns. The only way to get excess returns it to have unusual information or insight. And even then you’ll be wrong a lot of the time. This is weaker than the strong EMH since it acknowledges that information takes time for the market to assimilate, but its stronger than the weak EMH, because it rules out not only Chartism but most kinds of Fundamentalism.”

    But I don’t get this:

    “So I don’t see this view as inconsistent with what Scott has been saying about bubbles – it can be possible to make money by betting against the market for individual participants, but still meaningless to say there’s a bubble in the market as a whole.”

    If someone is creating a hill or “bubble” of honey by pouring honey out of a honey pot in one place on the floor, you can say there is a honey bubble that cannot last, but you can’t with any assurance say when the the bubble with disappear and all of the honey will be just as flat an all the rest — it depends on how long — lets call him Fred — continues to pour honey out of his pot.

  44. Gravatar of Tom Hickey Tom Hickey
    15. January 2010 at 15:51

    Bill Woosely: “If some institutional arrangements are more likely to result in bubbles than others, then go with the ones that are less likely to result in bubbles.”

    Good points, all, Bill. I agree that the real problems that lead to the crisis were and remain institutional, rather than merely “irrational exuberance” or “the extraordinary madness of crowds.” These need to be addressed in reforming the system.

    I would add in clarification, however, that the concern probably should not be with institutional arrangements that are “less likely to result in bubbles” as much as reducing institutional arrangements that introduce substantial inefficiencies, e.g., either tilt the playing field, or creating moral hazard or systemic risk, etc., which result in unsustainable activity (such as “bubbles”), or otherwise create serious imbalances. I think that is is what you mean from what you wrote.

    As far as I am aware, bubbles have never been defined operationally. Maybe bubbles are like pornography. As Justice Potter Stewart famously observed, hard-core porn is difficult to define, but “I know it when I see it.” However, bubbles are usually visible only in hindsight. Apparently the folks charged with seeing this sort of thing beforehand, just missed it in the case of the crisis. Or possibly they were in denial based on ideology, as some think.

    Tinkering with markets based chiefly on price runs too big a risk of introducing inefficiencies. Price “bubbles” rise instead from institutional inefficiencies that can be defined operationally and targeted.

    But it is possible to target institutional inefficiencies that tilt the playing field, for example, enable cheating, or otherwise threaten indispensable institutions or even the entire economy. As I understand it, that is what FCIC is attempting to do, so that Congress can use them as guides in legislating appropriate fixes.

    Of course, when it comes to the banking function, there are also fiduciary considerations that come into play and need to be addressed, too. Many think that commercial banking and financial markets don’t mix and need to be separated.

  45. Gravatar of scott sumner scott sumner
    15. January 2010 at 16:02

    William, Sure it’s worth asking the question, but I don’t see the link to the EMH. The market knew about these loans, and those were factored into the prices of homes, the stock prices of home builders, etc.

    123, Good for you. But did you avoid investing in oil when they said it was going to $10?

    David D, You missed my point. China went from 1700 to 6200 to 1700 very quickly. Are all those prices consistent with fundamentals? Did the expected futures profits of the companies in the FLAF go up 10 times?

    Rafael, I can’t comment on any specifics, because I am not that up on the research. When I do look at the research my general impression is that researchers underestimate the data mining problem, or that fact that they select models because they already think they will fit the data better. It makes the significance tests pretty meaningless.

    More later. . . .

  46. Gravatar of 123 123
    15. January 2010 at 16:36

    When was it? Perhaps I wasn’t a subcriber then.

    Economist can have a lot of false positives, but if they identify enough of real major bubbles, you can use them to beat the market. Warren Buffet has avoided lots of attractive assets too.

  47. Gravatar of David N David N
    15. January 2010 at 16:53

    Scott, I don’t know if China is a bubble or not. I never claimed it was, so you’ll forgive me if I don’t do the research. The article you quoted with that line from the former nightclub cashier turned real estate broker, about how it’s definitely a bubble but it “will never pop,” certainly reflects my radar.

    My point is you can’t tell from the tape. A bubble is not a technical pattern. Brazil started its recent run coming out of a long period of negative earnings. The whole index had an invalid P/E. I think its a normal recovery which maybe got ahead of itself in growth expectations and corrected. The kind of thing that happens all the time and that almost everyone agrees you can’t consistently time.

    You keep throwing around these rapid swings in valuation like they help your case. I think they hurt it. It’s not that hard to find companies with 52 week highs 2x the lows with only small changes in fundamentals. The market overreacts to stuff.

  48. Gravatar of Tom Hickey Tom Hickey
    15. January 2010 at 16:55

    My concern here is that REH and EMH are being deployed to bolster the claim that no one could have seen this coming, so nothing could have been done about it, and nothing can be done to prevent it happening again. According to this view, there were no institutional inefficiencies, and markets worked fine. Oh, except when there was a massive market failure when the interbank loan market froze up, essentially throwing a wrench in the gears of the global financial system.

    If Sec. Paulson is to be believed, this threatened to take down the entire economy unless it was fixed overnight by massive government intervention that is still continuing, with dubious success in restoring the economy.

    On one hand, I wonder if acceptance of REH and EMH, along with free market ideology, actually prevented the people in charge from seeing what was unfolding. On the other hand, if this sort of event really is unpreventable going forward, the world is in big trouble. It seems to me that this is question to be answered.

  49. Gravatar of Simon K Simon K
    15. January 2010 at 17:06

    123 – The Economist predicted $10 Oil in the near future in 1999. Makes me feel old.

  50. Gravatar of I Got Money in the Bank » Blog Archive » TheMoneyIllusion » Defending the indefensible I Got Money in the Bank » Blog Archive » TheMoneyIllusion » Defending the indefensible
    15. January 2010 at 17:12

    [...] that can be … TheMoneyIllusion – http://www.themoneyillusion.com/ Continued here: TheMoneyIllusion » Defending the indefensible January 15th, 2010 in [...]

  51. Gravatar of scott sumner scott sumner
    15. January 2010 at 17:49

    Tom Hickey, You said;

    “Scott, you are lumping traders together. I’m talking about the consistent winners. Yes, there are a few. I just don’t think that most economists are looking in the right direction in asset markets. Although apparently Keynes was a successful trader for his own account.”

    Keynes’ ability was very overrated. Once he had to be bailed out by his rich daddy. That makes it a bit easier to take risks and win big. I once won 12 hands in a row at blackjack. I barely knew how to play. Does that make me a “consistent winner.” I am not denying that you have observed the things you say you have observed—I am denying that you are drawing the right implications from what you have seen.

    Greg, you said;

    “There is no Platonic realm of “actual” individual values for individual goods outside of the ever adjusting relational network of subjective evaluations and interconnected prices relations and production processes across time.”

    Well put, now we are on the same wavelength.

    As far as the rest of your comment, let me see how much we can agree on. I agree that you can have inefficient levels of output. For instance, a monetary shock can cause a business cycle, and affect investment especially strongly. Can we agree on that? So I am not arguing that the optimal quantity of each good is always being produced. Rather, I suggest that when looking for problems in the economy, don’t look at prices in particular sectors, but look at disturbances in the value of money (measured by the price level or NGDP.) If you are still with me, we agree. If not, which specific price should the Fed look at to watch for bubbles?

    tgrass. Yes, I agree. I once said ‘bubble’ is a fancy way of saying “I haven’t a clue.” I like the “God” definition even better.

    Zosima, I don’t like the analogy because studying geology doesn’t make the earth behave differently. But if we discover something like “the January effect” then arbitragers make it go away.

    Bill, I can accept that. But I am skeptical that what you and I consider good macro policy will make bubbles disappear. The 1929 stock bubble occurred after 8 years of near zero inflation and roughly 3% or 4% NGDP growth.

    On the other hand, (and I am changing my mind in mid-answer) perhaps if we had kept NGDP growing at 3%, then stocks wouldn’t have crashed and 1929 wouldn’t have been viewed as a bubble. So if you look at bubbles from the crash perspective, not the upswing, you may be right.

    Simon K, You said;

    “This is just another form of the standard EMH paradox I was taught in school – you don’t find $10 bills lying on the sidewalk because someone would already have picked them up, but that does statistically imply that someone did in fact find them and pick them up. Its a difference between what the market as a whole does, and what individual market participants see.”

    I like this and hope others will think about it. I really believe others perceive me to be more fanatical than I am. The world is very messy, lots of people are stupid, entire markets sometimes make mistakes. Smart people sometimes observe entire markets making mistakes. If you can understand how I can agree with all that, and yet still like the EMH, then you are seeing things my way. If you think there is a contradiction, then you overestimate how fanatically I adhere to the EMH.

    The debate over the EMH is not quite as absurd as the debates over free will, but it’s surprisingly close.

    Dan, In retrospect the Nasdaq 2000 and housing in 2006 look overpriced based on what people knew then. Not so for oil. If we hadn’t had a steep world recession in mid-2008, oil would still be well over $100. It’s $80 in a massive worldwide recession, what does that tell you about what it would be if demand hadn’t collapsed.

    You said;

    “The EMH suffers from the problem in that it is a very broad generalization that is generally unprovable but explains everything. In explaining everything, it explains nothing.”

    This is wrong. It explains why asset prices respond immediately to new information. It explains why mutual funds that do well one year are not particularly likely to do well the next. I.e. it was luck. Anti-EMH predicts the opposite and is falsified by the data.

  52. Gravatar of scott sumner scott sumner
    15. January 2010 at 17:57

    123, I am not sure, someone else mentioned it.

    I just noticed Simon said 1999.

    David N. I also don’t know if it is a bubble. But if you think in terms of “fundamentals” then surely the huge swing either implies the high price was too high, or the low price was too low (negative bubble.) Again, I am trying to imagine how The Economist would see this if they believed fundamentals could be estimated.

    Tom Hickey, you said;

    “My concern here is that REH and EMH are being deployed to bolster the claim that no one could have seen this coming, so nothing could have been done about it, and nothing can be done to prevent it happening again. According to this view, there were no institutional inefficiencies, and markets worked fine. Oh, except when there was a massive market failure when the interbank loan market froze up, essentially throwing a wrench in the gears of the global financial system.”

    No. There are lots of things we’ve learned. We have a big moral hazard problem due to FDIC and TBTF. We might want to require downpayments, for instance.

    We’ve learned we need better monetary policy. The huge fall in NGDP made the preceding prices seem overvalued. So they fell sharply. Partly the problem was that prices were actually too high in retrospect, and I agree the EMH sounds defeatist in that case, but partly it is because monetary policy drove them much lower than necessary, and we can do better there.

  53. Gravatar of Friday links: black box blues | Financial engineering resource center Friday links: black box blues | Financial engineering resource center
    15. January 2010 at 18:58

    [...] bubbles exist, and if they do can they be profitably exploited?  (TheMoneyIllusion, Free [...]

  54. Gravatar of David N David N
    15. January 2010 at 19:57

    “But if you think in terms of “fundamentals” then surely the huge swing either implies the high price was too high, or the low price was too low…”

    Yes, but not necessarily a bubble, or a negative bubble, whatever that is.

  55. Gravatar of Greg Ransom Greg Ransom
    15. January 2010 at 21:02

    Scott writes,

    “let me see how much we can agree on. I agree that you can have inefficient levels of output. For instance, a monetary shock can cause a business cycle, and affect investment especially strongly. Can we agree on that? So I am not arguing that the optimal quantity of each good is always being produced. Rather, I suggest that when looking for problems in the economy, don’t look at prices in particular sectors, but look at disturbances in the value of money (measured by the price level or NGDP.) If you are still with me, we agree. If not, which specific price should the Fed look at to watch for bubbles?”

    What we want to look at is systematic shifts in structures of productions and relative prices across time that a linked to distortions in core valuations tools that systematically effect all price relations and production processes across time, e.g. fed policy, housing finance regulations, leverage rules and government moral hazard booby traps, China currency & bank policy, etc. — all of the systematically related price and financial and production factors identified by BIS chief economist William White and his research team beginning in 2003 and reported directly to Alan Greenspan and the world’s central bankers beginning in that year — and every yea after thru 2008.

  56. Gravatar of Tom Hickey Tom Hickey
    15. January 2010 at 21:24

    Scott, thanks for your response. I have no problem with the even a strong EMH claim that prices reflect value, so that there is no way to determine over or under-valuation profits are due to luck. But if that is all there is to it, financial markets are essentially casinos, and banks, especially, should be isolated from operating in financial markets and be restricted to intermediation as chartered institutions serving a public purpose. It would also be questionable whether large institutions should be allowed to put so much capital at risk in such casinos as to involve systemic risk.

    However, I think that many sophisticated traders think of “buy low and sell high,” not in terms of price, but in terms of risk. Market trading involves putting capital at risk. Traders are not concerned about price in relation to value as much as risk in relation to reward. They seek to enter a market at points of low risk when there is reason to believe that upward momentum is beginning to accelerate, and to exit when it begins to slow down. Conversely on the short side. This is how many experienced traders risk capital, not estimating price in relation to value as investors are encouraged to do, based on Graham and Dodd.

    Moreover, I think it is a rather gratuitous to assume efficiency in aggregating all micro markets in to a financial sector subject to macro influence without considering that influence, as Greg suggests. Bill Gross made a lot of money recently on his basic principle of following the government, and it doesn’t seem to have been a matter of luck.

    Nassim Taleb has written the folly of attempting to rely on predicting market risk in light of uncertainty and the greater folly of creating systemic risk based on this. But I don’t see that as an argument against trading on risk is ordinary circumstances, e.g., using options based on risk analysis. Very few traders risk so much of their capital at once that they cannot recover.

  57. Gravatar of 123 123
    16. January 2010 at 01:57

    OK – if the Economist said in 1999 that dotcoms and energy should be avoided, this is still an excellent recommendation.

  58. Gravatar of 123 123
    16. January 2010 at 02:02

    Scott, you said
    “Bill, I can accept that. But I am skeptical that what you and I consider good macro policy will make bubbles disappear. The 1929 stock bubble occurred after 8 years of near zero inflation and roughly 3% or 4% NGDP growth.”

    Good micro policy is needed to reduced bubbles. Housing bubble was born because of bad regulation of financial institutions. But I have no high hopes that this will ever happen.

  59. Gravatar of StatsGuy StatsGuy
    16. January 2010 at 06:15

    Quick questions to defenders of the Economist Bubble Theory (EBT):

    How many times in the past 15 years, and when, has the Economist called Chinese growth unsustainable at an ~8% rate??

  60. Gravatar of Tom Hickey Tom Hickey
    16. January 2010 at 09:40

    Well, the talk of the town, not only here but in China, is whether there is an emerging housing bubble similar to what happened in the US — an explosion of prices along with a corresponding increase in seemingly unsustainable debt.

    According to The Shaghaiist (emphasis added):

    “And the problem is getting worse: already astronomical real estate prices rose during December at the fastest pace in seventeen months, forcing the Chinese government to cut commissions to realtors who secure new mortgages in an attempt to slow growth. To give you a clearer picture of the problem, Shanghai’s residential property prices have risen nearly 20% in the past year.

    “The social ramifications of high prices are fairly widespread: the average price to income ratio in Beijing is 27:1, five times higher than the world average, which means it’s almost impossible for an average citizen to buy a house without a massive loan. And as many young people won’t consider getting married without an apartment, housing prices are exerting a noticeable strain on society. Just take a look at Snail House, the soap opera in which characters cheat, deceive and struggle to obtain housing at any cost.

    “As things are, it seems impossible for China’s real estate bubble to continue like this. Luckily for those of us who prefer to rent, average rental prices are somewhere around 1/500th of the value of the property. And though you might lose face, if you really can’t afford the price of a house in Shanghai, you can always pitch a tent in the subway.”

    http://shanghaiist.com/2010/01/14/chinas_housing_bubble.php?source=patrick.net

    So we are soon to have another test of the bubble theory.

    I”d say risk is very high at this level and wouldn’t be a buyer under those conditions. Renting and waiting for a correction looks like a better option. Actually, I know some savvy people in the CA who sold their own residences near the top and rented, waiting for the correction.

    BTW, the UK and Spain had worse housing crises than the US both their economies and finance are on the rocks. No wonder there is a lot of emotion around “bubble denialism.”

  61. Gravatar of Joe Calhoun Joe Calhoun
    16. January 2010 at 10:32

    There is nothing in my experience (19 years as a professional investor) that leads me to believe that individuals (me or anyone else) can consistently choose individual stocks (or bonds or commodities) that will outperform the relevant index. On the other hand, I do believe that individuals can (and do) produce superior risk adjusted returns by tactically adjusting asset allocation across asset classes. Why? Because fundamentals such as P/Es or P/Book value are not predictive for returns, except over very long time frames which are not useful for most investors. Fundamentals only tell us about risk. High price to rent ratios in the real estate market did not mean that prices had to fall. They only told us that there was a greater risk of that than if the ratio had been lower. They told us that unless something fundamental had changed, that the ratio would likely return to its long term trend. That again didn’t mean prices had to fall. It could have meant a long period of stagnant prices and rising rents. But the risk that prices would fall had obviously risen above what it was at a lower ratio. Anyone who claims to be able to predict more than that is either lying to themselves or lying to everyone else.

  62. Gravatar of Greg Ransom Greg Ransom
    16. January 2010 at 12:11

    Scott, “hard” scientists can’t predict when a sand pile will collapse, but they can provide the math explaining the causal mechanics and mathematical structure of the collapse after it happens. Similarly, Darwinian biologists can’t predict when speciation will occur or when particular adaptations will arise, but they can explain the causal mechanism at work after the facts, and then can even very roughly anticipate characteristics of these in advance — but one Darwinian biologist can’t make the equivalent of a better “money making” prediction of the future course of speciation and adaptation against other rival Darwinian biologist.

    What you and Fama are pushing is bad philosophy, a false picture of knowledge and science — and you are using this bad philosophy to create bogus pseudo-economics.

  63. Gravatar of ssumner ssumner
    17. January 2010 at 11:11

    David, I don’t care how people use the term ‘bubble’, the bottom line is that the anti-EMH view is that prices are often obviously above or below fundamentals, that should make it easy to run an mutual fund that beats indexed funds.

    Greg, I think that is asking far too much of policymakers, indeed it doesn’t even seem very Austrian, or have I misinterpreted you?

    Tom Hickey, I often get the sort of argument you raise in regards to Bill Gross, but don’t know how to think of it. There are about 300,000,000 Americans would would like to get rich; the fact that Bill Gross is famous must tell us something about how hard it is, even for educated people like you and me. So perhaps he did outfox the market, but I view the EMH as a theory of markets, and a theory of what the average investor or average regulator is capable of knowing. And my answer is still “not much.” Might there be a few people smart enough to occasionally outfox markets? Sure, it’s possible.

    123, Yes, I think “bubbles” will continue. What bubbles really are is a harder queastion.

    Statsguy, Good point, and they have averaged almost 10% for 30 years.

    Tom Hickey, China may have a housing bubble, but comparisons with the US are absurd. They don’t do subprime loans, for instance. And there is a need for a massive increase in the housing stock. China could use three times its current housing stock. And you said:

    “Shanghai’s residential property prices have risen nearly 20% in the past year.”

    You realize that average income per capita in Shanghai has been rising at 15% a year for decades, and will continue rising fast. You might be right, but your reasons aren’t at all persuasive.

    For China as a whole house prices rose 5.7% in the last year, which is below the trend rate of increase in incomes.

    Joe, I agree that specific stock predictions are difficult, but also think asset allocation is difficult.

    Greg, I answered that in a different thread.

  64. Gravatar of 123 123
    17. January 2010 at 14:33

    “What bubbles really are is a harder queastion.”

    Here’s my definition. Risky asset with a too low risk premium is a bubble.
    Some people say that stocks should have zero risk premium, but nobody says that negative risk premia are OK. But in the most famous bubbles risk premia were negative.

  65. Gravatar of Bubble, bubble, toil and trouble Bubble, bubble, toil and trouble
    17. January 2010 at 20:00

    [...] Wisdom from Scott Sumner on bubbles, Fama and the efficient market hypothesis. HT: Will Wilkinson). While everyone wants to gather around the corpse of EMH, Sumner notices it’s still breathing. Sumner is doing a spuerb job these days opening his mind and laying it out on his blog. [...]

  66. Gravatar of Bogdan Enache Bogdan Enache
    18. January 2010 at 01:05

    The efficient market hypotheses, whatever one thinks it says, only applies if you have a random walk and a normal probability distribution, doesn’t it?. But what if that is not the case? That’s what somebody like Nassim Taleb holds. This is, basically, the real issue. What’s your opinion on this?

  67. Gravatar of EMH « Thinking Things Through EMH « Thinking Things Through
    18. January 2010 at 05:47

    [...] via TheMoneyIllusion » Defending the indefensible. [...]

  68. Gravatar of Fred Foldvary Fred Foldvary
    18. January 2010 at 06:25

    The real estate bubble was easily spotted and predictable. Real estate has had a remarkably regular 18-year cycle since the early 1800s. This has been documented by several works, including those of real estate economist Homer Hoyt, and author Fred Harrison. I have written on this also (www.foldvary.net/works/crash08.html). The general business cycle is connected to the real estate cycle, which made the Crash of 2008 easy to forecast.

  69. Gravatar of Monday News Roundup — Gold, Agriculture, Oil and More | Red Hot Energy and Gold Monday News Roundup — Gold, Agriculture, Oil and More | Red Hot Energy and Gold
    18. January 2010 at 06:59

    [...] of economics at Bentley University in Boston, offers an interesting discussion on his blog, The Money Illusion, that shows how difficult it is to identify a bubble in progress. He points to the Fidelity Latin [...]

  70. Gravatar of muirgeo muirgeo
    18. January 2010 at 07:02

    From my reply on this article over at Cafe Hayek;

    I did read it. I also read and researched Eugene Fama and Efficient Market Theory. I read no fewer than 10 articles related to this post. I do my research because I am ignorant and inquisitive together. I think I understand Scott Sumner’s claim perfectly. I thus I understand how misleading and irrelevant it is. Thus I would ask Mr Sumner of the pre-crash memo’s floating about Wall Street among insiders and Hedge Fund manager noting that they’d be long gone when the house of cards collapsed. I believe somewhere there was even a code for it. Wall Street speak of a sort, mentioned in David Wessel’s book, In Fed We Trust. They are long gone, they beat the market…they beat it silly taking billions and using nothing of pricing mechanisms. Just ponzi schemes and complex financial products that made the pricing mechanism irrelevant to them. They beat the market Russ and they destroyed it too. That’s why guys like Posner, Rajan and Shiller call it , “the most remarkable error in the history of economic theory.” and why what Sumner presented was nothing but a logical fallacy propped up as something pertinent.

    They beat the market Russ… they have billions and the world is broken.

  71. Gravatar of Bob D Bob D
    18. January 2010 at 07:12

    Scot,
    Great article and my sentiments exactly! I think that some of the critics of Fama are people who are tied to the Investment Industry who rely on a dumbed down investor class in order to derive excessive fees for their insightful and typically wrong recomendations. Example: Lehman, Bear Stearns, Merrill, Morgan Stanley, BOA, etc.

  72. Gravatar of Greg Ransom Greg Ransom
    18. January 2010 at 09:25

    “Greg, I think that is asking far too much of policymakers, indeed it doesn’t even seem very Austrian, or have I misinterpreted you?”

    You must be misinterpreting me.

    It’s not asking too much to ask for something better than the incompetence of Alan Greenspan and Ben Bernanke — the competence of the research staff of the BIS demonstrates that the incompetence of Greenspan and Bernanke was not required.

    True enough, Selgin and Hayek and White have good arguments for thinking that the private market would provided better coordinated money and credit across time than the current price control regime operated by the Fed. And all sorts of people have explained how better regulations would put a boot down on the massive moral hazard created by today’s housing finance and banking and investment regime.

    But still, it’s not asking too much for policy makers in government not to be massively incompetent and pathetically corrupt (raise your hands Chris Dodd and Barney Frank, etc.).

  73. Gravatar of Lburkefiles Lburkefiles
    18. January 2010 at 09:55

    EMH is just that, a hypothesis – something that works is a world that is theoretical and has frictionless transactions. In the real world there are many thing that impinge upon markets, rules, regulations, obsolescence, taxes, corruption, inside dealing, etc… Buy theories are useful if they get us to think about what it is we are studying – but they are not a substitute for real world experience, aka hand on. Think of all of those theories on how to bet the dogs or horses – it is a good theory but the real world is very different, horses are doped, jockeys fiddle with the horses performance, dogs get sick. Or due diligence “check lists” a useful tools but hardly the end all in accuracy or efficacy. Look to EFH as just that than look to those things that impinge upon the EM and begin factoring those in to your analysis.

    As for the example of a man caught in bed with two other women – he should be lucky they were not paramours – those are much more expensive, in theory :-)

  74. Gravatar of scott sumner scott sumner
    18. January 2010 at 18:06

    123, It’s hard to know the risk premium, because it is hard to know the expected gain in stock prices.

    Bogdan, No, that is a different issue. I agree that the distribution of stock prices changes is not normal, but rather has “fat tails.” The EMH does not require normality.

    Fred, I don’t recall any real estate bubbles in 1960 and 1978.

    Muirgeo, That is how things work in Hollywood, but not in the real world. Most of the “bad guys” lost money.

    Of course they trusted the Fed, so did I. It’s too bad the Fed failed us when we most needed them.

    Bob D, I agree. I am not surprised that people in the investment industry don’t like the EMH.

    Greg, I say we should do something like NGDP targeting, similar to policies proposed by Selgin and Hayek, and then have Congress stop messing up the financial system. So it sounds like we aren’t far apart.

    Lburkefiles, I don’t have the time to do all that investigation, I’ll just stick with index funds and spend my time on more pleasurable activities–like answering reader comments.

  75. Gravatar of muirgeo muirgeo
    19. January 2010 at 06:29

    “Muirgeo, That is how things work in Hollywood, but not in the real world. Most of the “bad guys” lost money.”
    Scott

    I wonder if you have evidence to support that. And by “lost money” that could mean they went from 2 billion in net worth to 1 billion.

    No I don’t have the numbers but i’ll research it… because I’m pretty sure they beat the market. And they will continue to do so at the cost of the real productive market as they add nothing productive and only parasitize the real economy because of their elite positions and access that most do not have.

  76. Gravatar of Dan Dan
    19. January 2010 at 07:54

    I’m a trader: “I know the value of these securities, it’s just nobody is willing to pay my price.”

    I’m a senator: “The market failed, that’s why we need more government.”

    I’m a homeowner: “Who’s responsible for selling me this over prices house?”

  77. Gravatar of artemis artemis
    19. January 2010 at 09:57

    Greg, The problem with your statement is that you can say the same thing about Vegas. If enough people are guessing, someone will always guess right. A system where everyone lost would be as predictive as a system where everyone won. I’ve rephrased your statement to help illustrate.

    Several people made hundreds of million dollars betting against the house on presumption that they new better.

    It’s just massive dishonesty or ignorance to suggest this didn’t happen.

    He is nowhere suggesting that no one made money. He’s suggesting that they gambled and got lucky. It’s either massively dishonest or vast ignorance of math to miss that point.

  78. Gravatar of scott sumner scott sumner
    19. January 2010 at 19:23

    muirgeo, Talk to realtors who sell condos to NYC investment bankers. Ask them how the market is doing.

    Dan, That’s right.

    Artemis, I agree.

  79. Gravatar of scritic scritic
    28. February 2010 at 07:03

    Hi Scott,

    Your argument that a bubble is hard to predict in any meaningful, mathematical way is very persuasive but it seems to me to point to a completely different conclusion (something you didn’t intend and probably wouldn’t agree with). But here goes:

    Economists are (in)famously open about the fact that they consider their discipline to be superior to most other social sciences, more rigorous, more empirical, etc. etc. Yes, even Paul Krugman. What you are saying in your post is that simply using a lot of mathematics in your models doesn’t really guarantee that economics, as a discipline is any more rigorous than, say, sociology. (I don’t mean that sociology is not rigorous, I am just saying economics isn’t more rigorous than sociology, like, say, physics is.)

    Specifically, you are saying that it isn’t possible to predict a bubble algorithmically (or mathematically, take your pick. As a computer scientist, I prefer algorithmic). The existence of a bubble needs to be interpreted in some way, not derived. It seems to be some kind of lived-in, embodied skill that people acquire by living in the world (a skill that resides in the tacit dimension, to use Michael Polanyi’s phrase) and therefore is something that just can’t be done using some kind of general-purpose model of the “fundamentals” of the economy as a whole.

    What you’re arguing for, it seems to me, is that macro-economists stop looking for “generalities, principles” that are so dear to them and look more into the specificities of each so-called (or real!) bubble. Would this be a completely wrong interpretation?

  80. Gravatar of ssumner ssumner
    28. February 2010 at 12:53

    scritic, I’m not sure the term ‘rigor’ is very useful, as it is hard to define. It isn’t even clear that economics and sociology are different fields. Perhaps they are two approaches to the same field. I like economics better, because I believe we have better models, but I’m not sure that’s related to rigor.

    I do believe the EMH is testable, and I believe the proper test is to see whether the excess returns at mutual funds are serially correlated. It seems that they are not, or at least that any serial correlation is tiny. So I think the EMH has been successfully tested. I don’t know whether that counts as rigor or not; I’ll let others decide.

    To some extent the debate over rigor is meaningless. It is often said that physics is more rigorous than economics, because it can predict better. But can it really? Meteorology is just applied physics, and they don’t predict well even 10 days ahead. It depends on the purpose. I can predict that the fed funds rate will be 0.25% in June, and it is very likely that I will be right.

    Regarding your last question, I think economists should stop worrying about bubbles, and should focus on things that are useful. For example, it would be useful to have a more stable monetary policy, which produced steady NGDP growth. If we do that, any “bubbles” won’t hurt the economy very much.

  81. Gravatar of Ethan Ethan
    5. January 2012 at 07:31

    I think EMH belly flopping was bound to happen sooner or later. It proves that yesterday’s good idea is today’s abject stupidity. S and SS interpretations were just too….convenient. I think we expected a bit too much from a theory that was fundamentally based on a paradox. I’d be happy if we dropped bubbles and moved back to tearing apart the notion of economic rationality, even to a noobie at economics like me it seems to be an exceptionally feeble assumption. Since I may actually have an economist on the horn here I was curious, has anyone done any work cross referencing human response to panic senarios (I know they have done work in this field in cognitive psychology) with market corrections? Trying to get ideas for a new project. Don’t email me about possible methodology or you are going to get the textual equivalent of a blank stare. Cheers.

  82. Gravatar of Scott Sumner on Asset Prices and Asset Bubbles – Guarded Optimism Scott Sumner on Asset Prices and Asset Bubbles - Guarded Optimism
    24. August 2013 at 19:18

    [...] The following is a verbatim post of Scott Sumner’s article “Defending the Indefensible” from his Blog “The Money Illusion”. The original article is available here. [...]

  83. Gravatar of Clayton Clayton
    25. August 2013 at 13:36

    I think it’s helpful to think about market pricing mechanisms in terms of probabilities. Assume that economists model of asset prices are correct (i.e. asset prices are equivalent to the present value of future cash flows).

    Think of this example: the average market participant assigns some probability, say 1% to the mortgage market destabilizing. Now suppose that some market participant acquires new information that BNP Paribas is having trouble determining an accurate price for some of its Mortgage Backed Securities. Suddenly the probability of destabilization leaps to 10%. How will this affect stock prices? It’s reasonable to think that prices would fall sharply. It’s not clear though that the original 1% was not the most likely probability at that time given the information that was then available.

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