Avoid asymmetries

In a recent post I pointed to a weird asymmetry.  Even though bubble theory proponents think that prices are more likely to fall after a large run-up, those who correctly predict that prices will go even higher seem less famous (at least in America) than those who correctly predict the bubble will burst (which is allegedly the easier market call.)  I suggested this is just a part of the general problem of cognitive bias, which leads people to see patterns where there is actually nothing more than randomness. 

In the comment section of a recent Tyler Cowen post, Rajiv Sethi made the following observation:

Let me repeat that I admire Scott Sumner, the coherence of his vision, and his general approach to blogging (as laid out in his amazing birthday post). But I think that his faith in market efficiency is misplaced and his glib dismissal of those who take bubbles and crashes seriously (we suffer cognitive illusions) baffling.

On a certain level I agree with Sethi (who is a very smart guy.)  There’s nothing people like less than for someone to respond to their argument by calling them irrational, or suggesting they have bad motives.  But this also raises an interesting problem for the bubble theorists.  Unless I’m mistaken, most anti-bubble theories assume some sort of irrationality among market traders, or dare I say, cognitive illusions.  (Which is supposedly “proven” by economic experiments which in fact do nothing of the sort.)  I’m not sure Sethi was actually complaining about my cognitive illusions comment, although I got that impression.  But if so, is it really any different from what the bubble theorists assume about asset market participants? 

I need to constantly repeat a very important point; I’m not arguing the EMH is true.  I’m arguing the EMH is useful and that anti-EMH models are not useful.  The reason I don’t think the EMH is true is because I believe market participants do have cognitive illusions.  And the reason I don’t think the anti-EMH theory is useful is because I think academics and policymakers are equally susceptible to cognitive illusions.

Paul Einzig made the same basic argument back in 1937:

“On June 9, 1937, this veteran monetary expert [Cassel] published a blood-curdling article in the Daily Mail painting in the darkest colours the situation caused by the superabundance of gold and suggesting a cut in the price of gold to half-way between its present price and its old price as the only possible remedy.  He took President Roosevelt sharply to task for having failed to foresee in January 1934 that the devaluation of the dollar by 41 per cent would lead to such a superabundance of gold.  If, however, we look at Professor Cassel’s earlier writings, we find that he himself failed to foresee such developments, even at much later dates.  We read in the July 1936 issue of the Quarterly Review of the Skandinaviska Kreditaktiebolaget the following remarks by Professor Cassel:  ‘There seems to be a general idea that the recent rise in the output of gold has been on such a scale that we are now on the way towards a period of immense abundance of gold. This view can scarcely be correct.’ . . . Thus the learned Professor expected a mere politician to foresee something in January 1934 which he himself was incapable of foreseeing two and a half years later.  In fact, it is doubtful whether he would have been capable of foreseeing it at all but for the advent of the gold scare, which, rightly or wrongly, made him see things he had not seen before.  It was not the discovery of any new facts, nor even the weight of new scientific argument that converted him and his fellow-economists.  It was the subconscious influence of the panic among gold hoarders, speculators, and other sub-men that suddenly opened the eyes of these supermen. This fact must have contributed in no slight degree towards lowering the prestige of economists and of economic science in the eyes of the lay public.” (1937, pp. 26-27.)

Sub-men and supermen.  Hmmm . . . I wonder into which group Paul Krugman would place himself?

Now let’s see if we can draw a broader set of conclusions from this pattern, these asymmetries.  We’ve seen bubble predictors are treated differently from bubble deniers, and in the previous post we saw that conservatives were gung ho about focusing on commodity prices, except when commodity prices showed a desperate need for much easier money.  Can we find a third example?

How often have you heard people remark that high gasoline prices are caused by the machinations of oil market speculators?  But we know that the net demand for oil by speculators averages out to roughly zero in the long run.  This means that for every period where speculators are raising prices, there is another period where they are reducing prices.  But how often in general conversation do you hear people say:

Hmmm, gas is really cheap right now, I wonder if speculators are depressing the price?

Because I’m a mind reader, I can answer the question for you.  Zero times.  And it’s not just because people prefer to talk about bad news, they don’t even think speculators depress oil prices.

The world is full of this sort of asymmetrical thinking.  And it’s almost always a sign of sloppy thinking, of cognitive illusions.  And it often leads to bad public policy.

PS.  This isn’t an exact analogy, but notice that narcotics and sex transactions are usually considered bad if money is involved.  But in most societies the selling of sex and drugs is considered far worse than the buying of sex and drugs, even though each participant has an equal role in the transaction.  A sign of bad public policy?

PPS:  Five minutes after posting this I came across another example. We think that people who make lots of money are evil villians, whereas people who lose lots of money are innocent victims.  Consider the following:

Earlier that year, Picard claimed in court filings that Picower was a key beneficiary of Madoff’s scheme. The trustee said Picower had withdrawn $7.8 billion from Madoff’s firm since the 1970s, even though he only deposited $619 million. Picower “knew or should have known that [he] was profiting from fraud, because of the highly implausible high rates of return” on his accounts, the trustee said.

Right after the Madoff scandal broke all the brain-dead critics of laissez-faire said “see, this shows that unregulated capitalism doesn’t work.”  Eventually people pointed out that we don’t have unregulated capitalism, the SEC is supposed to prevent these sorts of abuses.  Even worse, someone told the SEC about the Madoff fraud, and even pointed to absurdly high and persistent rates of return that anyone with half a brain knew were impossible.  Or anyone who believes in the EMH knew were impossible.  But apparently the SEC is one of those groups that doesn’t find the EMH to be “useful.”  So they ignored the whistle-blower.  Now when we find someone who actually made off with lots of money from Madoff (pun intended) we react in horror.  Surely that rich bastard knew he couldn’t be earning that money legitimately! 

That’s right, the supposedly expert SEC is given a pass in not responding to these high returns, as people keep insisting this shows we need still more regulation.  But the person that benefited, who like all humans would just love to think his success was well earned, that it resulted from his investment acumen, is somehow obviously guilty. 

I give up.


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33 Responses to “Avoid asymmetries”

  1. Gravatar of Asymmetric Thinking | Retronomics Blog Asymmetric Thinking | Retronomics Blog
    19. December 2010 at 09:36

    [...] Marvelous post by Scott Sumner @TheMoneyIllusion. Everyone who is remotely interested in economic “bubbles” should read it. [...]

  2. Gravatar of Jason Jason
    19. December 2010 at 13:33

    Regarding the SEC and Madoff, I believe there were experts in the SEC who noticed the extraordinary returns in light of the EMH heuristic as early as the 1990s. The outside whistle-blower (Markopolos) was thwarted/ignored by SEC management, not the experts who were actually on his side.

    So I think the flaw here is not with asymmetric thinking but good old-fashioned institutional dysfunction. Top down directives were colliding with bottom up facts, with obvious resolution.

    Or maybe a serious flaw in the division of labor? People who lead experts in an institution only sometimes have the expert level knowledge to make decisions based on what the experts they lead say?

  3. Gravatar of Benjamin Cole Benjamin Cole
    19. December 2010 at 14:58

    One excellent post after another by Sumner. Is there a more-valuable commentator going today? I don’t think so.

    Yes, EMH is a good policy-making supposition, and sometimes there are exceptions.

    There are diseases that almost always respond to treatment, but sometimes don’t. Do you throw out the standard treatment?

  4. Gravatar of Blackadder Blackadder
    19. December 2010 at 17:22

    Picower “knew or should have known that [he] was profiting from fraud, because of the highly implausible high rates of return”

    If you think Picower is bad, just think of all the scumbags who *didn’t* withdraw their money. Presumably they also knew or should have known that they were profiting from fraud because of the implausibly high returns, but they kept doing it anyway.

  5. Gravatar of Greg Ransom Greg Ransom
    19. December 2010 at 17:41

    This is pat proof you don’t get the argument of Hayekian “bubble proponents:

    “bubble theory proponents think that prices are more likely to fall after a large run-up”

    My guess is that you actively work at getting the point wrong.

  6. Gravatar of TGGP TGGP
    19. December 2010 at 18:01

    “The reason I don’t think the EMH is true is because I believe market participants do have cognitive illusions.”
    That makes it more plausible, but I don’t think it’s sufficient. If the various illusions held by different people cancel out it could still be efficient.

  7. Gravatar of Greg Ransom Greg Ransom
    19. December 2010 at 19:32

    Let me put this bluntly.

    YOU _ARE_ MISTAKEN.

    “Unless I’m mistaken, most anti-bubble theories assume some sort of irrationality among market traders, or dare I say, cognitive illusions.”

  8. Gravatar of Greg Ransom Greg Ransom
    19. December 2010 at 19:36

    Sorry. Delete that.

    I thought you were tlking about bubble theories, not “ani-bubble” theories (which really aren’t much to be called ‘theories’.”

  9. Gravatar of Andy Harless Andy Harless
    19. December 2010 at 19:46

    The issue of speculators depressing oil prices is a bit tricky. It’s easy to see how speculators can raise oil prices: by buying oil and holding it in inventory. If they’re speculating against oil, on the other hand, their action won’t be effective in lowering prices, because inventories can’t go below zero, and the spot market will remain tight. The producers of oil will refuse to supply it at the speculatively depressed prices, so if prices go down at all, they will only stay depressed momentarily as supply gets withdrawn.

    What can happen, however, is that speculators who previously bought oil can liquidate their positions and drive down prices. That may indeed be part of what happened in the second half of 2008. I don’t remember anyone talking about that at the time, so there does appear to be an asymmetry. It’s actually quite interesting: when oil prices were rising, I didn’t believe it was due to speculation, because I didn’t see evidence of rising inventories. But the fact that oil prices crashed so hard subsequently is evidence that the spike actually was due to speculation. Somebody should have been telling me, “See, you were wrong! Look at this crash! It was speculation after all!” but I don’t recall anyone telling me that. The asymmetry is so strong that people don’t even think to say I told you so.

  10. Gravatar of Jon Jon
    19. December 2010 at 22:32

    The swing in oil prices was an expectations driven phenomena. A lot of people were convinced on the basis of ‘wrong’ information that there was structural supply problem. That was a mirage. A confluence of bad events impinged on production which drove short term price increases in 2007 and 2008 and the lemmings jumped off the cliff big time.

    For instance, Saudi Arabia was supposed to bring several new fields online. These fields missed their production start dates by about one year, but the Saudis trimmed back production from the Ghawar field on-schedule. When the Saudis were reported as having their highest ever production, they were scarcely producing above their levels from two years earlier. In essence, they had been at a 1 mb/day deficit.

    This was only one of the incidents in that 2007-2008 time period.

    The basic problem here is that the entire oil industry depends on demand forecasts. They carefully plot how much production to make available when. Capital is expensive. When unexpected events suddenly take as much production capacity offline as the industry usually adds in new production a year, they cannot turn on a dime and add twice as much new production–older wells can be brought back online, but usually at a high marginal cost.

    (e.g. saudi output: http://lostdollars.org/static/saudi_oil.png)

    In total there was a transient supply shocked amplified by a bit of ideology–peak oil panic. Eventually the industry started to get ahead of the game. Then when oil demand growth slowed with the economy, it became really easy for them to get ahead and prices promptly floored.

  11. Gravatar of NYD NYD
    20. December 2010 at 05:42

    re: Madoff, it’s not about “returns”, it’s about “risk-adjusted returns”, Mr Sumner. Are you suffering some sort of cognitive illusion yourself? ;)

  12. Gravatar of OGT OGT
    20. December 2010 at 07:38

    Hopefully Prof. Sethi will post his reply over here. But, my reading of his writing is that he, like most Minsky-ites, uses a an evolutionary approach to financial markets. The idea something like a prolonged seemingly stable up period will tend to reward more optimistic investors and money managers and chase more pessimistic investors out turning the rise into a self feeding phenamona. You, I assume, will object that there are arbitrage oppurtunities, but I don’t think assuming symmetry in these opportunities to going long is justified, especially given the timing issues.

    In any case, Prof. Sethi’s writing tends to use heterogenous beliefs and actors and gets very different results than the standard, “assume a normal distribution” that economists tend to rely on.

    In a previous discussion I noted that financial markets violate the wisdom of crowds because investors are aware of the opinions of others, and this may in part explain the volatility of financial markets that goes well beyond what Gaussian statistics would predict.

    Your response was that acadamics and government officials also suffer from group think. That’s true, but it used to be a different line of group think, in the post-EMH era everyone has been operating under the same line of finance market group think, making the sum total of decision making even less diverse.

  13. Gravatar of Ashwin Ashwin
    20. December 2010 at 08:46

    Scott – I don’t claim to speak for Rajiv but just to expand on what OGT just said: the framework Rajiv is using is an ecological/evolutionary one, not a behavioural one. It does not assume any sort of irrationality on the part of market participants, just the existence of irreducible uncertainty, “natural selection”-like forces operating in the market and limits to arbitrage a la Shleifer-Vishny. Try this post he wrote a while ago which summarises it quite well http://rajivsethi.blogspot.com/2010/03/ecological-perspective-on-financial.html .

    Or try this post on why “bullish” bubbles especially cannot be arbitraged http://www.macroresilience.com/2009/12/30/john-hempton-on-efficient-markets/ but why this still leaves room for Hayekian “pattern predictions” http://www.macroresilience.com/2009/12/31/efficient-markets-and-pattern-predictions/ .

    And claiming that such pattern predictions are not useful is tantamount to claiming that vast swathes of ecology and evolutionary theory are not “scientific”.

  14. Gravatar of marcus nunes marcus nunes
    20. December 2010 at 08:49

    Scott
    L Zingales has a nice and well thought piece on EMH on the latest Daedalus:
    http://faculty.chicagobooth.edu/luigi.zingales/papers/LearningtoLivewithnotsoEfficientMarkets.pdf

  15. Gravatar of Rajiv Sethi Rajiv Sethi
    20. December 2010 at 12:52

    Scott, following up on Ashwin’s points above, here’s what I wrote on MR a bit later on in the same thread:

    “I believe that traders are the smartest, most sophisticated agents in the economy and would never characterize their behavior as being driven by irrationality or cognitive illusions. In fact, I have often argued against what I see as the excessive application of behavioral economics to finance. Financial market behavior is psychologically rare (due to strong selection effects on entry and through competition) and therefore cannot be deduced from lab experiments.

    But the great sophistication of traders does not imply the EMH, contrary to Friedman’s famous 1953 claim that speculation can be destabilizing only if speculators lose money. What this neglects is the fact that fundamental research is costly, and extracting information from price movements may be highly profitable when this practice is sufficiently uncommon. Destabilizing strategies can therefore proliferate when rare, not because they lose money but because they make lots of it.

    The problem is not the irrationality or illusions of traders but the incredible complexity and non-stationarity of the task they face, and the spectacular heterogeneity of the strategies they use. Changes in the population composition of these strategies affects market stability, but in a manner that makes market timing extremely risky. The result is approximate information arbitrage (or weak form) efficiency, but major failures from time to time of fundamental valuation (or semi-strong form) efficiency.”

  16. Gravatar of Em economia a verdade absoluta não existe… « Historinhas Em economia a verdade absoluta não existe… « Historinhas
    20. December 2010 at 13:03

    [...] (EMH) é um exemplo importante em questão. Em seu blog, Scott Sumner tem uma discussão (aqui): I need to constantly repeat a very important point; I’m not arguing the EMH is true.  I’m [...]

  17. Gravatar of rob rob
    20. December 2010 at 13:42

    The anti-EMH view is very useful. If it weren’t held by most market participants, the market would not be efficient.

  18. Gravatar of scott sumner scott sumner
    20. December 2010 at 17:13

    Jason, If you are right then the SEC is far worse than even I imagined. I’ve never thought the SEC was needed, now I am even less in favor of it. The SEC causes investors to become lax and overconfident. I would never invest money with a firm like Madoff, I stick with large mutual fund companies like Fidelity and Vanguard.

    I can’t even imagine why the management of the SEC would tell its employees not to investigate a highly suspicious firm. But then my imagination often falls short of reality.

    Benjamin, I agree.

    Blackadder, Good point.

    Greg, I never mentioned Hayek. I was thinking of Shiller. Why did you assume I was referring to Hayek?

    TGGP, That’s right. My hunch is that the useful patterns do cancel out, making it hard to beat the market.

    Andy, The point is the one you made in your second paragraph, since the net holdings are stable in the long run, periods of speculation are offset by periods of negative speculation.

    You are wrong about being wrong, you were right in 2008. The huge drop in oil prices was a rational reaction to the sudden collapse in the world economy in the second half of 2008.

    Jon, You said;

    “The swing in oil prices was an expectations driven phenomena. A lot of people were convinced on the basis of ‘wrong’ information that there was structural supply problem. That was a mirage.”

    No, they were right. If the world economy hadn’t suddenly and unexpected collapsed after mid-2008, there would have been a supply problem. Even now, with the US, EU, and Japan all very depressed, oil has risen from 30 to 90 dollars. Just imagine where it would be if the world economy were healthy.

    NYD, I know that, but the gains were very steady year after year, suggesting highly safe investments.

    OGT, You said;

    “You, I assume, will object that there are arbitrage opportunities, but I don’t think assuming symmetry in these opportunities to going long is justified, especially given the timing issues.”

    No, I don’t need to assume arbitrage opportunities. A anti-EMH mutual fund could just buy assets that are 20% undervalued relative to fundamentals and hold them until they are 10% overvalued. The fund would move money around from asset class to asset class, country to country. If the anti-EMH people were right this fund would outperform index funds.

    Ashwin, If he’s not claiming irrationality then he’s not claiming markets are inefficient. But I seem to recall he was criticizing the EMH. One can’t have it both ways. Either there are unexploited profit opportunities or there aren’t. If there aren’t, then the markets are efficient. If there are, then investors are irrational. See example above in reply to OGT.

    Marcus, Thanks, I’ll take a look.

    Rajiv. You said;

    “The problem is not the irrationality or illusions of traders but the incredible complexity and non-stationarity of the task they face, and the spectacular heterogeneity of the strategies they use. Changes in the population composition of these strategies affects market stability, but in a manner that makes market timing extremely risky. The result is approximate information arbitrage (or weak form) efficiency, but major failures from time to time of fundamental valuation (or semi-strong form) efficiency.”

    What are the pragmatic value of this observation to me as an investor, me as an academic, or me as a policymaker? How do I behave differently knowing this, from how I’d behave if I believed the EMH.

    My second question is whether you’d consider this anti-EMH model to be different from the famous anti-EMH model of Shiller, which is the one I usually have in mind when criticizing the anti-EMH approach. By the way, I don’t do that because I think Shiller’s model is weak, rather I think it is the strongest anti-EMH model. But perhaps if I knew more about your approach I’d consider it even stronger.

    You also might be interested in my response to OGT. The “anti-EMH mutual fund” is the thought experiment I like to use when grappling with this issue.

    Rob, Yes, useful to them, or should I say the minority of them that are smarter than the market. But not useful to the average investor, the average academic, or the average policymaker. And policymakers are average almost by definition. George Soros will never be invited to set exchange rate policy anywhere.

  19. Gravatar of scott sumner scott sumner
    20. December 2010 at 17:32

    Marcus, reading that Zingales piece makes me feel better about my views. I don’t see any good argumetns against the EMH. He cites “anomalies” but I just don’t see the evidence. You’d expect lots of anomalies even if the EMH were true. Often they don’t hold up in out-of-sample forecasts. Sometimes they do, but you’d expect that even if markets were efficient.

    Then he argues there were $100 bills lying on the sidewalks in 2008, because the markets went crazy and risk-free arbitrage opportunities opened up. But that smart people lacked money to take advantage of those opportunities. Later he points out that Warren Buffett is a smart guy who always did have money to put into those opportunities. But Buffett did horribly in 2008, even worse than I did. Why didn’t he snap up all those $100 bills on the sidewalk in 2008? So the thesis put forward seems refuted in the latter part of the paper.

  20. Gravatar of Rajiv Sethi Rajiv Sethi
    20. December 2010 at 18:34

    Scott, you said:

    “What are the pragmatic value of this observation to me as an investor, me as an academic, or me as a policymaker? How do I behave differently knowing this, from how I’d behave if I believed the EMH.”

    As a small investor, there’s not much you can do. Stick to passive investing or perhaps simple well-diversified value funds.

    As an academic there are fascinating questions to explore, with major policy implications. Think about what happened on May 6 – prices of some shares and ETFs crashed to practically zero, then bounced back in a matter of minutes. Other securities (Sotheby’s for example) traded at a hundred thousand dollars a share for a few moments, then crashed. Contrary to initial media reports, this was not caused by a fat finger or computer glitch – all trades were executed precisely in accordance with the instructions coded in algorithms. It was the interactions among trading strategies that did it, triggered by a single fundamental sell order.

    In my view this was not a pathological event except with respect to speed and scale — this is how speculative asset markets behave from time to time. As an academic, I’m interested in the design of institutions that can make this kind of event (and its less dramatic, more prolonged cousins) less likely. This requires shifting incentives towards longer holding periods, or finding other ways to alter the balance between technical and fundamental analysis.

    Finally, policymakers must be alert to the development of asset price bubbles. This can be done, for instance, by looking at the prices of index straddles (combinations of put and call options with the same expiration date and strike price, written on a market index.) There is some evidence that these increase in price during a bubble, as the market expects unusually high levels of volatility. Ironically, the higher prices of volatility bets make it hard to profit from identification of bubbles, but that doesn’t mean that policy makers can’t respond to them by targeting leverage or the cost of borrowing.

    Finally, let me add that while I am a great admirer of Shiller’s empirical work on excess volatility, I do not consider his psychological explanations of the phenomenon to be very convincing. Traders can read articles on behavioral economics as easily as anyone else, and stand ready to exploit psychological regularities in force.

    But this does not imply that prices track fundamental values reliably. My own view is that speculative asset markets are characterized by endogenous regime switching (a term I used in a 1996 paper that develops the argument in some detail). Stable markets favor the proliferation of technical strategies, but the market itself is destabilized once such strategies exceed a threshold (bifurcation value). This instability makes fundamental research more rewarding, and eventually shifts the composition of trading strategies back towards stability. Periods of relative tranquility are therefore punctuated by major disruptions from time to time. As Ashwin an others have noted, this is an ecological rather than psychological perspective on speculative markets. I am not, by any stretch of the imagination, a behavioral economist.

  21. Gravatar of Rajiv Sethi Rajiv Sethi
    20. December 2010 at 18:52

    Scott, following up on the comment I just posted, here are some links to posts where these ideas are developed more fully.

    On trading strategies and market efficiency:

    http://rajivsethi.blogspot.com/2010/04/trading-strategies-and-market.html

    An initial response to the flash crash:

    http://rajivsethi.blogspot.com/2010/05/algorithmic-trading-and-price.html

    The crash as an extreme version of a routine event:

    http://rajivsethi.blogspot.com/2010/06/extreme-version-of-routine-event.html

    And on the identification of bubbles:

    http://rajivsethi.blogspot.com/2010/01/identifying-bubbles.html#uds-search-results

    One last comment about policy implications. A huge number of trades in almost 300 securities were canceled on May 6 even though there was no evidence of trader error, computer malfunction, or fraud. This was a subsidy to destabilizing strategies and a major error in my view.

  22. Gravatar of Ashwin Ashwin
    21. December 2010 at 02:15

    Scott – you said: “Either there are unexploited profit opportunities or there aren’t. If there aren’t, then the markets are efficient. If there are, then investors are irrational.”

    Even the behavioral economists wouldn’t claim that. Unexploited profit opportunities can persist without investor irrationality due to many reasons, some of which Shleifer and Vishny discussed in their famous paper on the limits of arbitrage http://scholar.google.co.uk/scholar?cluster=13733948988120362784&hl=en&as_sdt=2000&as_vis=1 .

    Shorting overvalued equities especially is an incredibly risky activity which is why bubbles persist for so long as I discuss here http://www.macroresilience.com/2009/12/30/john-hempton-on-efficient-markets/ .

  23. Gravatar of malavel malavel
    21. December 2010 at 04:45

    “But in most societies the selling of sex and drugs is considered far worse than the buying of sex and drugs, even though each participant has an equal role in the transaction.”

    Selling sex is legal in Sweden, buying is not. Are we the weird case? Selling drugs is considered worse than buying though.

    About SEC. I actually told them about insider trading about 15 years ago. They just ignored the comment. Although to their defense, I called about some other stupid question and only mentioned insider trading after making a fool of myself.

  24. Gravatar of OGT OGT
    21. December 2010 at 11:16

    Your thought experiment is a bit confusing. From my perspective you seem to jump back and forth between weak and strong or semi-strong version of EMH. The different versions have very different implications, and one should be very clear about what they are proposing and defending.

    To you the thought experiment reveals that a particular asset price may be difficult to arbitrage, therefore markets are efficient. This is true if, and only if, we stick to the defintion ‘efficient’ as hard to arbitrage.

    It does not follow that the price is ‘right’ nor that the price is stable.

    The fact that mispricing may be difficult to arbitrage away makes hash of the strong form of EMH, while leaving the weak form intact, especially when we consider that difficult to arbitrage prices may increase instability and non-linear price movements.

    EMH is useful for most investors (until most other investors start following it and return opportunities increase for researching information increase). Individual investor do not internalize the entire societal risk of market crashes or capital misallocation. It is, therefore, much less useful for policy makers who are charged with internalizing those risks. For me, the value of ‘bubble theories’ coming from the Minsky school is that they highlight increased risks of possible sudden and dramatic volatility in asset prices and the social dangers of increasingly fragile balance sheets.

  25. Gravatar of scott sumner scott sumner
    21. December 2010 at 19:15

    Rajiv, You said:

    “As a small investor, there’s not much you can do. Stick to passive investing or perhaps simple well-diversified value funds.”

    But why should one do this if Shiller is right? Shouldn’t one do market timing? Buy when P/Es are low and sell when P/Es are high?

    You said;

    “As an academic there are fascinating questions to explore, with major policy implications. Think about what happened on May 6 – prices of some shares and ETFs crashed to practically zero, then bounced back in a matter of minutes. Other securities (Sotheby’s for example) traded at a hundred thousand dollars a share for a few moments, then crashed. Contrary to initial media reports, this was not caused by a fat finger or computer glitch – all trades were executed precisely in accordance with the instructions coded in algorithms. It was the interactions among trading strategies that did it, triggered by a single fundamental sell order.”

    No one has ever explained to me why this is a public policy problem. If the trades are rational, no one is hurt. If the trades are irrational, the person causing the flash crash is also the person hurt by it. Hence no need for regulation.

    No one has shown me an example of a bubble where regulation could have improved things. Some people cite the housing bubble, but that argument makes no sense, as the policymakers were actually encouraging the bubble. And if you argue “just do better next time” the obvious response is that one could say the same thing to the investors who bought all the MBS junk.

    I think all these studies suffer form the same mistake—they are backward looking. They look at what went wrong and figure out how it could have been prevented, from the perspective of someone who already knows what went wrong. But if we knew in 2006 what we know now, the housing bubble wouldn’t have happened. So I see no role for regulation, unless there is something I missed. Regulation seems to require the regulators to be smarter than those inside the bubble–which is very implausible.

    You said;

    “One last comment about policy implications. A huge number of trades in almost 300 securities were canceled on May 6 even though there was no evidence of trader error, computer malfunction, or fraud. This was a subsidy to destabilizing strategies and a major error in my view.”

    That’s exactly what I thought! Now we are on the same page. But weirdly, I saw that as a policy implication of the EMH. Why in the world should trades be canceled? From an EMH perspective that seems insane; it creates moral hazard, encourages people to do crazy things on the assumption that if it doesn’t work they get bailed out.

    Sorry I don’t have time to give you a more thoughtful answer tonight, I have to get back to grading. I’ll try to look at those links you provided over the break, and see if I can say something more intelligent.

    Ashwin, I’ve never understood why shorting securities is the only way to take advantage of inefficient markets. Why don’t mutual funds just go long in markets that are undervalued, and stay out of markets that are overvalued? No need to go long, and the anti-EMH view says you should still beat an indexed fund. But mutual funds don’t beat index funds reliably. Why not?

    malavel, Yes, I knew about Sweden, and indeed mentioned it in an article I once wrote on liberalism.

    OGT, The 1987 stock market crash, which was just as big as the 1929 crash, showed that stock market crashes do not have any external effects that policymakers need worry about. That’s because Greenspan was basically doing NGDP targeting.

  26. Gravatar of Rajiv Sethi Rajiv Sethi
    21. December 2010 at 20:47

    Scott, I do hope you’ll read the posts and perhaps we can talk again when we’re both less busy. And while you’re at it, take a look also at Ashwin’s blog (Macroeconomic Resilience). It’s brilliant, original and wise.

    I’m absolutely convinced that the excess volatility in our financial markets has major economic implications – on portfolio choice, risk-bearing, growth and job creation. I also believe that there are steps that can be taken to make these markets work better (and move closer to fundamental valuation efficiency). But this is not the time or place to keep belaboring the point.

    I do appreciate your taking the time and trouble to respond to all comments.

  27. Gravatar of Mr. E Mr. E
    25. December 2010 at 16:42

    “What are the pragmatic value of this observation to me as an investor, me as an academic, or me as a policymaker? How do I behave differently knowing this, from how I’d behave if I believed the EMH.”

    You’d behave like George Soros.

  28. Gravatar of ssumner ssumner
    26. December 2010 at 21:32

    Thanks Rajiv.

    Mr. E, That’s precisely why I’m skeptical–as I would be if someone explained to me how I could play basketball like Michael Jordan.

    (Sorry if you were joking–I always answer as if the person is serious.)

  29. Gravatar of Doc Merlin Doc Merlin
    26. December 2010 at 21:49

    @scott

    Soros doesn’t believe in EMH, because he generally uses politics to make his money. For example he has made a ton of money recently pushing through a “food safety reform” bill which would would favor large powerful food corps over smaller ones, and putting a lot of money into Monsanto corp.

  30. Gravatar of Anthony Anthony
    27. December 2010 at 09:40

    I’m not sure buying vs. selling drugs is a good example. Given the assumptions that (a) both sides of a drug transaction “earn” the same amount of badness; (b) badness is proportional to either the size of the transaction (by any measure) or the number of transactions; (c) there are more buyers than sellers.

    From (c) plus the observation that each transaction includes both a buy and sell of the same amount, we can conclude that the average seller has a larger total transaction than the average buyer. From that and (a) and (b), we can conclude that the average seller has more badness than the average buyer.

    The same argument could be made of the market for sex.

  31. Gravatar of Scott Sumner Scott Sumner
    28. December 2010 at 09:10

    Doc Merlin, OK, but I doubt whether that works.

    Anthony, That might be part of it, but not all. In some places there is no penalty at all to buying drugs, or buying sex.

    I’m also told that most drug users also sell drugs on occasion, so I don’t know if the differences in numbers is quite as great as it might seem.

  32. Gravatar of Doc Merlin Doc Merlin
    28. December 2010 at 10:03

    @Scott:
    It not only works, it earns him significantly above market rates, year after year. Actually there have been numerous studies on returns from lobbying, and they all say the same thing… lobbying generates revenues very effectively.

  33. Gravatar of ssumner ssumner
    30. December 2010 at 08:59

    Doc Merlin, I agree that lobbying can pay off, so it’s possible you are right about the food safety bill.

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