I should be specific and say that the joint probability math you use is wrong, because it suggests that if even one assumption in formally modeling efficient markets is completely unsupported, then none are supported, and that obviously isn’t true. And anyway, problems with some micro transactions don’t necessarily lead to problems with macro pricing. It’s important to avoid fallacies of composition.

]]>First, market efficiency need not depend on any model. It can exist and be shown to exist empirically without being able to explain why markets are efficient.

And my software, for example, helps demonstrate that broad stock indexes respond very predictably and precisely to nominal shocks. It models real shocks far less well, but then it isn’t designed to model real shocks. That’s a more complicated challenge. Fortunately for me, most US recessions are mostly the result of relatively large nominal shocks.

Second, I think Milton Friedman addresses the criticism of unrealistic assumptions in economic models well in his “The Methodology of Positive Economics.” This essay introduces Friedman’s principle that assumptions need not be “realistic” to serve as scientific hypotheses. They only need to make significant predictions.

Third, I think the mathematical approach taken in your comments to assess the joint probability of assumptions being correct is wrong, and anyway, large liquid asset markets like US stock markets obviously meet the assumptions you mention extremely well.

Fourth, in the paper you cite from Werner, it begins with a patently incorrect statement about interest being the price of money. It isn’t. Interest is the price of credit. The price of money is related to nominal economic output. That’s one of the central market monetarist claims. The value of a unit of the medium of exchange is $1/NPV of current and future NGDP, in the simplest conception. From the market monetarist perspective, get that wrong, and the whole model that follows is hopelessly flawed.

Then, Werner goes on to claim that higher interest rates are associated with higher economic growth, as of he’s discovered a new principle, when that’s exactly what market monetarists claim. Market monetarists agree that interest rates are the result of changes in the supply of money versus demand, not the cause. That said, for the purpose of ease of communication, I say that to properly stimulate the economy, one needs to engage in a monetary policy that leads to low enough short-term rates to raise long-term rates consistent with the long run NGDP growth path, to the degree wages haven’t adjusted, making such a sustainae return to the trend path impossible.

]]>“The focus on equilibrium and prices is due to the hypothetico-axiomatic method, a.k.a. the deductive methodology. The axioms are postulated that people are individualistic and focus on maximising their own satisfaction (named ‘utility’, in honour of Jeremy Bentham, the first economist to argue for the legalisation of the then banned practice of charging interest; Bentham, 1787). Next, a number of assumptions are made: perfect and symmetric information, complete markets, perfect competition, zero transaction costs, no time constraints, fully flexible and instantaneously adjusting prices. McCloskey (1983) has argued that economics has been using mathematical rhetoric to enhance the impression of operating scientifically. Equilibrium will not obtain, if only one of the axioms and assumptions fails to hold. But their accuracy is not tested. Yet, one can estimate the probability of obtaining equilibrium.

Despite the claims to rigour, the pervasive equilibrium argument and focus on prices reveal a weak grasp of probability mathematics: Since for partial equilibrium in any market, at least the above eight conditions have to be met, if one generously assumed each condition is more likely to hold than not – corresponding to a probability higher than 50%, for instance, 55% – then the probability of equilibrium equals the joint probability of all conditions, which is 0.55 to the power of 8: less than 1%. As the probability of each of the eight conditions being an accurate representation of reality is likely significantly lower than 55% (most having a probability approaching zero themselves), it is apparent that the probability of partial equilibrium in any one market approaches zero (Werner, 2014b). For equilibrium in all markets, these very low probabilities have to be multiplied by each other many times. So we know a priori that partial, let alone general equilibrium cannot be expected in reality. Equilibrium is a theoretical construct unlikely to be observed in practice. This demonstrates that reality is instead characterised by rationed markets. These are not determined by prices, but quantities: In disequilibrium, the short side principle applies: whichever quantity of supply and demand is smaller can be transacted, and the short side has the power to pick and choose with whom to trade (not rarely abusing this market power by extracting ‘rents’, see Werner, 2005).1

Without equilibrium, quantities become more important than prices.”

https://www.sciencedirect.com/science/article/pii/S0921800916307510#bb0295 ]]>

My last comment there wasn’t referring to liquidity-adjusted prices, but you’ve expressed skepticism in the past regarding the ’87 crash being primarily caused by a nominal shock, for example, and referred to the 90s-to-early 2000s tech run up as “fishy”. Also, I don’t think market monetarists take the relationships between NGDP growth expectations and liquid asset market prices as seriously as I do, i.e. serious enough to try to model it with precision.

And then there are my truly heterodox(perhaps merely amateur) ideas about the structural relationships between interest rates and rates of return on capital and NGDP growth expectations. There are only hints that I’m correct, which certainly aren’t enough to be convincing.

]]>I had a lot less faith in liquid asset markets when I started reading this blog in early 2009. After reading your arguments and looking at the evidence over the years, I now have more respect for liquid asset market pricing than anyone else I know of. I’m more market monetarist than the market monetarists.

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