Being There
I had a dream where my plumber won the multi-state Megabucks. Sixty million dollars. Afterward everyone began treating him like a genius. He started being invited onto TV shows, where he provided folksy, homespun wisdom about everything from global warming to the current economic crisis. Of course in the real world nobody would be treated like a sage simply because he got lucky and made a lot of money. That’s just the stuff of Hollywood movies. At least I thought so until I saw an article (here) on Yahoo entitled “Buffett says government is doing the right things.” Here is an excerpt:
Billionaire Warren Buffett spent Saturday praising the decisions U.S. officials made to right the economy in the midst of a “financial hurricane” and defending the ones he made to help his company navigate the storm.
The state of the economy and Berkshire Hathaway Inc.’s recent performance were among the first things addressed at the shareholders’ meeting. Roughly 35,000 people packed an arena and overflow rooms to listen to Buffett and Berkshire Vice Chairman Charlie Munger answer questions for more than five hours.
“Overall, I commend the actions that were taken,” Buffett said. But he said no one should expect perfection because the economy experienced a “financial hurricane.”
But Buffett said he can’t predict how quickly the economy and the markets will improve. He said last fall that the U.S. was facing an “economic Pearl Harbor.”
To illustrate the challenges the nation faced last year, Buffett showed a sales receipt for $5 million in U.S. Treasury bonds that Berkshire sold in December for $90.07 more than face value, ensuring a negative return for the buyer. Buffett said he doesn’t think most investors will see negative returns on U.S. bonds again in their lifetimes.
“It’s been a very extraordinary year,” he said.
The economy, succession at the top of Berkshire and the state of the company, which last year had its worst year since Buffett took over in 1965, were on the minds of many shareholders.
Berkshire’s Class A stock lost 32 percent in 2008, and Berkshire’s book value “” assets minus liabilities “” declined 9.6 percent, to $70,530 per share. That was the biggest drop in book value under Buffett and only the second time its book value has declined.
But despite Berkshire’s rough year “” which was depressed by unrealized multibillion-dollar derivative losses “” the company still outpaced the market index Buffett uses as a measuring stick. The S&P 500 fell 37 percent in 2008.
Berkshire reported a 2008 profit of $4.99 billion, or $3,224 per Class A share. That was down 62 percent from the previous year, but better than many companies.
The meeting began as usual with a humorous movie, but instead of the traditional comical cartoon, Berkshire offered a reassuring message from animated versions of its products.
I suppose one might argue that Buffett is nothing like my imaginary plumber. Most people would say that he didn’t get rich by chance, and that the odds are a million to one against an investor getting that lucky. Well the odds are a million to one, but according to the Efficient Markets Hypothesis, he is the one.
For those not familiar with the EMH, consider a million affluent American investors. Each year 50% will do better than average (of better than median to be precise.) If their gains are serially uncorrelated, then only 250,000 will do better than average during two consecutive years. Only 125,000 after three consecutive years. How many will do better than average for 20 consecutive years? Only one. Of course that doesn’t mean he or she would be the richest American, as everyone doesn’t start out equally affluent. So if your name is Rockefeller you might do better with somewhat less luck. But there are far more merely affluent Americans, than very rich, so an unknown could easily end up on top through sheer luck. And since humans are hardwired to see patterns where none exist, we can assume people would not view his success as mere luck. Especially since common sense suggests a smart person should be able to beat the “wisdom of crowds,” even though when we are able to test these things they do not.
I suppose this should be testable. If the EMH is correct than the top ten richest Americans should not see out-sized returns, once they have reached that pinnacle of success. I have no idea whether the data exists to do this test, but is would be a good way of resolving the issue of whether Buffett just got lucky. When similar tests are done with successful mutual fund managers, it turns out to be merely dumb luck.
Do I really believe this nonsense, or am I just being provocative? I little of both, but as you will see I have a different issue in mind. I don’t think the EMH is literally true. Models are models, and I would expect that in the real world there are a few people who are smart enough to occasionally outfox the market. On the other hand those people would still need lots of luck to become super-rich, so we probably have never heard of them.
I should also say that from the little I know about him, Buffett seems an enviable human being in every way. He’s probably much smarter, more talented, and more ethical than I am. If I was that rich I wouldn’t live in a nice house in Nebraska, I’d splurge on trophy houses in NYC and LA. I gather that (like a true utilitarian) he is giving his fortune to the Gates Foundation.
[BTW, Bill Gates essentially taxed middle class consumers all over the developed world, and is giving almost all of the money to the disadvantged in poor countries. That’s something governments don’t do, and yet for his “monopoly profits” he is despised by many on the left. Nor does this fact show up in the so-called “income distribution” data that is taken seriously even by economists who should know better.]
So Buffett is a great guy. But so is my plumber. The question is why should we seek out his advice on the economy? You might say he is much smarter than my plumber. But I would guess that’s also true of the recent winners of the Nobel prize in chemistry, or physics, and I don’t see them getting interviewed about the economy. Now we are finally reaching the point of this exercise. Correct me if I am wrong, but isn’t there an implicit assumption here that businessmen are more qualified to talk about the economy than scientists? But why would being a businessperson give one any special expertise in fiscal multipliers and the relative advantages of interest rate targeting vs. QE?
Am I just being a snob, arguing that only us macroeconomists should be consulted on economic issues? Well by now you know my view of macroeconomists; almost alone among economic pundits, I blame the guild of macroeconomists for the crash of 2008, not bankers or regulators. Yes, I might seem to be only blaming the Fed, but they basically did what the consensus thought they should be doing, perhaps even more. So far be it from me to get defensive about outsiders offering advice on the economy—recent events have shown we could use some outside advice.
So what’s my point then? Well maybe at a very deep level the same misconceptions that make us look to business leaders for economic advice; also explain the crash of 2008. If you are an economist, you know that non-economists tend to think economics is the study of the business world, or that capitalism is a regime that “favors business.” People have trouble thinking about abstractions like “the science of choice” or “a free market economy.” So from a commonsense perspective it would seem like business and economics are actually closely related fields. If you don’t believe that this misconception is widespread, then please explain why many economics departments are located in business schools, rather than the social science departments where they naturally belong.
Suppose this is also true of monetary economics. We know from monetary theory that AD is determined by the interaction of money supply and demand. When the Fed injects more base money than the public wants to hold, they try to get rid of excess cash balances, and AD rises. Although monetary economics is actually about the supply and demand for base money, from a commonsense perspective it seems to be about banking. Yes, banks demand a significant share of base money (usually about 10%) but then so do drug dealers. And monetary economics courses generally spend little time on drug dealers. And most importantly, there is absolutely nothing in monetary theory that suggests we should worry about whether banks are “lending” or not. I put “lending” in quotation marks, because of course banks are almost always lending, even if they invest in T-bills. We only need worry when they change their demand for base money (i.e. reserves.)
My hypothesis is that even very smart monetary economists often slip into the commonsense view and think monetary policy is about banks and credit markets, rather than the supply and demand for base money. Would a central bank focusing on the supply and demand for base money start paying interest on excess reserves during the very week the economy was clearly sliding into deflation?
But like Warren Buffett and Chauncy Gardner, I am an optimist. For those who missed the film “Being There,” here is an excerpt:
President “Bobby”: Mr. Gardner, do you agree with Ben, or do you think that we can stimulate growth through temporary incentives?
[Long pause]
Chance the Gardener: As long as the roots are not severed, all is well. And all will be well in the garden.
President “Bobby”: In the garden.
Chance the Gardener: Yes. In the garden, growth has it seasons. First comes spring and summer, but then we have fall and winter. And then we get spring and summer again.
President “Bobby”: Spring and summer.
Chance the Gardener: Yes.
President “Bobby”: Then fall and winter.
Chance the Gardener: Yes.
Benjamin Rand: I think what our insightful young friend is saying is that we welcome the inevitable seasons of nature, but we’re upset by the seasons of our economy.
Chance the Gardener: Yes! There will be growth in the spring!
Benjamin Rand: Hmm!
Chance the Gardener: Hmm!
President “Bobby”: Hm. Well, Mr. Gardner, I must admit that is one of the most refreshing and optimistic statements I’ve heard in a very, very long time.
[Benjamin Rand applauds]
President “Bobby”: I admire your good, solid sense. That’s precisely what we lack on Capitol Hill.
Of course the real problem is that we have too much “good, solid sense” and not enough counterintuitive economistic reasoning.
Despite my policy disagreements, I find Ben Bernanke a hard person to dislike. In any case, as Christians like to say “love the sinner, hate the sin.” And the following quotation from a recent Paul Krugman column shows that Bernanke and Obama share the same optimism that Gardner, Buffett and I have:
Ben Bernanke, the Federal Reserve chairman, sees “green shoots.” President Obama sees “glimmers of hope.” And the stock market has been on a tear.
Although I find optimistic gardening metaphors as inspiring as the next guy, it’s even nicer to see signs of spring in the stock market.
BTW, after completing this post I saw some good examples of people seeing patterns everywhere. Someone noticed that Japan looks like its own Phillips Curve (inverted.) Then others starting see patterns for their own country. I have no doubt the Japanese example is “statistically significant.”
Tags:
3. May 2009 at 19:13
I thought Soros was the one …
3. May 2009 at 19:48
Scott: “Although monetary economics is actually about the supply and demand for base money….”. Why *base* money?
I would argue (I did just argue, http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/why-an-excess-demand-for-money-matters-so-much.html) that it’s an excess demand for the medium of exchange that is the underlying problem, and a “medium of exchange” definition of money is wider than the base. A general glut is an excess demand for the medium of exchange. Banks matter insofar as part of their liabilities are media of exchange.
3. May 2009 at 20:13
Or, to put the point another way: an excess of desired saving over desired investment is not the problem. The problem is an excess desire to save *in the form of media of exchange*.
This is both narrower than “saving” in the standard sense (income from the production of newly-produced goods that is not a demand for newly-produced consumption goods), but wider than saving in the form of base money.
3. May 2009 at 21:44
Nick: that’s precisely Mises’s conception–and he was the first one to really clearly sort through relevant and irrelevant distinctions between money.
Base money & reserve ratios happen to be the mechanism to which central planning ropes ‘broad money’ creation.
I still haven’t wrapped my head around whether liquidity in the form of federal reserve notes is really different.
3. May 2009 at 22:08
If you read some of his articles or letters to BRK shareholders you will notice that not only is Buffett a great businessman but he is also an ok economist- check out this article he wrote in 2003(http://www.berkshirehathaway.com/letters/growing.pdf). Buffett has good insight into spotting economic trends as well because he owns so many businesses, such as energy companies, retailers, food chains, insurance companies, real estate brokers, etc etc. So I believe his thoughts on the economy are honest and fair- but maybe not the best.
On the EMH though. I think its very clear that the markets are not efficient. Buffett is not the only person to spot market inefficiencies. What about Shiller and others spotting the tech bubble in the late 90s? (I believe Mr. Buffett was being dismissed in the same period because he refused to buy tech stocks). What about Grantham spotting MANY bubbles (including housing)? Many, many value investors saw the carnage coming to the markets b/c the markets are not efficient: Whitney Tilson, Bill Ackman, David Einhorn, Seth Klarman, John Paulson are some of them. Buffett’s piece “The Superinvestors of Graham-and-Doddsville” is great and truly shows how many have beaten the market.
On another note, great blog! Its nice to see a Bentley professor have friendly battles with Krugman. I’m a sophomore at Bentley.
4. May 2009 at 01:22
Nick,
“Why base money?”
Exactly. And profoundly so.
This makes for an interesting bone of contention, particularly when the MI blog has started up posts and discussions in a period of unprecedented “base money” explosion. Or, more precisely, an explosion in excess reserves, since the aggregation of wildly different components makes “base money” supremely suspect for aggregate analysis.
4. May 2009 at 02:36
From the post:”To illustrate the challenges the nation faced last year, Buffett showed a sales receipt for $5 million in U.S. Treasury bonds that Berkshire sold in December for $90.07 more than face value, ensuring a negative return for the buyer. Buffett said he doesn’t think most investors will see negative returns on U.S. bonds again in their lifetimes.”
Hmmm, those discredited examples just won’t go away will they Scott?
And, btw Nick, that’s quite a demand for something that is not the medium of exchange…
4. May 2009 at 02:57
“Well the odds are a million to one, but according to the Efficient Markets Hypothesis, he is the one.”
Funny though, all of his success stems from a firm belief that EMH is a steaming pile of ….
Same thing with George Soros. The world’s top speculator, and the world’s top investor (according to Graham’s distinction) agree: Efficient Market Hypothesis is complete nonsense.
http://www.amazon.com/Security-Analysis-Classic-1934-GRAHAM/dp/0070244960
http://www.amazon.com/Soros-Staying-Ahead-Curve/dp/0471119776/ref=sr_1_5?ie=UTF8&s=books&qid=1241437135&sr=1-5
Were they just “lucky”? I highly doubt it. They are information hounds and have consistently used information asymmetries to their advantage.
4. May 2009 at 02:59
“Well the odds are a million to one, but according to the Efficient Markets Hypothesis, he is the one.”
Funny though, all of his success stems from a firm belief that EMH is a steaming pile of ….
Same thing with George Soros. The world’s top speculator, and the world’s top investor (according to Graham’s distinction) agree: Efficient Market Hypothesis is complete nonsense.
Were they just “lucky”? I highly doubt it. They are information hounds and have consistently used information asymmetries to their advantage.
4. May 2009 at 03:23
Just to be clear, I think I would agree with what Scott wrote, if he just switched “base money” for “medium of exchange”, which is still a narrow definition of money. (M1?). It’s the medium of exchange function that makes money unique, and “weird”. And that fact that some components of broader monetary aggregates may be close substitutes for the medium of exchange at the individual level does not make them functionally similar at the aggregate (economy-wide) level.
Jon: were you talking about von Mises on definitions of “money”, or on definitions of “saving”?
JKH: Yes, I have been very recently stumbling and groping towards the conclusion that “bad banks” may matter because they may prevent/hinder the central bank in increasing M1, and that QE matters, inter alia, because it is a way for the central bank to bypass bad banks and increase M1 (or the medium of exchange) by doing OMO’s directly with the non-bank “public”. http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/04/bad-banks-and-the-effectiveness-of-fiscal-and-monetary-policies-on-ad.html?cid=6a00d83451688169e201156f6ff33d970c#comment-6a00d83451688169e201156f6ff33d970c
(oops! Sorry. Must learn how to do tinyurl.)
Adam P: you lost me on: “And, btw Nick, that’s quite a demand for something that is not the medium of exchange…”
4. May 2009 at 03:49
Nick, I understood Buffet to be giving an example of somebody buying treasury bonds at a negative expected return. That’s quite a demand for treasury bonds, are they medium of exchange?
Or are you saying I misunderstood what Buffet was saying?
4. May 2009 at 03:52
Nick,
‘QE matters, inter alia, because it is a way for the central bank to bypass bad banks and increase M1 (or the medium of exchange) by doing OMO’s directly with the non-bank “public”’
Again, exactly perfect and very important.
Nick, you don’t have to associate yourself with my interpretation of your statement, but it’s correct in my view in the sense that it’s absolutely fundamental to understanding the true transmission effect of QE currently. It’s not about the base (in my view). And it’s also why the Fed has no problem with the idea of paying interest on reserves (in my view). I think your interpretation is “inter alia”. Mine is exclusive.
4. May 2009 at 03:59
Greg, There are many Chauncey Gardners.
Nick, In my view monetary economics is the study of the supply and demand for the medium of account, not the medium of exchange. The first part of this long post explains why:
http://blogsandwikis.bentley.edu/themoneyillusion/?p=461#more-461
In some cases one could argue there are two media of accounts, such as gold and Treasury currency in 1929. Then you study the one that is most illuminating (which in my view was gold–the non-medium of exchange in that case.) My entire Depression manuscript is a study of how gold market shocks caused AD shocks.
When one has close substitutes for base money, such as transactions balances denominated in dollars, then I agree that either approach is acceptable. I find the MB approach much more convenient, because it allows me to simplify the analysis by assuming the Fed has a complete monopoly on the supply side. All other factors that you look at from a M1 or M2 perspective, then become factors that shift the demand for base money. I.e. a banking crisis reducing M1 will increase the demand for base money. Of course I am not doing anything “wrong” by leaving out transactions balances, it is merely a matter of analytical preference. You probably know all this, but not everyone does.
By the way, in the absence of reserve requirements the demand for reserves would normally be very low, and changes in the demand for transactions balances would only be important to the extent that they were substitutes for cash, and thus reduced the demand for cash (for any given total supply of base money.)
I haven’t had a chance to read your post yet, but I definitely will. (Still grading finals.)
Jon, I agree that RRs are the way the government controls banking demand for base money.
Francisco, Glad to see Bentley students here. “Buffett is an OK economist” Exactly my point, the national media doesn’t normally follow the thoughts of OK economists, but they are very interested in the super rich. You are right that some smart people missed the carnage. But the vast majority of really smart investors (including Warren Buffett himself) took huge losses last year. Just on the basis of chance you would expect a few smart people to have been in T-bonds at the time. Shiller’s not a good example. He made his famous “irrational exuberance” call in 1996 (encouraging people to sell), and the stock market then proceeded to nearly double. He’s been right on some occasions, but so has almost everyone.
JKH, The payment of interest on reserves does arguably make aggregation misleading. But I still prefer to view the interest as a factor shifting demand for base money.
Adam, Exactly my point! ERs now earn much higher rates than T-bills. Thus it’s no surprise that demand for ERs has soared, with the expected deflationary results.
bob, The EMH predicts people like Buffett and Soros (as I pointed out in the post.) So their existence doesn’t have any implication for the EMH. Regarding their own view that it was skill not luck that got them there, well people do have egos. I’d be shocked to find any person who carefully studied markets, got rich (even through luck), and thought that their careful study had nothing to do with it.
4. May 2009 at 04:13
And that discredited example Scott?
4. May 2009 at 04:50
God this is exciting, interesting, and important! But I must prepare for an MA thesis. Will read your medium of account argument before returning, Scott. But my initial reaction is to disagree with you totally! Medium of exchange is crucial, medium of account is secondary (and only matters because of sticky prices). (Though it depends on whether we want to explain P or y (recessions)). Will be back later.
4. May 2009 at 06:25
[…] Crisis Timeline: On his blog in a post that looks at broader themes, Scott Sumner wonders how much luck has to do with Warren Buffett’s success. “Most people would say that [Buffett] didn
4. May 2009 at 06:35
[…] Crisis Timeline: On his blog in a post that looks at broader themes, Scott Sumner wonders how much luck has to do with Warren Buffett’s success. “Most people would say that [Buffett] didn’t get rich by chance, and that the odds are a million to one against an investor getting that lucky. Well the odds are a million to one, but according to the Efficient Markets Hypothesis, he is the one. For those not familiar with the EMH, consider a million affluent American investors. Each year 50% will do better than average (of better than median to be precise.) If their gains are serially uncorrelated, then only 250,000 will do better than average during two consecutive years. Only 125,000 after three consecutive years. How many will do better than average for 20 consecutive years? Only one. Of course that doesn’t mean he or she would be the richest American, as everyone doesn’t start out equally affluent. So if your name is Rockefeller you might do better with somewhat less luck. But there are far more merely affluent Americans, than very rich, so an unknown could easily end up on top through sheer luck. And since humans are hardwired to see patterns where none exist, we can assume people would not view his success as mere luck. Especially since common sense suggests a smart person should be able to beat the “wisdom of crowds,” even though when we are able to test these things they do not.” […]
4. May 2009 at 06:37
Scott,
This is my version of the EMH:
“For every dollar weighted excess return above the market return there is an identical but opposite one.”
To put in a simple example. Suppose there are three investors A, B and C. A buys the market portfolio. B and C will buy different ones based on the belief that they can beat the market. A gets the average return. What about B and C? Well if B gets a higher return than average then C has to get a lower than average return. If one wins the other one must be loosing. So next time you think you can beat the market ask yourself: “Am I really the guy who knows something the market does not or am I the guy who just thinks he knows”.
Alex.
4. May 2009 at 06:49
Fundamental misunderstanding: Buffet doesn’t just invest. He buys (large chunks of) companies and actively participates in management. Makes the EMH discussion regarding his success kind of pointless.
4. May 2009 at 06:59
I think Scott’s point was more that there are just about the right number of Soros/Buffets out there to be consistent with the EMH, after all if there were none that would be evidence against the EMH.
In fact, I think it was Carhart who showed that the worst performing mutual funds did have a sort of persistence that at first glance was inconsistent with them just being unlucky. I imagine it was resolved by showing that they were generating huge amounts of transactions costs.
4. May 2009 at 07:42
[…] Crisis Timeline: On his blog in a post that looks at broader themes, Scott Sumner wonders how much luck has to do with Warren Buffett’s success. “Most people would say that [Buffett] didn’t get rich by chance, and that the odds are a million to one against an investor getting that lucky. Well the odds are a million to one, but according to the Efficient Markets Hypothesis, he is the one. For those not familiar with the EMH, consider a million affluent American investors. Each year 50% will do better than average (of better than median to be precise.) If their gains are serially uncorrelated, then only 250,000 will do better than average during two consecutive years. Only 125,000 after three consecutive years. How many will do better than average for 20 consecutive years? Only one. Of course that doesn’t mean he or she would be the richest American, as everyone doesn’t start out equally affluent. So if your name is Rockefeller you might do better with somewhat less luck. But there are far more merely affluent Americans, than very rich, so an unknown could easily end up on top through sheer luck. And since humans are hardwired to see patterns where none exist, we can assume people would not view his success as mere luck. Especially since common sense suggests a smart person should be able to beat the “wisdom of crowds,” even though when we are able to test these things they do not.” […]
4. May 2009 at 09:28
Base money is the medium of account. Its “market” has to clear by changes in its purchasing power. That requires prices throughout the economy to change. To motivate such adjustments, excess supplies or demands for these various other goods must be generated, and so, the notion that excess demands or supplies of base money are related to changes in nominal expenditure.
Base money also serves as one element of the medium of exchange. The medium of exchange is important because it can be spent into existence (and with banks, including central banks, creating it, that means lent into existence.) Also, incomes are paid in the form of the medium of exchange, so an increase in the demand for the medium of exchange can occur by a reduction of expenditure out of income. And, for that matter, an expansion of ordinary expenditures creates a simple way to reduce excess money holdings.
Money flows through cash balances as part of the flow of income and expenditure and output. Disequilibrium between the supply and demand for money naturally results in a distubrance in the flow of income.
Much of the medium of exchange is tied to the medium of account (base money) through redeemability. The price of a one dollar deposit doesn’t define the dollar, but the issuer must adjust the quantity to keep its market value at par.
My view, however, is that any plausible market process by which the market for the medium of account will clear must operate through the market for the medium of exchange. (I have given a good bit of thought to monetary institutions where the two functions are very much separate.)
How that impacts the real world is that I find it very unlikely that the market process that clears the market for the medium of account (base money) could operate without impacting the market for the medium of exchange, particularly those elements of the medium of exchange that are used for nearly the entire dollar value of payments.
The value of the bank issued medium of exchange is fixed by redeemability (though much of it has variable yields too.) However, the banks’ balance sheet shows that there much be changes in credit associated with changes in quantity of money. Further, these monetary liabilities are themselves debt instruments that people are holding.
Generally, credit involves shifts of expenditure between and among households and firms. While each household or firm is choosing to allocation expenditures (and production) through time, there is a shift of expenditure now. Surpluses or shortages in credit markets are at the same time surpluses or shortages in total expenditures–keeping in mind that most expenditure is funded out of current income and that the imbalance in expenditure is one of increases or decreases out of income.
In the absence of monetary disequilibrium, interest rates must ajust so that the credit markets clear, and so the adjustments in total expendture balance.
My view is that the base money, as medium of account is essential. The quantity of money, inclusive of base money is important because that is how disequilbrium in base money is going to impact the economy. And, because most of the money supply is made up of debt instruments that are claims to other sorts debt instruments, all of this is going to always impact interest rates and credit.
And while all of these relationships are important, the fundamental problem is clearing the market for the medium of account–which is base money.
4. May 2009 at 09:53
AdamP, I’m not sure your point. I have had at least a dozen posts talking about why tight money causes deflation which drives T-bill yields to zero. If Buffett’s example has any bearing on those posts, please let me know.
Thanks Alex.
Steve, It was meant to be light-hearted and a bit off the wall. But I’m not blaming you as most people also missed the humor in my Mishkin post. Humor is not my strong suit. Especially because I mix up serious points with provocative points. You are right that the management angle weakens my argument. I should have picked a passive investor. But it doesn’t change my argument that he is not an economist. Even that argument, however, was nuanced. I think outside opinion is useful, but not on the basis of wealth, rather based on what the person has to say.
Obviously my opinion on whether Buffett was actually lucky is worthless. The interesting test would be to see if the top 10 passive investors outperform the market after they become top ten. It wouldn’t at all surprise me if they did. As I said, I think it is more likely that the EMH is roughly true, rather than exactly true.
AdamP, Thanks for the info on mutual funds. I was just relying on what I read–and haven’t looked at the issue closely.
Bill, One area where I slightly disagree is when you say interest rates are affected because money is linked to debt instruments. I think the key reason is because wages and prices are sticky. If there was complete W&P flexibility then money would be neutral in the short run, and interest rates wouldn’t show a liquidity effect. Technically the flexilibility would also need to include indexed debt. So it’s a moot point in practice. I’m not saying you’re wrong, just that I find the sticky wage price angle more to my liking.
Bill and Nick, There is no fundamental theory at stake here. You can model the price level with the supply and demand for base money, or M1, or M2. Factors that affect supply in one case, will affect demand in others (as cash, DDs and TDs are substitutes.) It’s just a question of convenience.
4. May 2009 at 10:51
[…] He writes, [BTW, Bill Gates essentially taxed middle class consumers all over the developed world, and is giving almost all of the money to the disadvantged in poor countries. That’s something governments don’t do, and yet for his “monopoly profits” he is despised by many on the left. Nor does this fact show up in the so-called “income distribution” data that is taken seriously even by economists who should know better.] There is a huge contest going on between politicians and rich people over who should get to spend their money. Most of us have no direct stake in the outcome–as neither politicians nor rich people, we will not have the choice. […]
4. May 2009 at 11:24
Scott:
In the context of a pure outside money (heliocopter money or else government spending money to finance expenditures,) combined with organized financial markets and then final goods and services and incomes determined in the usual way, I think your story about the impact of monetary disequilibrium on interest rates is correct. I think of it in exactly the same way.
In the context of a pure inside money system, where all money is created by banks, and the medium of account is not used as money at all, but rather tied to the money through some kind of indirect convertibilty (say index futures on nominal income,) then there is a more intimant relationship between money and credit.
This relationship is not one that involves equilibrium, but rather disequilibrium. Any imbalance between money supply and demand is an imbalance in credit markets (and between saving and investment.) It must follows from the logic that all money is a debt instrument and it is all financing something or other.
None of this means that interest rates are good operating targets for monetary policy. Or that you can watch interest rates and they will tell you if there is monetary disequilibrium or not.
Now, the status quo is a sort of hybrid. Central banks do operate on banking principles. While that can all be treated as an illusion, if it is taken seriously–then the balance sheet of the monetary system has implications for interest rates.
I fully agree that no matter what, if the quantity of base money is sufficient to meet the demand at the target value of nominal income given the existing conditions generating the demand for base money, then nominal income will be on target. Interest rates will clear credit markets at the same time. And those credit markets will shift funds between household and firms in ways that are consistent with total spending remaining on target. Perhaps that is a reason why we can forget about interest rates, but.. I like a complete story.
4. May 2009 at 11:56
“So next time you think you can beat the market ask yourself: “Am I really the guy who knows something the market does not or am I the guy who just thinks he knows”.”
The point I was trying to make above is that Buffett and Soros do consistently have more information than the market when evaluating certain investments. Buffett has his conglomerate with numerous counter-parties and clients throughout the economy feeding him a massive amount of non-public information. He has made this point ad nauseam. Soros on the other hand has different, and possibly more scandalous sources of information, but the principle is the same.
I think that if you were to ask most money managers they would agree that the average Joe Blow faces a hopeless task if he is attempting to beat the market with a Scottrade account and a Reuters feed. The point though, is not that it is senseless or impossible to try to beat the market, the point is that you can only expect to do so with information and resources that are above average, and hence not reflected in the price reached in an auction where the participants are comparatively ill-informed and lacking resources.
4. May 2009 at 12:34
Scott, I guess I did miss the humor but it was probably because you hit one of my minor hot buttons–people casting Buffett as a stock-picker somehow deminstrating that some people are smarter than the market and can consistently beat it. Fama and French showed long ago that while there *may* be people who can be smarter than the market and pick winning stocks, it’s impossible to distinguish them from those who are just lucky. It’s lost in the statistical noise. Nothing new.
Here’s a far more interesting question I’ve been wondering for a long time, haven’t found any answers to: are there people who can consistently beat the market by choosing *asset classes*? (Really, a form of market timing.) Or more specifically, can we tell beyond the statistical noise whether there are such people, and who they are?
4. May 2009 at 13:09
[…] Crisis Timeline: On his blog in a post that looks at broader themes, Scott Sumner wonders how much luck has to do with Warren Buffett’s success. “Most people would say that [Buffett] didn’t get rich by chance, and that the odds are a million to one against an investor getting that lucky. Well the odds are a million to one, but according to the Efficient Markets Hypothesis, he is the one. For those not familiar with the EMH, consider a million affluent American investors. Each year 50% will do better than average (of better than median to be precise.) If their gains are serially uncorrelated, then only 250,000 will do better than average during two consecutive years. Only 125,000 after three consecutive years. How many will do better than average for 20 consecutive years? Only one. Of course that doesn’t mean he or she would be the richest American, as everyone doesn’t start out equally affluent. So if your name is Rockefeller you might do better with somewhat less luck. But there are far more merely affluent Americans, than very rich, so an unknown could easily end up on top through sheer luck. And since humans are hardwired to see patterns where none exist, we can assume people would not view his success as mere luck. Especially since common sense suggests a smart person should be able to beat the “wisdom of crowds,” even though when we are able to test these things they do not.” […]
4. May 2009 at 16:39
Scott: I think I can now see the cause of our disagreement on which is important: monetary base/medium of account, or medium of exchange.
If the question is: “what determines the long-run equilibrium price level?” then I agree that the demand and supply of the medium of account is what matters.
But if the question is: “what could cause a short-run recession, or general excess supply of goods and labour, assuming sticky prices?” then I say that the demand and supply of the medium of exchange is what matters.
As a thought-experiment, suppose apples are the medium of account, and dollar bills are the medium of exchange. Assume all prices are temporarily fixed. Destroy half the stock of apples, and you get an excess demand for apples, which might spillover into an excess demand for pears, but that’s about it. If instead you destroy half the stock of dollar bills, and you will get an excess supply of goods in all markets, as individuals try to restore their stocks of dollar bills by buying less and selling more. To a first approximation, real output will fall by half.
It is an excess demand for the medium of exchange, not the medium of account, that explains a general glut, taking prices as given in the short-run.
Basically I agree more or less with Bill, I think. But it just happens to be true that part of the stock of medium of exchange is inside money, and represents a loan from the public to banks (demand deposits). It doesn’t have to be that way. And it just happens to be true that central banks currently control the stock of medium of exchange by controlling lending to banks. It doesn’t have to be that way.
4. May 2009 at 17:11
Nick,
I don’t disagree exactly, but if half of the applies disappeared, and the medium of exchange is denominated in applies and tied to apples through redeemablitity, then the quantity of money would fall until the apple market clears at its defined price.
If the quantity of money fell in half, and this started putting downward pressure on the price of apples, then either the quantity of money expands or it trades at a premium and its nominal value rises.
I suppose all this is inconsistent with no prices changing, but there you have it.
4. May 2009 at 17:34
[…] In the course of a recent post on Warren Buffett and the Efficient Market Hypothesis, Scott Sumner made the following aside: Bill Gates essentially taxed middle class consumers all over the developed world, and is giving […]
4. May 2009 at 17:54
Bill: OK. I was (implicitly) assuming that dollar bills were not redeemable in apples, so we could disappear half the stock of apples, while leaving the stock of dollar bills in public hands unchanged.
Otherwise I fully agree with you. But I was (implicitly) assuming the price of money were held fixed too.
If the medium of exchange were not the medium of account, it is hard to see how a halving of the medium of exchange would not result in a very quick doubling of its price (though we can assume it for the sake of a theoretical argument, as I was doing). A sticky price of the medium of exchange is much more plausible if the medium of exchange is also the medium of account.
5. May 2009 at 03:10
Nick:
Ages ago, I wrote a paper about a payments system with nonmonetary medium of account and a fiat currecy with a variable price in terms of the medium of account. The price of the medium of exchange was determined in a continous auction market for the medium of account, and then that price of the medium of exchange was used in all other markets. The purpose of the paper was to show that it was the changes in the nominal value of the quantity of money (price in terms of the unit of account times quantity of the fiat currency in its own units) that effected changes in the price level so that the market for the medium of account clears. And further, that changes in the quantity of the medium of account (measured in its own units) have the usualy impact on prices, but as the demand for the medium of account is impacted, this feeds back on the price of the medium of exchange.
You know, if there is no Walrasian auctioneer, what is the market process that actually makes the price level adjust so that the market for the medium of account clears at its defined price? The medium of exchange is the only way that effective demnands are going to change.
Redeemability schemes (indirect ones) are more plausible, of course, than everyone having to keep track of a variable nominal price of the medium of exchange. I worked this out with all mutual fund monetary systems. (Checks, however, are made out in terms of the unit of account.) The macro isn’t much different than with a more conventional banking system. The mutual fund money is going to have cause prices to adjust to clear the market for the medium of account. And “monetary changes” (now that scheme is an identity of money and credit) must impact the medium of account too. Or so I thought.
5. May 2009 at 05:12
Bill, I can’t fully answer this now, but a few observations. Let’s revisit this later as well. I recognize banks matter for two reasons, they demand a significant amount of base money, and they indirectly affect the demand for cash (as substitutes). So my drug dealer example was a bit weak. So was I just being provocative? No. Look at where I ended up:
“Would a central bank focusing on the supply and demand for base money start paying interest on excess reserves during the very week the economy was clearly sliding into deflation?”
Bob, Soros might have been a better example, as you say. Maybe Soros got lucky. Or maybe not. Either is possible. My point is we don’t know.
Of course “most money managers” are just a clueless as Joe Blow, as most don’t outperform dartboards.
Steve, I didn’t have any real “jokes”, I just found amusing the idea that the guy everyone worships might just have been lucky. As I said to Bob, it’s also very possible that skill was involved.
Nick, I think short run shifts in AD are caused by changes in the expected future path of AD. And those long run changes are caused by the classical money supply/demand transmission mechanisms. (Plural emphasized.) Woodford makes the same argument about short run fluctuations determined by shifts in the future expected path of policy, albeit with a different transmission mechanism. So I am well within the modern new Keynesian framework here. (although obviously I might well be wrong.)
I may have misunderstood your apple example, because if cash is not the medium of account, then a fall in apple supplies would cut in half the market value of each currency note. Or did I miss something? So the two approaches would be unified. But I have a better example. A test similar to what you proposed was done in the U.S. in 1933. The gold price was raised sharply, so the nominal amount of the medium of account was increased roughly 70%. The money supply didn’t change much at first. Why, because the expansionary impact of more gold was initially offset by the fact that the vigorous recovery it promoted led to less hoarding demand for money. So we have a horse race:
1. Much more non-circulating medium of account (nominal terms)
2. About the same amount of money (M1 ended the year slightly lower than it started.)
Here’s what happened before FDR implemented his disastrous 20% wage shock in late July:
1. The WPI rose 14% between March and July 1933.
2. Industrial production rose 57% between March and July, regaining half the ground lost in the previous 3 1/2 years.
Nobody seemed to notice one of my favorite posts, which discussed this episode:
http://blogsandwikis.bentley.edu/themoneyillusion/?p=308
My theory is that the gold price increase led to a higher future expected money supply and NGDP, which raised current AD through all the (non-banking) transmission channels that Mishkin discusses in his text.
I’m kind of rushed today, so I’ll try to revisit the Bill and Nick discussion when I have a bit more time.
7. May 2009 at 15:42
“I suppose this should be testable. If the EMH is correct than the top ten richest Americans should not see out-sized returns, once they have reached that pinnacle of success. I have no idea whether the data exists to do this test, but is would be a good way of resolving the issue of whether Buffett just got lucky. When similar tests are done with successful mutual fund managers, it turns out to be merely dumb luck.”
I haven’t seen anything at that fine a level, but Krugman has a section on mean reversion (as it relates to general income) in his book “Peddling Prosperity”. He, of course, claims that the numbers are just statistical anomolies and do not represent income mobility… but they may give some insight into your question.
For example:
“Half of the families who start in the top or bottom quintile of the income distribution are still there after a decade.”
Obviously this indicates a pretty substation staying power that probably arises from a fundamental skill difference (though this isn’t necessarily related to stock gains, but rather the value of someone’s job skills). However, the fact that half leave their quintile says a lot about the pressure of mean reversion… or vice versa of the random factors that temporarily drive poeple into the extreme income brackets.
At the high end:
“The average income of families whose income exceeded $100,000 in 1983 was $176,000, in that year; their average income over the sevel-year period ending in 1985 was $153,000.”
Of course, the catch with this data are the people who have an unusually good year (like someone who cashes out a large block of stock options during ’83). They show up in the top quitile with an exceptionally high income, increasing that average. The rest of the years, they earn a far more moderate number, dragging down the overall average (and probably earn the options which they will later cash).
He ends (derisively) on what is itself a striking statistic:
“Families who were in the bottom quintile in 1977 saw their income rise 77% by 1986, while families in the top quintile saw their income rise only 5 percet.”
His “gotcha” which borders on innane is that “families in the top quintile in 1986… had experienced a 65% gain [over the same period]”. Not a surprise that those moving into the top quintile saw huge gains (how else would you get there), but it’s equally interesting that the number is smaller (on a percentage basis) than the overall rise by the bottom quintile.
8. May 2009 at 03:44
Clayton, I agree with you that Krugman misinterprets the income quintile data. That data means almost nothing (I may do a post on that sometime.) And it certainly has nothing to say about the EMH, as it is mostly wage income, and even the capital income is total, not percentage rate of return (risk adjusted.)
11. May 2009 at 22:37
[…] Sumners, a professor of economics at Bentley University, in one of his lengthy posts, made this parenthetical statement: [BTW, Bill Gates essentially taxed middle class consumers all over the developed world, and is […]
12. May 2009 at 19:37
[…] managed mutual funds seem to do worse than index funds (some perform badly enough that they posed something of a problem for the EMH). Now a company claims to have a predictor that outperforms both humans and software […]
9. April 2012 at 05:18
[…] Three years ago I argued that even if markets were perfectly efficient, they would look inefficient. That’s because […]
8. April 2014 at 18:56
Scott,
I appreciate your passion for EMH, but if you factor for corporate taxes paid had Berkshire employed the strategy you discussed (10% into the best opportunity, the rest into an index), the taxes would mean they would still underperform the market.
If you strip out the appropriate level of taxation on the capital growth & dividend components of the S&P results over the 5 years examined, Berkshire would have beaten the S&P in 4 of the last 5 years.
If he can last long enough to see another 20 or 30% drop, I’m pretty sure the trouncing Berkshire will inevitably have in such a year will remind people that ‘Alpha’ can come in very large irregular chunks in the stockmarket…
15. February 2017 at 06:05
[…] “Ouch! Three years ago I argued that even if markets were perfectly efficient, they would look inefficient. That’s because […]
16. February 2017 at 04:36
[…] “Ouch! Three years ago I argued that even if markets were perfectly efficient, they would look inefficient. That’s because […]
16. February 2017 at 06:37
[…] “Five years ago I did a post entitled Being There. I compared Warren Buffett to the character played by Peter Sellers in the famous film. […]