Another nail in the coffin of the anti-EMH model(s)

Every few months I foolishly post a defense of the EMH, knowing that it will enrage my readers and cause me to spend endless time responding to critics.  My basic argument is that the question is not whether the EMH is “true” (which to a Rortian like me is a rather ambiguous concept) but rather whether the EMH is useful.  I think it is, and I think the anti-EMH is not useful.  The EMH underlies much of my research, and much of the analysis of this blog.  If I had started blogging in September 2008 my reputation would be higher than it is, as I’d be given credit for pointing to the Fed’s mistakes in real time.  All because the markets told me so.  (Of course if I’d started blogging in 2005, I’d have looked like a fool in 2008.)

The anti-EMH doesn’t seem useful.  Even if there are bubbles, low paid federal regulators won’t spot them.  We can’t base policy on the assumption that regulators will prevent sophisticated investment banks from making the wrong investments.  And indeed almost all levels of regulation were cheerleaders for the housing boom–hence the housing bubble is a massive failure for the anti-EMH model.  The anti-EMH model is not useful to regulators.  (Of course regulation can be used to offset moral hazard, but that has nothing to do with the EMH.)

And it’s also not useful to investors.  In the past I’ve argued that mutual fund excess returns are not serially correlated.  Just because someone does well one year, doesn’t mean he’s more likely to do well the next year.  It’s just luck.

My commenters insist that this is the wrong test.  They say the managers of mutual funds aren’t very smart–that the Smart Money manages hedge funds.  OK, so how has this ultra-smart money done in the past few years?  From The Economist:

Since a low point for global stockmarkets in March 2009, returns have been rather modest for hedge-fund investors and bondholders, while equity investors have done much better. According to the Hedge Fund Research index, a closely watched performance measure, total returns to investable hedge funds were just 19.6% in the 26 months to May 2nd. In the same period holders of rich-world government bonds saw total returns of 21.2%. Investors in stockmarkets in the developed world fared well in comparison. They enjoyed returns of more than 114% in the period covered. Since the beginning of 2011 equities have risen by 10%, while hedge-fund investors have seen total returns of only 1.4%.

Wow!  They must have been following the advice of Nouriel Roubini.  I’m sure glad I don’t invest with hedge funds, my 401k has almost doubled since early 2009.

PS.  Shiller should have been out in the streets screaming BUY in March 2009.  Instead he was kind of wishy-washy.

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.

More evidence that the BOJ is not trying to create inflation

I frequently assert that no fiat-money central bank ever tried to inflate and failed.  Some people respond by pointing to the long period of mild deflation in Japan.  I won’t repeat all my arguments that the BOJ was intentionally pursuing a highly contractionary monetary policy.  Instead, I’d like to cite the findings of a new study by three Japanese economists, who use a New Keynesian DSGE model to estimate the Taylor rule.  The study by Koiti Yano, Yasuyuki Iida, and Hajime Wago, found that the BOJ seemed to shift from a roughly 2% inflation target in the 1980s and early 1990s, to a roughly negative 1% target after 1995.

Unfortunately, I went to grad school back in the stone age when we mostly taught economic intuition, not math and econometric skills.  So I’m hoping my very smart commenters will help me out with this paper.  I wasn’t quite able to figure out how they got the estimate of minus 1% inflation target.  Does their method seem reasonable?

Part 2:  Three from The Economist

I’ve been so busy that I haven’t had time to link to my last three essays for The Economist.

The ECB has made the European debt crisis much worse

There’s little risk of inflation

QE has helped raise commodity prices

I should have an article in the National Review very soon.  I’ll let you know.

Part 3:  No one should pay any attention to my political forecasts.

I said Obama was unlikely to get more fiscal stimulus, and he got a lot more.   I would have thought if he got a lot more, the Keynesians would have been ecstatic.  Instead they are outraged.  The announcement seemed to raise the expected rate of inflation by about 8 basis points per year over 5 years.  There’s two ways of looking at that.  On the plus side, it shows fiscal stimulus does have a positive multiplier.  On the minus side, it’s not much bang for the buck, as I was under the impression that the FICA tax cut was a surprise.  Real interest rates rose by 13 basis points, and nominal rates rose by 21 basis points.  (So much for Ricardian equivalence.)

But I also believe Obama missed an opportunity.  If you believe as I do that sticky wages explain part of the high unemployment, it would have made much more sense to cut the employer’s share of payroll taxes, not the employee share.  Still, if we need to do fiscal stimulus, I favor tax cuts both for small government reasons, and for stimulus reasons.  I agree with Christina Romer that tax cuts are much more stimulative than spending increases.

Part 4:  The endless, pointless, debate over the EMH

A few reactions to comments on my recent post on the EMH.  Some people get extremely angry when you defend the EMH.  The debate reminds me of arguments I have over free will.  I point out that either events have causes, or they are random.  In either case there is no room for free will.  My opponent responds that he is free to pick up either the salt or pepper shaker in front of him.  The debate never really gets joined, and is thus largely a waste of time.  I’ve decided I shouldn’t waste any more time arguing against free will, or defending the EMH.

I must have done at least 6 posts on the EMH and I always get the following responses, even if they have nothing to do with the specific arguments that I make in the post:

1.  It is noted that some people correctly predicted this or that bubble.  The way I look at it, you have roughly a fifty/fifty chance of being right if you predict prices will fall.  Given there are 7 billion people on planet Earth, I’m not blown away by the finding that some of them predicted this or that bubble would pop.  What does blow me away is that some people who have become world famous predicting bubbles, have done so despite also making important false predictions.

2.  Some commenters point to anomalies.  I point out the EMH predicts there will be millions of anomalies.  Some respond that a few anomalies have even done well in out-of-sample forecasts.  That’s great, but you’d expect that.  I recall reading about studies showing many anomalies failed to do well after they were published.  Was I misinformed?

3.  Some point to experimental economics.  I point out that studies have found experimental results do not always hold up in the real world.  Some commenters found the experimental evidence against the EMH to be irrefutable.  But this is also part of that evidence:

But people do learn. By the third time the same group goes through a 15-round market, the bubble usually disappears.

I’m guessing that real world traders are more savvy than college students playing a game for only the third time.

4.  Don’t get me wrong, I think there is evidence against the EMH (such as the 1987 stock crash), my real argument all along has been that the anti-EMH view is literally useless.  And that which has no practical value has no theoretical value.  In contrast, the EMH has been very useful in my research on the Great Depression.

5.  Several people mentioned market observers who denied bubbles, but no one provided me with a specific example of a bubble denier who became famous because his or her prediction was correct.  During bubbles, I find all the sophisticated people I talk to are pessimists, arguing it’s a bubble and it must burst at some point.  I rarely find people who say it’s going much higher.  So I think a successful bubble denial ought to earn some praise from the intellectual elites.  Given that pessimism is the only fashionable stance if one wants to be viewed as a SERIOUS THINKER, the bubble deniers ought to be viewed as being the ones going against the grain.

So I feel it’s hopeless, I get way more comments than I have time to answer, and only 10% or 20% actually address the specific arguments in my post.  So I’ll just give up, and stop doing bubble posts.  Of course as soon as I find another interesting way of denying the existence of bubbles, I’ll break my vow and post another EMH defense.  After all, it can be logically shown that I don’t have any free will.

PS.  I will be super busy until after New Year’s Day, not doing as much blogging.  (Although I’ll try to do some.)  Apologies to those who used to get Christmas cards from me.  Consider this:  “Merry Christmas,” to be my holiday greeting.

PPS:  I just noticed that Bryan Caplan and Arnold Kling commented on my post.  In response to Bryan Caplan, I think Fama became famous for inventing and defending the EMH, not making a specific correct forecast that a specific bubble would keep inflating.  I don’t know the other guy.  Arnold Kling’s definition of a bubble is one of many out there.  My problem is not that it is wrong, but rather that even if true, it is a useless concept.  I insist that unless a bubble call is an implied prediction, it is useless.

PPPS.  Thanks to Yasuyuki Iida for sending me the paper.  He indicated it was presented at this year’s Econometric Society World Congress (ESWC2010).

Who are the famous bubble deniers?

More and more I think that the entire bubble/anti-EMH approach to economics is founded on nothing more than superstition.  Superstitions are caused by cognitive illusions; we think we notice more patterns than are actually there.  You dream your son got in a traffic accident, and the next day it happens.  You forget the other 10,000 dreams that didn’t predict the future.

In economics people notice bubbles bursting, but fail to pay much attention to bubbles not bursting.  But I admit I might be wrong, so I’ll give my opponents one more chance.  If it’s not really a cognitive illusion, then bubble deniers who are right ought to be just as famous as bubble predictors who are right.  Indeed as we will see they should be even more famous.

People who actually understand finance know that if the term “bubble” is to mean anything useful, it must contain an implied prediction of the future course of asset prices.  Not a precise prediction (everyone knows that would be impossible) but at least a better than a 50/50 prediction.  If someone said in 2005 that housing prices were a bubble, but still was unable to offer more than a 50/50 odds on whether real housing prices would rise or fall over the next 5 or 10 or 20 years, then what would their assertion actually mean?  Asset prices are very volatile; we know that at some point all markets will go down.  When I read predictions from people like Paul Krugman, I infer that there is an implied prediction that real prices will fall over some reasonable period of time—say 5 years.

And of course Krugman was right in predicting that real US housing prices would fall in the 5 years after 2005, as was Dean Baker, Nouriel Roubini, and some others who became well known and lauded for their predictions.

At the same time we also know that bubble-like patterns don’t always yield reliable predictions of future trends.  The Australian housing market looked just as bubbly as the US market in 2005, but since then has soared much higher.  Some day it will fall, but the 2005 prices no longer look excessive.

If people like Robert Shiller (another person who became famous from bubble predictions) are right about asset prices being too volatile, then it should be true that US-type cases are more common than the Australian case.  I don’t think that’s true— in most developed countries real housing prices have risen since 2005, despite real upswings before 2005.  But let’s say I’m wrong and Shiller’s right.  Then the easy prediction to make is that prices will fall after a big upswing.  The much harder prediction is that prices will keep rising, even from inflated levels.  Those cases would be much rarer, and those who correctly call them when they occur (as in the Australian housing case) should be lauded as great heros of the investment world.

So who are they?

If they don’t exist, I have a theory why.  Most people are convinced bubbles exist, regardless of the data.  Hence if the prediction doesn’t pan out, then the market was in some sense “wrong.”  Traders haven’t yet woken up to the stupidity of their behavior.  When they do, prices will crash and the bubble proponents will be proven right in the long run.  So most people would implicitly think; “Why praise someone for being right for the wrong reason?”  Of course this makes bubble theory into a near tautology, irrefutable in volatile asset markets that will almost always eventually show price decreases.

Perhaps I am wrong and there are lots of famous bubble deniers out there.  But if not, that would in my mind be the last nail in the anti-EMH coffin, pretty much confirming that people are seeing what they expect to see, indeed given the satisfaction we get from seeing the high and mighty brought low, perhaps what they want to see.

One final point; I also have noticed that lots of people are given credit for bubble predictions that were wrong.  John Kenneth Galbraith saying stocks were a bubble in January 1987.  Robert Shiller saying stocks were a bubble in 1996.  Dean Baker saying US housing was a bubble in 2002.  The Economist magazine touting its successful housing bubble predictions of 2003 in an ad, despite the predictions being incorrect for most of the countries listed.  That’s how strongly we want to believe in bubble predictions—we even assume that people who were wrong, were actually right.

PS.  For those interested in global housing prices, The Economist has a great interactive graph.  It helps to show the pattern from say 2000:1 to 2005:1, and then from 2005:1 to the present.  In the earlier period almost all countries showed gains in housing prices, even in real terms.  The two notable exceptions were Germany and Japan, where prices fell sharply.  If I was to use a Shiller-style model that predicts asset prices will self-correct after excessive swings, I would have predicted most housing markets to slump after 2005:1, but Germany and Japan to rise.  Instead almost the opposite happened.  Germany and Japan continued to do very poorly, while almost all other markets rose in nominal terms, and most rose even in real terms.

The two nominal decliners (in addition to Germany and Japan) were the US and Ireland—which is why people assume they had had a bubble.  But why didn’t all the other bubbles collapse?  Perhaps because asset prices are not as easily forecasted as most people naively assume.

BTW, if you can’t get a 2000:1 starting date, then white out all the country boxes and start over.  That worked for me.

Bubble predictions: better late than early

Reader comments often inspire new posts, and this is a good example.  In my post on Krugman’s 2005 prediction of a housing bubble, a number of commenters pointed out that Dean Baker made the same call three years earlier, in 2002.  The clear implication was the earlier was better, and that Krugman was late to the game—just copying Baker.  I think that’s wrong.

Just so I am not misunderstood, this post is not a criticism of Dean Baker.  Commenters sent me links to bubble predictions Baker made in 2002 and also 2005.  I am going to argue that the 2002 prediction was neutral, neither particularly good nor bad, and the 2005 prediction was a good one.  All in all a decent record, nothing that deserves criticism.  Rather I’d like to focus on a narrow technical point, and argue his 2005 prediction was actually far superior, even though it came later.

Precisely what does it mean to predict a housing bubble?  Are people predicting that one will occur in the future?  That prices will rise very rapidly?  Or are they predicting that one is already here, that prices are too high relative to market fundamentals?  I think it is usually the latter.  If the term ‘bubble’ is to have any meaning at all (other than the trite observation that prices have recently risen) there must be an implied prediction that in the not too distant future (i.e. not 100 years out) prices will fall back closer to their fundamental value.  I’ve argued this point ad nauseum, and won’t repeat it here.  My hunch is that people confuse these two issues, which is why many people assume it is easier to spot bubbles than it really is.

Here is what Dean Baker said in 2002:

This paper examines whether the increase in home prices can be grounded in fundamental economic factors or whether it is simply a bubble, similar to the stock market bubble. It concludes that there is a housing bubble. While this process can sustain rising prices for a period of time, it must eventually come to an end.

He does acknowledge prices might rise before dropping, which is of course what happened.  But that comment is so vague that I take it as one of those things you almost have to say.  After all, if prices have been rising fast, only a fool would predict an immediate and sharp decline, especially given that housing prices have a bit more momentum that stock prices.  In a nutshell, I infer that he is mostly saying that housing prices have risen above their fundamental value and that at some point the real price of housing should drop to more reasonable levels.

In this paper from late 2005, he and David Rosnick again make a bubble prediction.  This time much more accurately, in my view.

In my Krugman post, I used this graph to think about the accuracy of bubble predictions.  I argued that those seeing a bubble in the US in 2005 were right, but in Britain, New Zealand and especially Australia they were wrong (thus far.)

If you just eyeball the data, to me it looks like these prices occurred in the US:

2002:  200

2005:  300

2006:   350

2010:   250

So it’s fair to say that 2005 bubble predictions turned out to be accurate.  But what about 2002?  Well the actual price seems to have risen about 25% in 8 years.  That’s not too different from the overall inflation rate, and hence I’d say there hasn’t been much change in real housing prices.  So I’d call that a neutral, where lower real prices in 2010 would be a win for Baker, and higher real prices would have been a loss.

I’d like to use an analogy, to suggest why it’s better to be late than early, why Krugman actually deserves credit for being late to the bubble party.  I recall after the 1987 stock market crash that someone praised John K. Galbraith for having predicted a stock crash.  He made the prediction in January 1987, when the Dow was around 1700.  It then rose to 2700 in August, before crashing to 1700 in late October.  So was Galbraith right?   As this post shows, people seem to assume he was.  But I’d say no, as his prediction really didn’t convey useful information:

1.  If you sold stocks on his prediction, you would not have made money—even in the long run.

2.  It was an implied prediction that stocks were overvalued relative to fundamentals.  But today very few people would say the Dow was overvalued in 1987 at 1700, indeed if anything it might have been a bit undervalued.  This shows how hard it is for even a very smart person to know whether something was overvalued in real time.  I could say the same about Boston house prices in 1987, and I’m sure people living in Manhattan, London, Vancouver or San Francisco could provide similar examples of prices that once seemed insane, but now (even in this recession) actually look (in retrospect) like equilibrium prices.

I think a good prediction, a useful prediction, would be someone that predicted a stock market crash in August 1987, not January 1987.  Those are the people who deserve credit if you (unlike me) believe market predictions aren’t just dumb luck.

I can think on one counterargument.  One could argue that an early prediction might have resulted in public policy changes that prevented the worst of the housing bubble.   But I favored those public policy changes even without being able to predict the bubble.  And I’m claiming it’s not obvious there was a bubble in 2002.  I’d hate to have public policy decisions based on inaccurate bubble predictions.

So from now on when someone tells you that Dean Baker predicted the housing bubble back in 2002, the correct response is “You think that’s impressive, well Krugman predicted it in 2005!”  Enjoy the puzzled look in their eyes, and savor the thought that you are soon about to show your superiority by setting them straight.  At least if you’re as big a jerk as I am.

PS.  Take a look at the link discussing Galbraith.  It was from 1994, and they assumed we were in the midst of another speculative bubble—when the Dow was trading in the 3500 to 4000 range.  What do you want to bet that they said “I told you so” in 2003, after the crash brought prices down to 8000?