Thursday, November 29, 2012

Quiggin Responds!

John Quiggin, author of Zombie Economics, graciously engages this post I made in response to his book in the comments. He also points to an interesting and easy to read paper he wrote on the equity premium puzzle. My real critique is that the equity premium puzzle isn't an EMH puzzle it's a macroeconomics puzzle. Let me try to explain the difference.

In Quiggin's book and definition of EMH he is confounding two ideas:

    Efficient Markets Hypothesis - prices fully reflect all available information.

    Market Efficiency - a well functioning market will allocate all resources in the best possible way

The second idea is often strictly defined as the First Fundamental Welfare theorem, which basically says that if you make a bunch of assumptions (that aren't true) like markets are perfectly competitive, markets are complete, no externalities and perfect information, then the market outcome is efficient.  In this case, efficient means pareto efficient, a weak notion that means we can't make one person better off without hurting anyone else.

This confusion explains a lot of odd statements he makes, like, "The Efficient Markets Hypothesis implies that governments can never outperform well-informed financial markets."

The first fundamental theorem does say that (under very restrictive assumptions) and if our notion of improvement is limited to pareto efficiency, but the EMH just says markets adjust in the background.  Let's say there is an negative externality called pollution.  A government may be able to enact a policy to limit pollution and make everyone better off, say a tax on gasoline.  The EMH just says that stocks will adjust to that new policy.  The tax on gasoline will limit the amount of gasoline consumed, so companies like Exxon and BP will see their profits decrease.  People will probably drive less, so Ford's stock will go down.  The EMH just says that security prices will reflect all available information.

The EMH is still not a weak hypothesis.  If we imagine that the government is deciding on whether or not to enact the policy, the market prices must be constantly adjusting to the updating chances that the knew policy will be enacted.  The prices must be the best guess for the properly discounted value of future dividends for every stock in the market, even stocks that will only be barely affected by the law, like a theme park that will lose profits, because it is far out of town and a few less people will want to make the drive.


  1. I covered this point (p44, in the paperback edition) saying

    Capital markets will fund the subset of investments with the highest market value. If there are no relevant market failures outside capital markets, the Efficient Markets Hypothesis says that these will also be the most socially valuable investments

    and followed up with exactly your example in footnote 8 saying

    "Suppose, for example, a company is considering an investment that will be highly profitable but environmentally damaging. Stock markets will value the company on the basis of the profits, and will fund the investment, even though it may be less socially valuable than an alternative, more environmentally friendly choice. But, an advocate of the Efficient Markets Hypothesis will say, the answer is not to try and change financial markets, but to address the market failure directly by “getting prices right" in the relevant market, for example, by taxing polluters.

  2. Doctor Quiggin: As I read your point, that doesn't follow. Just because I believe:

    1. Markets are efficient, and
    2. In an idealized market, you get an allocation of resources which maximize social value, and
    3. Those ideal markets are impossible

    It does not imply that the best marginal policy change will always be in the direction of "fixing" the market price (IE, keeping the market but trying to make its prices better reflect all the externalities). Those three points tell us that ideal markets are best but impossible, they do not tell us what is second best.

    Practical example: Let's imagine an industrial process of very marginal value to a factory owner which is also absolutely devastating to the environment. In an ideal market, we would have clear property rights, no transaction costs, and either the people downstream of the pollution would pay to get rid of it or the factory owner, faced with how much he would have to pay in order to pollute, will stop all on his own. But this is the real world and all the damaged parties have trouble uniting to press their claim and some environmental goods are held in common and etc.

    Now why, if I believe that markets are efficient, is my only possible policy move "make the market price better reflect the real cost?" This chemical is only used in this one industrial process. This process is clearly harmful. I can set up a tax or pollution market to try to get the chemical's use down to where an ideal market would get it, sure. But why not just ban it? That would have the same effect and waste less time and resources.

    All of which is to say, Charlie is right and the EMH and the first fundamental welfare theorem are different things with different implications that can be believed by different people. It's a useful distinction, and you can't treat people advocating EMH as if they were claiming 1. markets in the real world can or do have socially optimal outcomes, and/or 2. the solution to every policy problem is tweaking prices in a free market to better reflect externalities.

  3. Thanks I again for the comment. I agree with everything Wophugus said, and let me add another example.

    I am one of the people that think for air pollution that the best solution is fixing prices. We should tax carbon emissions and thus improve the price signal to be more socially optimal.

    Take a different violation of the first fundamental theorem, bailouts (which I think you also mention). A lot of economists say we should eliminate bailouts and bailouts are the problem. I think it is politically infeasible to eliminate bailouts "ex post." That is, it will always seem to the Fed and Congress that bailing out a systemically important firm is preferable to risking a financial crisis. In other words, a no bailout strategy is time inconsistent. Thus, my preferred solution is heavy regulation ex ante for systemically important firms. We must have strong regulation, because we know we will bail these firms out if you know what hits the fan. Just like I must get rid of all the ice cream in my house or else I will binge on it at 2am when my willpower is weak.

    It is true that "people at Chicago" (which is what I think you really mean by an advocate of the EMH) usually think the best way to regulate is to fix prices, but that is not a conclusion of the EMH. In a lot of your book, I think you confound different aspects of neoclassical economics with each other and then with neoliberal policies, because it happens that people at Chicago believe it all simultaneously. But plenty of neoclassical economics is useful to moderate Democrats like myself. The EMH, for instance, need not be a political statement.

  4. First, I'd like to remind you that this is a popular book, so I'm more concerned with getting the message right than with precision in stating it. I'd hope that economists reading the book would fill in the gaps in the way that makes most sense, rather than seeking to drive them.

    On the response, it's true that there is no logical necessity for belief in EMH to go with a belief that the first welfare theorem implies that getting prices right is the way to go in policy. But that's the most common pairing, and that's the one I addressed in the footnote.

    Suppose that the EMH believer in the footnote thought that regulation was the best solution to pollution. Nothing would change. They would still advocate fixing pollution by intervention in the relevant market and would still conclude that, conditional on optimal regulation, capital markets will direct investment to the most socially valuable enterprises.

  5. "On the response, it's true that there is no logical necessity for belief in EMH to go with a belief that the first welfare theorem implies that getting prices right is the way to go in policy."

    It's good that we agree on this.

    "conditional on optimal regulation, capital markets will direct investment to the most socially valuable enterprises."

    If I define regulation broadly as policy, what Social Democratic policies does this rule out? We try to write good laws to get us in the best "second-best" world we can, since we know the first fundamental theorem doesn't hold. Isn't this exactly the type of mixed economy you advocate in your book?

  6. Yeah, I think that sort of underscores why the EMH is not about policy. At the end of the day pretty much everyone thinks, "given optimal policy you will reach the best possible outcome," and if that is all EMH says about policy it doesn't say much at all. And that's our point! Pretty much all policies can fit within an EMH world.

    But the EMH is still useful, because while it doesn't tell us much about policy it tells us a whole lot about how to gather information. If the EMH is true, I still don't know the best way to regulate carbon emissions. But I *do* know about how likely the US dollar is to suffer a big bout of inflation over the next ten years, thanks to the TIPS spread. This is why the EMH is a useful idea even outside the University of Chicago worldview: it's not primarily about policies, either theirs or yours. If true, the EMH simply gives a useful way to gather accurate information, which is something people on every side of the policy spectrum could take advantage of.

    I appreciate the "I was engaging the University of Chicago worldview for a general audience and didn't have the time or the audience patience to go through neoliberal economics point by point, looking for its good ideas. I had to treat it in toto" argument, though.

  7. Wophugus,

    Your second paragraph is brilliant, but I don't agree with your last paragraph. The book has chapter titles like "The Efficient Markets Hypothesis" and "Dynamic Stochastic General Equilibrium." It is ostensibly a critique of mainstream and/or neoclassical economics. If it was primarily an argument against neoliberal policies, the specifics of this stuff are less important. This book was calling the type of economics that makes up a large part of the work in macro and Finance "Zombie Economics," so I do in fact think it's important to get this stuff right. If you are going to go to a general audience and call a lot of other scholarly work junk, then I think the argument should be more than, "because some people that do that work are neoliberals."

  8. I think you've missed my point. I'm saying that, if you accept EMH it says

    1. If there are no relevant market failures (eg externalities) in the activities concerned, then allocating funds to the projects with the highest market value, as determined in capital markets, is socially optimal.

    I further assert that neoclassical economists (a superset of EMH believers) would generally argue

    2. If there are relevant market failures, the best thing to do is to address them directly, not to intervene in capital markets to fix them up.

  9. @Wophogus
    "But I do know how likely ..."

    I'm going to substitute a couple of examples:

    "But I knew in 1999 that dotcom companies as a group were almost certainly going to be immensely profitable ..."

    "But I knew in 2007 that nothing bad was going to happen in US real estate markets or the global economy ...."

    My whole point, contrary to the title of the previous post is that the EMH, with any reasonable auxiliary assumptions does have testable implications and these implications have been shown to be false.

    As I said in the book, dodging refutation by adjusting auxiliary hypotheses is a sign of a degenerating research program in the sense of Lakatos.

  10. "And I knew when I rolled a D100 dice that it probably wouldn't come up 88... BUT THEN IT DID."

    "And I knew when I rolled a Dx dice, where the best available information indicated that X was under 100, that it probably wouldn't come up 101. BUT THEN IT DID!"

    The best guess, taking advantage of all available information, is not going to necessarily be right. In the second example, let's say on a prediction market you could buy for a cent a contract paying out 100 dollars if the dice comes up 101. And it comes up 101. Was the market wrong? Or was it missing key information? Or did something really unlikely happen? We have no underlying model to check the market's work and can't say.

    And that's Charlie's point: any time you test to see if EMH is taking advantage of all available information you are testing it against some model of what the "right" outcome was. But no one has that model.

    You can say, as I think you are saying, "Look, what matters here is *other people* claimed they had reasonable auxiliary assumptions on EMH. They thought they *did* have a model. They thought they could make falsifiable predictions, but then when their predictions proved false, they just adjusted their assumptions rather than admitting EMH is wrong." And you should be mad at those guys, they suck! But they suck because their first claim, that we know enough to put reasonable constraints on the EMH and make predictions about how efficient markets behave, is dumb. And most people doing research in Finance didn't buy that. None of this proves EMH wrong, it just proves those people stupid.

    And lost in all this is the fact that, whether or not the EMH is correct, pretending it is is an extremely useful heuristic for getting information (IE, want to know the price of something, given all available information? Check the market! Or create and subsidize a market, then check it! The market might be wrong, but you can't do better!).

    Again, not an economist. I'm sure I'm missing something here. But the EMH looks difficult to falsify. Which is sad, but which sort of by definition does not prove it wrong. Meanwhile, it looks real helpful as a heuristic: I don't really see anyone consistently outguessing the market, so I shouldn't try. If anything, the crash in 2007 made me more convinced of that: turns out a bunch of people who were making above market returns were actually just taking heavy risks and/or taking advantage of government subsidies (IE, bailouts). You can tell me some dudes thought that with reasonable constraints we could make predictions about EMH, and those predictions turned out to be wrong, but that just makes me think those guys are stupid, not that 1. The EMH is wrong, or 2. I should live my life as if the EMH is wrong. All I'm seeing is markets that make bets that don't pay off sometimes, which could happen under EMH for about six reasons.

    Personal questions: Do you buy the market when you invest? You indicated that the TIPS spread might inaccurately reflect the risk of major US inflation, are you taking advantage of that by buying inflation protected securities? Do you think you have some special area where you can outperform the market and, if so, how are you doing? In other words, do you think the EMH is 1. clearly wrong, 2. not even useful as a heuristic, or 3. Neither, but some economists made dumb claims about it and haven't faced up to that fact?

  11. John,

    When you say on page 59:

    "It was obvious, and pointed out by many observers, that the prices being paid for dotcom investments could not be justified on the basis of standard principles of valuation."

    What model are you thinking of? Can you apply it to stocks today? What rate of discount are you using, and are you assuming it is constant through time? It's hard to engage the evidence you are relying on, without knowing how we are supposed to value stocks.

    You are the first I've ever seen to use LTCM as an argument against efficient markets. Most use it to show the opposite. If someone tells you they can make 50% return with no risk, grab your wallet. Don't hope you've found the next Buffet, worry you've found the next Madoff. For two years, LTCM was thrown in EMHers face almost as often as Buffett. "Look it's arbitrage profit!" They'd say. Most academics see it as a lesson in overconfidence in models, not irrationality in markets.

    The Shiller volatility puzzle of prices vs. dividends isn't really developed in the book, but I will write a post laying out his argument and the mainstream (EMH) critique later in the week. If you are interested, I'd appreciate your comments.