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Markets again

One of the principal troubles with a certain class of people is a staunch belief that markets are the Baby Jesus. Daniel talked about this yesterday, but this analysis on the implications of Greenspan’s ‘confession’ got me all riled up for another take:

The failure of the Efficient Markets Hypothesis is, perhaps, an even more significant outcome of the crisis than the end of the Great Moderation.

The EMH implies that, provided governments get prices right (avoiding distorting taxes, internalising externalities and so on) it’s impossible to improve on the allocation of investment capital generated by private markets. The converse doesn’t hold automatically. Even granting that private markets are subject to bubbles and fads, and that their investment decisions may not make sense in the light of publicly available information, it doesn’t necessarily follow that governments can do better. Still, for large scale infrastructure systems, the case for leaving investment planning as, in Keynes words ‘the by-product of the activities of a casino’, looks a lot weaker now than in did before this crisis. Of course, for anyone who cared to look, the ludicrous investment decisions made during the dotcom boom had already undermined the EMH.

Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century. I’ve written a more detailed version of this argument here here

For all my bitching and moaning, I believe the EMH gets it almost as close to right as possible; and when it doesn’t, I think the reasons it doesn’t have less to do with the fundamental chasm between rational and irrational behavior, but simple obfuscation. For instance: global warming, and the nations’ uniform lackluster response to it, is not a market failure anymore than a rained out baseball game is a baseball failure. Rather, the market never really got to have its say. If the externalities of energy consumption are so obscured that some people have no idea that they’re even there, well, you shouldn’t be surprised when there’s so much idiocy everywhere.

This happens whenever you isolate people from the consequences of their actions. Trust fund babies are fucked up weirdos because they’ve never had to earn a living and never had to deal with real people; the rules of the world, as they know it, are different from the rules of the world as we know it. Within their bizarro universe they are reasonable people; the problem is that their universe is a tiny subset of the larger universe. They’d all be just as fine and dandy as anyone else if the larger realities had been taken into account.

Is this just splitting hairs? I dunno. My point is that even in cases of “market failures” the first 80% of redress should be in making sure all the information required by the EMH is actually reflected in the market, not buried from ten levels of indirection in SEC filings, but right in front. A lot of people made some really, really stupid decisions because they honestly didn’t know any better. Fuck, if real estate gains twenty percent a year for the entire period of your awareness you’d be stupid not to buy in. You’re actually making a RATIONAL DECISION with the data you have.

And anyway, the market _is_ behaving efficiently, right now. Economic conditions were built on smoke and mirrors, and now they’re gone – that’s efficiency. If you find this sort of mega-efficiency to be too slow, or too clumsy, the first redress should be to reduce the grain of these giant market cycles. Give people the tools to be more rational and often times they will be. Creep carefully into the dangerous territory where the Government decides what’s the best economic policy, even a ‘hybrid’ policy, even one informed by behavioral- and neuro-economics.

(I wonder if I’ve ever written a post the legions of LSH readers have ever cared about less. Votes?)

  • nagasaki
    I'm trying not to get involved with these discussions...but...I'm weak. Everybody knew there was a housing bubble that knew anything about markets. The trouble is, you never know at what point you are in the bubble. You start hand waving to early and you are the constant bear.

    I don't think experts were too worried about a real estate bubble at the time. The logic was that the subprime market, which was only like 6-10% of the loan market could implode, but that would be self-contained. The rest of real estate could afford some drops as people had such high amounts of equity built in. Then things turned worse than expected, subprimes weren't self-contained, people who could afford their mortgages began mailing the bank the keys in record number so they could buy the same house at a 20% discount, oh yeah, and investment banks along with hedge funds pulled some complicated shit that got way outta control. You see, experts may have believed there was a bubble, but the way these contracts were being crafted, the risk was not correctly perceived.

    Who started it, govt or free markets? I'd say both are at fault. We all know free markets go nuts from time to time and they always will, so it is acting exactly by definition. Highly regulated markets also experience bubbles. It is felt that the govt perpetuated some of the careless derative betting by insuring too many mortgages with low capital down. People were taking bets that they never would have in a normal situation as they never would have wanted debts they couldn't get off their books. So like I said, the risks were hard to evaluate.

    And some of these corporate lawyers are just getting too smart, finding too many ways to make money. There are such complicated derivitive schemes that I still don't think the bulk of us understand wtf is happening...that includes CEOs. Matter of fact, this shit is so complicated that Buffett himself decided to sell a company he had purchased that was involved in some sort of CDS operation, because he couldn't understand it well enough. Scary. I've also read the CDS market was as loose and unpatrolled as can be. Contracts were agreed upon over voice mails, emails, hand shakes, whatever. Then you end up with stuff being leveraged a dozen times over. That's the shit-kicker with leverage. You can make a fortune, but it goes both ways.

    And so, that's were we are. Greenspan acknowledges his error in betting markets cannot govern themselves properly. Maybe. Or maybe 3 years of ridiculously low interest policy pushed us into a real estate bonanza and the market were powerless to stop the feeding frenzy. Maybe Greenspan would rather blame the market's inability to self-police than his policy. I think markets are acting as they should...basically like a toilet flushing out all the shit. Trouble is, this is one painful flush as the bowl was brimming with turds and without some stabilization effort nobody really knows how bad it can get. It will be hard to argue some oversight isn't required to prevent markets from skyrockting too far from greed-driven easy money schemes like CDSs as I doubt most of us are willing to watch the economy crumble after these schemes finally detonate. I hope it isn't under piles and piles of SEC regulation...I don't see much efficiency from the SEC. Ever.

    Yet, with all the smart assholes out there inventing knew ways to do this stuff....
  • That illustrates the main point I was trying to make: even with all this
    post-mortem Really Smart People can't agree on what exactly happened, why it
    happened, and they certainly can't propose anything that would convince me
    they could keep it from happening again. Maybe - MAYBE - they could keep
    the system from blowing up in exactly this way, but that really ignores the
    nature of unexpected events: you can prevent terrorists from flying another
    plane into another skyscraper, but of course nobody's trying to fly planes
    into skyscrapers anymore. The next terror attack will be something else.

    So I say: make everything as transparent as possible so every agent taking
    part in economic exchanges has access to realistic information. Hell,
    appoint some public-service commission to issue reports and recommendations;
    maybe that would have convinced a few people that interest-only mortgages
    were perhaps not as great an idea as they had thought. But in the end
    you've got to let the market do its thing. To paraphrase Winston Churchill,
    it's the worst possible system except for everything else that's been tried.
  • houlios
    Here's what I don't get - nagasaki was telling everyone that would listen that there was a housing bubble and it was gonna burst so be f-ing careful - that leads me to believe that these big-wigs on Wall St. knew the same thing which then leads me to believe that it wasn't really foreclosures and bad loans that caused all this. After that point though, I'm not sure who has the expertise to say what happened - I've read people saying that its these credit default swaps and I've read other people who say that's not the real reason and on and on it goes.

  • DDB
    "Trust fund babies are fucked up weirdos because they’ve never had to earn a living and never had to deal with real people; the rules of the world, as they know it, are different from the rules of the world as we know it."

    Are you saying The Monarch is a fucked up weirdo?

    I cared less about your "Cyborg" post.

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