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04/13/2009

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ryan brown

Your claim that the market is driven by uncertainty instead of risk may explain aggregate market performance (ie, when stocks might outperform bonds). But it isn't directly related to most empirical tests of stock market efficiency (meaning which stocks/industries will outperform others on a relative basis). Asset managers want to beat the market(DJIA), since lucrative pay packages are at stake. It certainly isn't clear whether riskier stocks, characterized by the Knightian uncertainty concept you describe or the classical definition of risk as variance/beta, explains the cross-section of equity performance.

Regarding the "Monday-morning Fed quarterbacking", I've been reading your blog since inception (which is indicative of my expectations of the quality of the B-P posts), and I don't recall either of you making calls for more regulation or imploring the Fed to raise rates in 2006/2007. In fact, recall the mass hysteria around your suggestion that trans-fats should be regulated--imagine the argumentative leap from food products to CDS or MBS!

Jack

"Yet I believe that the Federal Reserve should have lanced the housing bubble no later than 2006 by raising short-term interest rates (which would have pushed up long-term rates as well by increasing the borrowing costs of banks and other financial intermediaries and thus the rates they would have to charge for lending their borrowed capital), and if this did not burst the stock market bubble (the bubble that reached its maximum expansion in October 2007) to lance that bubble as well, by increasing margin requirements."

I can't help wondering if the above was even a possibility given the flood of foreign capital that "had" to be recycled, and the antics of the "non-banks" who were buying sub-junk mortgages at Ponzi scheme multiples of leverage?

Politically it would seem even more impossible as many/most? econ watchers could see that housing with its related appliance and furnishing sales was the last leg of a very fragile economy that was falling behind on job creation and yet further behind on wage generation. In fact what else DO we have?

A relatively small tech sector with broadband mostly built out, computers and other electronics becoming low margin commodities? An airline industry that has "matured" and may be up against energy limitations? While the rest of us are "taking in laundry" in one fashion or another ranging from selling each other insurance or other financial services down to a saturated latte market.

Now the question is, where does the "hot money" go? At the first sign of rising oil consumption or hint of a shortage in supply, I'd guess it again pours into the energy futures markets that give the sovereign funds of OPEC a whopping twofer.

Jack

"Yet I believe that the Federal Reserve should have lanced the housing bubble no later than 2006 by raising short-term interest rates (which would have pushed up long-term rates as well by increasing the borrowing costs of banks and other financial intermediaries and thus the rates they would have to charge for lending their borrowed capital), and if this did not burst the stock market bubble (the bubble that reached its maximum expansion in October 2007) to lance that bubble as well, by increasing margin requirements."

I can't help wondering if the above was even a possibility given the flood of foreign capital that "had" to be recycled, and the antics of the "non-banks" who were buying sub-junk mortgages at Ponzi scheme multiples of leverage?

Politically it would seem even more impossible as many/most? econ watchers could see that housing with its related appliance and furnishing sales was the last leg of a very fragile economy that was falling behind on job creation and yet further behind on wage generation. In fact what else DO we have?

A relatively small tech sector with broadband mostly built out, computers and other electronics becoming low margin commodities? An airline industry that has "matured" and may be up against energy limitations? While the rest of us are "taking in laundry" in one fashion or another ranging from selling each other insurance or other financial services down to a saturated latte market.

Now the question is, where does the "hot money" go? At the first sign of rising oil consumption or hint of a shortage in supply, I'd guess it again pours into the energy futures markets that give the sovereign funds of OPEC a whopping twofer; making that the next bubble and further crippling the US economy.

Michael F. Martin

First, Knight went under-appreciated for a long time, and his distinction between risk and uncertainty deserves a prominent place in any evolutionary theory of economics.

But second, I want to push back at what I see as a hidden premise in this post, which is that rationality is required for an "equilibrium" in the form of a market price to be achieved. We have known at least since Schelling published The Strategy of Conflict that it is not rationality, but symmetry that accounts for equilibrium outcomes -- symmetries and broken symmetries in expectations of market actors drive transactions in ways that rational expectations alone don't. See more discussion of this point here.

What quantitative hypothesis could be more general than the rational hypothesis and yet as useful in forecasting group behavior? How about a hypothesis as simple as this: Human behavior is periodic because of biological cycles hardwired into our circulatory, respiratory, and nervous systems. We breathe, eat, and sleep in cycles. Rather than postulating rationality, we might simply postulate ergodicity -- i.e., that the same frequency distributions of consumption and production that are observed for a group in one window of time will appear in subsequent time-windows. Letting go of some of the constraints of the rational hypothesis frees economists up to consider evolutionary biological explanations for group behavior outside of the rational hypothesis.

Michael F. Martin

There are some "rational" price bubbles and crashes that are not hard to conceptualize. For example, Bouchaud has argued convincingly (summary here) that prices cannot instaneously equilibrate after new information is discovered by market actors. The time required for equilibration obviously depends on the liquidity in the market.

One could generalize from there to the observation that whenever market production and consumption are characterized by cycles of different lengths in time, transactions will have to be synchronized in time to avoid buildups or shortages of goods. This asynchronicity in supply and demand is not the only form of transaction cost recognized by Coase as solved by the assembly line at Ford, but it sure is an important one in markets where liquidity is highly constrained!

In fact, there is a movement in operational management to induce artificial shortages in inventory in order to reveal asynchronicities in production. This, in a nutshell, is what Toyota perfected, although Toyota's managers will tell you that they learned it from Ford (Henry Ford, that is -- Ford the company is in the process now of relearning it from Toyota).

An analogy from physics is useful here. When energy is transferred through a system that behaves linearly, waves will form but will not interfere with one another. In the deep ocean, although energetic swells are traveling constantly, the surface may remain calm. It is only when the waves approach the shore, where the bottom of the ocean floor provides a mechanism for exchanging energy between otherwise independent waves, that waves break.

Similarly, on the stock market trillions of dollars in goods may be exchanged with little volatility so long as there is plenty of liquidity. But when, for whatever reason, the quantity of goods that market actors want to exchange approaches the order of the total outstanding quantity of those goods, the market prices are going to break just like waves on the shore.

Now putting numbers on all of this is hard. But conceptually, it's quite simple.

Michael F. Martin

Whoops. Second comment was meant for Becker's post.

Matthew C.

Is the stock market an "Efficient" market?


No.

rcm

It doesn't take luck to time the markets consistently well on a relatively short-term (1-5 day) basis. U.S. and European markets are mean-reverting and have been that way for about two decades now, with the reversion only becoming stronger and stronger in recent years. Asian markets (ex-Japan) are trending. They respond both to their own medium-term momentum and to the short-term momentum of the S&P 500.

Markets may best be described as moderately efficient, and usually can only become efficient if trades are made to "arb away" the inefficiencies (i.e., markets tend not to be magically, instantaneously efficient). The fact that any trading is done is because there is disagreement about the future (given its uncertainty). Those with access to better information or better means of transforming public information (to essentially make it private information) can consistently outperform the market. Throw in the repetitive behavior of the retail trader, i.e., the "dumb money" (who buys the high and sells the low) and you have a recipe for continual outperformance for those who take the other side of the trade.

Jim

Efficiency generally means input/output. Perfect efficiency is 1. Certainty is a probability of 1 with a standard deviation of 0. I guess that means that the answer to your question is NO. And I suspect that as efficiency goes up, certainty goes down with a standard deviation somewhere around -3. I am not sure about what the curve would look like.

a

"For example, when stock prices begin to fall, the market value of savings invested in the market falls and this may make cautious investors move their money into safer forms of saving to make sure they have enough protection against a rainy day--a decision that has little or nothing to do with predicting future stock prices"

That has everything to do with predicting future stock prices. The explicit prediction that they make is that those losses will continue in perpetuity...resulting in a "get me out of the market" reaction.

WM

Imposed on banks, the mark-to-market rule is deflationary. Therefore, we experienced deflation. When news leaked that the rule was about to be abolished, the market reflated. No analysis of EMH is complete without taking into account the existence of information about the availability of capital.

Anonymous

"The Dow Jones Industrial Average peaked at 14,200 on October 9, 2007, fell to 9,600 on November 4, 2008 (election day), kept falling, to 6,400 on March 6, 2009, and since then has risen sharply, to 8,100. (I have rounded to the nearest hundred. I use movements in the DJIA rather than in the S&P 500 because the DJIA is composed of heavily traded stocks and thus gives a clearer view of market-price changes.) What explains these gyrations?"

Has anyone ever considered the thought that GOVERNMENT is behind these gyrations...? I know I might be labeled an "extremist" for suggesting this today, but maybe, just maybe the government really is controlling public opinion by using INFLATION and DEFLATION.

Does anyone know who Thomas Jefferson is anymore...?

"If the American people ever allow private banks
to control the issue of their money,
first by inflation and then by deflation,
the banks and corporations that will
grow up around them (around the banks),
will deprive the people of their property
until their children will wake up homeless
on the continent their fathers conquered."

But here is Posner:

"Protecting the economy is the business of government."

Better rev up that printing press...!

cizevova

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Jim

Extremist? No. It is perfectly reasonable to consider the possibility that our current government would like to nationalize the banks. The government would then control the entire economy in all of its functions except the black market. Who works, who doesn't, who gets loans, who gets housing who gets health care, who gives health care, etc, etc. Why would anyone consider that extremist with the likes of Harry Reid and Nancy Pelosi at the helm.

Anonymous

All these really intelligent theories on market behavior...

...And all along it is just Uncle Sam manipulating markets. Yup, government sets up ponzi schemes such as subprime lending. Yup, govt. print 10 trillion if they feel the need. Yup, all of a sudden the Federal Reserve is the SEIZER (not lender) of Last Resort. It is government building and popping bubbles, all to steal our property and wealth, all to get the masses 100% dependent.

Blame free markets, why not...? Barrack Obama never misses an opportunity to demonize capitalism and markets, and the masses will just buy whatever the Con Artist is selling.

Who is Thomas Jefferson...? He must be one of those "extremists" Janet Napolitano now says is a terrorist.

Jack

Anon? and Jim? Do you two think that what the President, most of Congress, and most of us denounce in "banking" is "capitalism?" or anything akin to a working "market?"

As for the choice of "nationalizing" these "banks" or shoring them up by buying 80% of their pig in a poke "assets" and then trying to coax them into lending to credit worthy borrowers before that lack of liquidity takes down what's left of our economy; does one approach stand out as being more like "capitalism" than the other?

At this point I'd favor a temporary nationalizing; splitting off conflicting functions (like insuring and lending) and reselling them in chunks of a size that would renew competition and NOT be "too big to be allowed to fail". This approach would seem to me to be the closest and most orderly means of approximating the bankruptcy they all deserve without the disruption of a normal bankruptcy we can't afford to have take place.

The option of covering their massive markers for them and trying to refloat their whole corrupt enterprises replete with leaving the cast of bonus entitlement leeches in place to avoid the stigma of nationalization hardly strikes me as anything related to "free market capitalism".

Control of us??? Government? Ha! How about giant corporations as we've just seen? How about concerted piles of capital running the price of oil up from $20 to $140? Kinda controlled most of us quite a bit? How about parasitic medical "insurance" corporations who've prevented Congress from rationalizing health care administration for the last 40 years or more?
Do you see elements of capitalist "markets" at work in H/C that would contain costs or create competition?

neilehat

Is the Stock Market an "Efficient" Market? It's about as "efficient" as any Roulette table and wheel at any Casino worldwide when it comes to the redistribution of wealth. As long as the wheel isn't "fixed". "You put your monies down, you takes your chances". Such a metaphor goes far in explaining the current Economic Crisis.

Gambler's Fallacy anyone? Unfortunately, it's the only "game" in town.

Anonymous

"Control of us??? Government? Ha! How about giant corporations as we've just seen?"

Did you read Jefferson's quote...?

If corporations are too big to fail and government continues mortgaging our future by bailing out their inefficiency... these institutions continue getting bigger and bigger to the point that they are monsters. They control us because GOVERNMENT has prevented free market forces from checking these monsters...

...and now Average Joe cannot say failure must be an option in our society because his 401k and college savings plan would go worthless.

Just let markets work without government interference (inflating and deflating bubbles) and we will be better off. We don't need to be psycho-analyzing market behavior, all we have to do it open our eyes and realize that government is getting in the way of the natural self-corrective forces that make markets efficient.

Failure has to be part of our economy, if it isn't it is only a matter of time before we are 100% communist. Barrack Obama is doing nothing today to correct anything, he is just re-inflating our artificial economy. It will work in the short run, but wealth depletion, dependency and loss of individual freedom comes with it.

Jim

Jack, what do you mean by "rationalizing health care"? Do you mean "rationing" because that is what you are going to get. My friends are always telling me that Europe is so "rational". Yes they are, unless you are a 55 year old person with end stage renal disease and you are told to go home and rest, thank you very much, or unless you are one of the one million patients in the UK on any given day waiting to get admitted to a hospital or unless you are one of the 20% of breast cancer patients in the UK who die of their disease who would not have died had they been screened every year starting at age 40 instaed of every three years starting at age 50. Is that what you mean by rational. I have other suggestions for rationalization: rationalize the tort bar. Rationalize the 80 billion annual medicare expenditure in the last year of life. Rationalize the impending physician and nurse shortage and so on and so forth.

Jack

Anon: Not too much disagreement, but let's say "timing is everything". I too wonder where the Anti-Trust Division was (vacationing?) as Citi was allowed to combine with Travelers or where regulators were when AIG and others thought they could write "insurance: at vast multiples of historic asset/debt ratios.

The "short run" is what we have to deal with just now, and you'll note the President having charged Congress with design a new set of rules that will help prevent "our?" corporations from operating like gamblers on a junket to Monte Carlo in the future.

"Just let markets work ...." Indeed, but "markets" are a game and every game requires rules and umpires.

You appear to be a bit soft on allowing powerful rent-seeking corporations to purchase or lease enough Congressmen to deal themselves market distorting favors at the expense of consumers and taxpayers; let's HOPE that this admin and Congress sees the need for balance and proper regulation.

Jack

Jim, thanks and happy to clarify:

We too ration health care not only for those lacking "benefits" but for those who, increasingly, can not afford the copays and other limits.

WE spend nearly TWICE what the nations you claim are rationing spend but are not even keeping pace with their outcomes, such as infant mortality, life span and a host of other benchmarks.

While I don't favor copying the programs that the nations offering universal care designed for themselves 50 years ago, even their plans would serve us well with TWICE the amount they allocate.

Assuming your numbers are correct (which seems in doubt these days) a RATIONAL health care system would be delighted to pay the small annual checkup cost instead of bearing the tremendous cost and human suffering of the faulty practice of medicine you mention.

I might go further; since many men and women put off screenings for prostate, breast, prostate and other, I might offer a coupon for lunch or another incentive if two come in at once, the idea being for each to help the other overcome a potentially deadly procrastination.

The "tort reform" mantra is more political than "reform" and the "savings" are VERY difficult to assess, and especially so when we have such a high rate of malpractice and the vast majority of cases are not litigated. Once we DO move forward about three decades in computerized record keeping, I'd much rather focus on the positives of far better outcomes research with that data feeding back to a far more comprehensive "best practices" program and doctor education than we have today.

Yep! The shortages of docs and nurses are and will be a big problem. The nursing shortage is largely one of poor pay and tough working conditions but shares with docs a bottleneck at college level.

Our horse and buggy era "fee for service" from thousands of small medical practices combines the worst of "capitalism" and the worst of "socialism" which is further exacerbated by the overhead costs of squabbling with "insurance" companies. It strikes me that "insurance" companies are well placed with sufficient capital to provide medical services to their subscribers instead of simply being parasites on a system that was never designed to provide efficient service or contain costs.

What would YOU do about the "last year" costs? If it were a family member? How would you know it was the "last year?" Rationing? Will euthanasia? sell well to most of our religions?

Anonymous

I agree with you on some points there. Entire industries were formed around the giant ponzi scheme (AIG clearly). But make absolutely no mistake about it, GOVERNMENT set up the ponzi scheme. Wall St. isn't innocent in this mess, but GOVERNMENT set rules based on fraudulent principles that got in the way with the market's natural corrective process.

SO DON'T CRY WHEN BUBBLES FORM AND BURST. Don't pretend this requires psycho-babblicious theories (like everything Posner just wrote) on the behavior of our "EVIL" MARKETS. All you have to do is examine the core of the problem, and it is GOVERNMENT almost all the time interferring with markets.

For the record, no liberal democrat can ever complain about the cost of energy EVER AGAIN. You lost all credibility on this topic when our OBAMAnation of a president proposed his carbon energy tax in the middle of our economic depression all on the fraudulent theory that is "global warming". Let's let Obama reinflate our artificial bubble before he pops it with $4 gas... again. Of course he'll continue lying and go on blaming republicans and evil markets for the next pop.

Did Bill Clinton ever accept responsibility for the TECH BUBBLE? Oh that is right, it popped the day after he left office so it must have been ENTIRELY BUSH's FAULT.

Anonymous

"The "short run" is what we have to deal with just now"

Sacrificing capitalism for short run stimulation is about as irresponsible as a child eating too many cookies before dinner. We may go hungry for an hour or two, but it is healthier to wait for dinner.

Keyes pretty much tells it how it is here:

http://www.youtube.com/watch?v=lqkMfToY9Pk

Jack

Anon? How did "GOVERNMENT" set up the AIG and non-bank Ponzi's?

"it is GOVERNMENT almost all the time interferring with markets."

.......... I often lament the process of corpies buying favors for themselves from a Congress that is far too dependent on the lucre of lobbyists and PACs for re-election.

.......... as for energy, not sure if you count me as a "liberal" but I find myself closely aligned with T. Boone Pickens; a lifelong Republican. The carbon tax? Well, it's a complex subject but we have been flying OURSELVES up a blind canyon with the cheap oil of yesteryear. Now we are flying up a blind canyon with far pricier oil that is bound to become pricier yet.

........ I'm not sure how any President can light off another unregulated oil futures run-up with billions of sovereign, self-serving, funds fueling a runaway "market". IF oil futures are meant to provide stability and hedging for those whose businesses are highly dependent on oil, instead of yet another Las Vegas style lottery for mega-billions of hot money, perhaps the "players" should be limited to those who ARE the consumers of oil and COULD take possession.

The "tech bubble?" I don't blame either Clinton or Bush though Greenspan piling on rate increase after rate increase leading up to the election and very rapidly unwinding them once Bush was installed did catch my eye a bit. Puzzling too that the terms: internet, information highway and broadband seemed to go on an eight year vacation from the White House, and that now the need for universal broadband is now a main topic. (After falling half or more of a decade behind Korea, Japan and most of Europe)

Short run fix? I gather from what you say that you've not much of a fix on the magnitude of The Mess. Students of the last Depression will note that FDR and the New Deal very likely saved capitalism in an era tiled toward socialism and even communism. As we can see in nations like Russia and many others, once an economic system is broken and laying in ruins it is VERY difficult to resurrect with strongmen, gangsters and international corporations grabbing much of the spoils.

I don't think the responsible folk of either party favor taking such a chance. I don't recall Keyes having ever displayed much econ savvy. Have you studied econ at all? I find it rare among those of the extreme right.

Jim

Jack,
We are getting off subject a bit here but since I started it I should try to complete my thought(s).
Since I have seen the tort problem up close and personal, My estimate is 30% of health care costs are defensive medicine. I come to that from 35 years of practicing radiology in very large private and academic medical centers. In addition, I worked as a "top cop" in a medical center, responsible for all medical quality, with a medical staff of 800 and know that the amount of "malpractice" is related to very few physicians and situations. As you know, 95% of all cases are either dropped or found not guilty. Most cases brought are because of poor communication and PR. I recently wrote a paper which evaluated the cost of finding one positive CT scan of the head in the ER in patiens who had one of 17 symptoms without neurological findings. Using VERY conservative assumptions, it comes to $12,000 all "rationalized" on the basis of defensive medicine. I would be happy to send you a copy if you wish. In addition, at age 72, I just completeed my masters degree in medical informatics at Northwestern University and have been involved in medical IT issues for many years and while there are some aspects of health care that could use some streamlining and record storage and transmission, the entire idea of standardization and decision making is fraught with danger for the patient. The electronic medical record will save nowhere near the 80 billion figure in the Rand report on the subject in 2005. In fact it might even cost more. My last paper was on reforming healtcare in the US. I would also be happy to send you a copy if you wish. You might not agree with all of it but I tried to be complete and even handed.

Obviously, you can tell that I agree with both Anon and with you in that unfettered capitalism is cruel and ruinous but the government, particularly right now, has gotten completely out of hand in its own self perpetuating interest and is on the cusp of making things worse. One has to ask who is pulling the strings. Just as in healthcare, the best solution is a well educated, involved and energetic public. I am not sure that we have a critical mass in that regard even amongst the folks who have completed undergrad degrees and are therefore "educated".

I understand that I sound negative, but I belive that there is adequate evidence to be sincerely worried about the future of our country.

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