Mario Rizzo has an interesting take on Robert Lucas’ recent essay on prediction of business cycles.
Lucas’ post is quite an odd defense of the mainstream economics gurus who were caught flat-footed. Here are some good excerpts:
One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama’s “efficient-market hypothesis” (EMH), which states that the price of a financial asset reflects all relevant, generally available information. If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier.
This is far too clever and slippery. Someone can evaluate a situation as unsustainable (or poised in an “unstable equilibrium”) without being able to predict exactly when the break will occur. Lucas’ logic strikes me as similar to when game theorists stubbornly say what the “rational” strategy is, even though the commonsense strategy pays more in practice. (Believe it or not, I think Brad DeLong and I are in basic agreement regarding Lucas.)
Also, without in any way justifying my claim, let me just throw it out there that I’m starting to think the efficient markets hypothesis is a state of mind, a consciously chosen way of looking at the world. I’m not sure what it would mean to really falsify it. It seems that any attempt to test it would rely on assumptions about seemingly random events, which in the final analysis would mean you weren’t really testing the efficient markets hypothesis alone.
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Maybe some of these “economists” still believe in the broken window theory?
The economy is in a bad rut because people aren’t breaking enough windows! There, I have explained everything. Let us encourage the statists to go out and launch some good old fashion riots or something, it is sure to have our economy rolling in no time.
I really fail to have any faith in any economist who is cited regularly by the media in this country.
The Economist has a discussion going on about the fault of mainstream econ over at http://www.economist.com/blogs/freeexchange/. It’s interesting that only Mark Thoma offers any criticism of mainstream at all. Everyone else is quick to defend it at all costs.
The real problem with mainstream is that they don’t think cycles have a cause other than random shocks, and of course you can’t predict random events. They see their role as guiding the feds in cleaning up the mess after the disaster, not predicting or stopping disasters.
“Also, without in any way justifying my claim, let me just throw it out there that I’m starting to think the efficient markets hypothesis is a state of mind, a consciously chosen way of looking at the world.”
This is exactly right.
The Efficient Market Hypothesis is false. The evidence should be obvious. If it weren’t false, there would never be a bubble, there would never be a crash. In a bubble, things are overvalued. Crashes often bring things down to a value more in line with what the EMH would predict, but sometimes value dips below that, and they are undervalued. This happened with the stock market earlier this year. And not all bubbles can necessarily be blamed on monetary policy or interest rate manipulation (like this last one). The internet bubble was caused by irrational exuberance. EMH would have never predicted pets.com to become more valuable on the stock market than IBM — because pets.com never was that valuable.
You can’t spend irrational exuberance: while you can have a bubble without credit expansion, it’s just another fad.
Troy,
Your understanding of what the EMH is, is obviously different from Lucas’. Lucas obviously is aware of what happened to housing prices, and he doesn’t think it violated EMH.
This is partly what I was getting at in my post. I’m pretty sure that Lucas thinks the housing market was hit with a really big shock in 2006, and that made prices fall.
Lucas knows it must have been an unexpected shock, because…(you fill in the blanks).
So my point is that Lucas thinks he just empirically tested whether EMH held up during the housing boom and bust, and he thinks it passed through with flying colors. Yet what wouldn’t pass with flying colors?
Don’t misunderstand, I’m agreeing with you: The housing bubble is a great reason that I personally don’t endorse the EMH. But technically speaking, the EMH is consistent with what just happened. So Lucas isn’t wrong, he just doesn’t realize how a priori his worldview is.
Bob is basically right. The EMH says that the *risk-adjusted* expectation of a future price equals today’s price. The risk-adjustment part is critical; what’s being said is not that expectations of future prices equal current prices under the actual (or “physical”) price distribution, but under a different, risk-adjusted (or preference adjusted) distribution. Think of change of measure theory from option pricing theory (e.g., Girsanov’s theorem) and martingale pricing. This can allow for all kinds of distributions consistent with things like crashes, etc. The question, of course, is how do you go from the physical measure to the pricing measure? As Bob alludes to, essentially by assuming EMH is true, and backing out or implying the change of measure that takes you from one probability measure to another. A lot of the debate in the literature concerns, ultimately, whether this mapping says something reasonable about preferences or not. From an Austrian standpoint, that kind of question is kind of beside the point.
How does EMH explain the success of, say, Warren Buffett??? If market prices already contained all information that is available, there should be no one who constantly beats the market.
Only if we accept bad information as “information” is EMH correct. Thus, Lucas would have to accept bad information as information. But bad information is what causes distortions. If we are able to identify the bad information being used, and what that bad information is, it seems to me that one could identify in a general sense when a bubble is occurring. Of course, one could also simply look at the stock market trends over the last 100 years, see the top and the bottom averages, see where the market is above or below those log curves, and observe the bubble. One could then begin to look for what bad information is causing the distortion, and keep an eye out for similar situations as occurred in the past to burst the bubble.
I have a friend who actually did predict the bursting of the internet bubble. He took every last dime of his and his clients’ money out of tech when the U.S. government brought anti-trust against Microsoft. He then moved his clients’ money to less and less risky stocks, keeping ahead of the collapse. Earned him a vice presidency at the bank he worked for when he was only in his late 20′s.
Or efficient markets hypothesis is just a trivial observation like water is wet.
Toby,
The EMH would say that on AVERAGE an individual cannot beat the stock market. However, there can be outliers such as Warren Buffett that do beat the market consistently.
Bob,
You can test the Efficient Market Hypothesis:
1. Assume the EMH to be false.
2. Become filthy stinking rich.
Throw me a bone when you’re the next Buffet, will you?
Andy
The Efficient Market Hypothesis does not state that markets or prices are rational. It states that if and when irrationalities exist, they are not exploitable using a risk-free arbitrage.
In the case of pets.com, many hundreds of analysts stated — correctly — that pets.com and countless other dot-com stocks were extremely overvalued and would eventually collapse in price.
But, to capture this market irrationality required shorting volatile stocks at unlimited risk or purchasing put options. The breakeven cost of put options on pets.com, yahoo etc. during the dot-com bubble and collapse was about 10% per month. In retrospect, the options priced the slide correctly, most dot-com stocks declined 10% a month for 8 or 9 months in a row.
Because the Efficient Market Hypothesis worked as advertised, very few of the analysts or traders who correctly identified the impending dot-com collapse profited from it. The insanity was in full view for all to see, but there was no means to exploit it.
If EMH merely states that you can’t predict the stock market, it’s of zero value, and the mere statement of a truism. Since it in fact says something about information, then one can prove or disprove it, since EMH in fact says more than you can’t predict the stock market.
To phrase it mathematically, imagine that prices (under the pricing measure) follow some kind of jump diffusion, so
they can wander around, then suddenly collapse (or explode). As long as, say,
put options are also priced with respect to this measure, there will be no
arbitrage opportunities to take advantage of collapses. In this sense
the market is efficient, assets fairly
priced, etc. It does not follow, owever,
that actors may not or cannot view as a
reasonable or good bet the selling of
an asset in light of a (perceived) future
collapse in price.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=806246
more wood on the bonfire….
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