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Source link: http://archive.mises.org/15277/following-the-efficient-markets-hypothesis-into-absurdity/

Following the Efficient-Markets Hypothesis into Absurdity

January 10, 2011 by

Most Austrians stop short of following Chicago School economists’ advocacy of the “efficient-markets hypothesis” (EMH). In its most extreme form, the EMH becomes a caricature of itself in which asset bubbles are not just unlikely but logically impossible. FULL ARTICLE by Robert P. Murphy

{ 39 comments }

Walt D. January 10, 2011 at 1:25 pm

This is what happens when people are unable to see the difference between a model and the reality it is supposed to model or forecast. In the housing bubble, the model and the reality are at odds. So, ignore reality – the model can’t be wrong? This is Krugmanism.
At least the scientists involved in Climategate were still scientists in the sense that they realized that the had a problem when their model and its forecasts were at odds with reality. Their solution was to falsify the data so that it appeared that the model and its forecasts were still honoring the data. It seems that economists of the Krugman ilk are oblivious to the problem of the model and its forecasts being at odds with reality.

Hugo January 10, 2011 at 1:32 pm

If reality does not follow the model is obviously a market failure.

Eric January 10, 2011 at 2:05 pm

Actually, as I read the climategate code (or in truth, just some comments in it), it appeared more likely that the filter programs they used to process the raw data were ill-understood (by programmers that got caught up in the maintenance of someone else’s code they couldn’t figure out) and so modified them to agree with the expected results – perhaps thinking they were debugging them. So, were they scientists or just people looking for a job and got stuck with a mess? Who knows? Of course this is the problem with large computer models, how in the world do you verify them when you can’t tell the difference between correct output and output flawed by bugs in the code.

Program proofs were a hot topic when I was in grad school, but quickly died off when it became clear that the proofs were orders of magnitude more difficult to verify than the code they claimed to prove. So, testing against known results is still the only game in town.

In the case of the economists, I once thought they too used sophisticated computer models, but have been told (here) that they just use equations like calculus where it’s not justified (e.g. on non-continuous functions). Nothing as sophisticated as a computer model apparently.

Dave Albin January 10, 2011 at 5:31 pm

Climate scientists also are guilty of wild extrapolation and poor methodology. Whether just trying to gain fame or money, or actually trying to destroy society, their motives are not known.

RTB January 10, 2011 at 9:18 pm

Eric, a very enlightening comment. I have a Computer Science degree from way back (have long since trodden down other paths) and didn’t realize this about the climate models . I understand that there is bias and data is being falsified and that there is no way all inputs can be accounted for, quantified or even plugged in the correct equation.

But debugging the programs to fit the desired results is something I’ve not thought, read or heard of. If you think about it, it only follows – Incredible!

Yet, like everything else, I’m sure it would fall on deaf ears and blank stares.

david janello January 10, 2011 at 3:41 pm

Bob Murphy makes a clear and cogent DEFENSE of the EMH in this article. He is also very good at explaining the capital constraints on why the various EMH factors take time to play out.Scott Sumner’s viewpoint is patently absurd and directly contradicts the EMH on every count.Sumner is basically advocating a negative gamma trade, one with 95% odds of winning and 5% odds of losing 10x or 100x all the “profits” that were made from the trade itself. The old saying is ‘picking up nickels in front of steamrollers’.The EMF is the steamroller that will be annihilating anyone foolish enough to bet on the currency debasement that academics like Sumner advocate.

The Anti-Gnostic January 10, 2011 at 9:11 pm

I think Murphy is kind of arguing with a straw man. I would say Sumner’s greater crime is sophism: using arcane proofs to argue for conclusions that clearly don’t make sense. We are comfortable saying that “markets clear,” which is surely a testament to the ultimate efficiency of markets.

james b. longacre January 10, 2011 at 9:39 pm

shit happens too..but it isnt necessarily good or desired or efficient.

was that arcane and sophist??

Beefcake the Mighty January 10, 2011 at 9:44 pm
James January 11, 2011 at 12:57 am

My favorite argument against the “vernacularized” EMH is quite simple: if market price were always perfect, there wouldn’t be any profit in trading at all, hence the market wouldn’t even exist! Seriously, who would be bearing the cost of transactions if market prices were always perfect? There wouldn’t be any profit to be made in trading at all in a market where pricing is always perfect.

A valid EMH can only be understood as: market price evolution as determined by multitude of traders can capture and transmit new information more efficiently than any apriori price setting or ongoing price setting by a smaller set of traders (the logic extreme of “smaller set” being 1 “trader,” the official price setter flipping securities from one account to another, both owned by himself).

james b. longacre January 14, 2011 at 10:26 pm

if market price were always perfect, there wouldn’t be any profit in trading at all, hence the market wouldn’t even exist!

why arnet market prices currently perfect of noone is forcing you to price something a certain way??

drew January 12, 2011 at 4:49 am

I like the EHM in general, but when you’re trying to implement it in practice, you have to look at whether its underlying assumptions are met. One of them is that all market players are price-takers, i.e. none of them can manipulate prices on their own. This is clearly untrue in this case, since the FED can “rig the market”, it is large enough to push asset prices around on its own.

Chris January 14, 2011 at 8:15 pm

I went back and read R. Murphy’s article of Fama’s arguments about the housing bubble. Fama’s arguments were, indeed, absurd, notably the position that a bubble has to be predictable to exist. Strange indeed.

But I am very surprised that R. Murphy has used the notion of “speculative” demand to differentiate a bubble from the absence of one. The demand need not be “speculative”, i.e. exist for the purpose of short term profit taking, to cause a bubble. The demand simply needs to ARTIFICIAL…more specifically, artificially high. And of course in this case the demamnd was artificially high because easy money created excessive lending. Combine the easy money from the Fed with government agency gaurantees of principal and intrest of mortgage loans…which then facilitates the securitization of such loans…and you have all the makings of some significant, nationwide (as opposed to some localized ‘hot market”)…bubble. Now, THAT is what caused the bubble, and what causes ANY widespread bubble. Although there was indeed a lot of speculative buying…that was only part of it. MOST of it was just normal Americans buying overly expensive first or second HOMES TO lIVE IN (not speculation). The excessive credit from the Fed essentially provided a huge incentive for banks to relax their lending standards. As other Austrians have pointed out, artificially low rates creates a FALSE signal to lenders and borrowes alike and spurs more lending and borrowing than would otherwise exist.

james b. longacre January 14, 2011 at 10:31 pm

ow, THAT is what caused the bubble, and what causes ANY widespread bubble.have bubblers occurred without any of the claimed securitization??

Chris January 14, 2011 at 8:19 pm

And by the way, I am also surpised that few Austrians are pointing out that this bubble has been going on for decades…perpetuated by continuously easy money and government agency intervention into the housing market. Not to mention the fact that mortgage interest is tax deductible…yet rental payments are not and other interest and other expenditures are not. So people use mortgage interest as a shelter from some income tax. This bubble accelerated in the 2000 decade due to 1) easy money 2) continued securitization of mortgage related securities 3) the fact that the 2000-2002 tech stock bubble scared people away from paper assets into real estate assets.

james b. longacre January 14, 2011 at 10:23 pm

what bubble??

have houses been torn down for new construction??

as offices emptied out people flocked to real estate???

i was told that about 10 percent of mortgages were the risky type and only a portion of those were in real trouble??? not so??

Chris January 16, 2011 at 1:04 am

I don’t know who told you only 10% of mortgages were of the “risky type” (whatever THAT means)…but what a silly concept. If by that you mean “sub prime”..perhaps. ACROSS the BOARD credit standards were relaxed dramatically, from amount of down payment, to income/payment ratio, assets/debt ratio, income verification, integrity of appraisals.

james b. longacre January 14, 2011 at 10:23 pm

has easy money provided other benefits that also arent pointed out?

james b. longacre January 15, 2011 at 7:13 pm

iow, can more pro-investment take palce than so called malinvestment??

did teh tech bubble that you claim occurred set teh paltformm for ever increasing advances in technolgy at a faster rate than would have been??? less space, more memory and capabilty, iow??

Chris January 16, 2011 at 1:12 am

Yes one can argue that easy money leads (in the short run) to more houses, more production in some areas, etc. And it comes at the cost of fewer resources in the areas where it would have gone otherwise. The result in this case was too many resources flowing to housing and related industries. I could go through the whole exercise but what you are missing is the concept of opportunity cost. Through intervention resources are effectively taken away from something in order to go into housing, etc.

james b. longacre January 14, 2011 at 10:10 pm

“The excessive credit from the Fed essentially provided a huge incentive for banks to relax their lending standards. As other Austrians have pointed out, artificially low rates creates a FALSE signal to lenders and borrowes alike and spurs more lending and borrowing than would otherwise exist.”

the excessive credit you say (true?) entered the banks…did the credit make its way into money supply fugures?? i was told that consumer credit isnt shown in money supply fugures??? true ???

is more borrowing and lending that would other wise exist a bad thing??? woudl more blenders mean more margartias than woudl other wise exist??? are false signals bad?? or is it incorrect signal and not necessaily a false one???

Chris January 16, 2011 at 1:16 am

Yes it is a bad thing indeed. Lending to people who won’t be able to pay it back is generally a bad thing. Lending against collateral that will not be able to serve as collateral…is a bad thing.

Yes the money supply expanded. Are these serious questions? Eventually when banks lend there follows multiple deposit creation and money supply expansion.

And in the current case, even when the money supply isnt yet expanding because lending has not accelerated yet, it prevents the and defers the liquidation of bad assets.

james b. longacre January 16, 2011 at 2:36 am

if you lend to someone perhaps. but if for some reason numerous defaults begin to occur is it necessarily bad to insure thos e payments with money that takes pretty much nothing from the economy (gols, dirt, steel , machines) to keep further disasters??

i can see it would be bad from a monetary freedom standpoint but if easy money ( computer entries, iow) brings market results faster for more people is it a bad thing??

james b. longacre January 16, 2011 at 2:36 am

the excessive credit you say (true?) entered the banks…did the credit make its way into money supply fugures?? i was told that consumer credit isnt shown in money supply fugures??? true ???

james b. longacre January 16, 2011 at 2:53 am

i was told that something called consumer credit was not in any of the M-figures or money measures. if consumer credit is a real or a false measure of some type of dollars i dont know.

james b. longacre January 14, 2011 at 10:13 pm

is the credit that you say entered th banks measurable?? a posted figure somewhere?? is it that much of a false signal??

Chris January 16, 2011 at 1:18 am

Yes the credit is measurable (not perfectly, but yes it is measurable). The monetary base, the money supply…these are measured. Yes check out the Fed’s balance sheet some time and see how it has grown.

james b. longacre January 14, 2011 at 10:14 pm

would a bank prospectus show the amount of credit they got?? wouldnt that be widely reported preventing false (as you claim) signals??

Chris January 16, 2011 at 1:22 am

The excess credit leads to artificially low interest rates. Interest rates are a PRICE…and THAT is the false signal. It tells a business borrower, for example, that his project that could earn say 8%…if the business is borrowing at 3%…will provide a 5% return above the borrowing cost. But absent the easy credit as a result of monetary policy…if the rate would otherwise be say 6%…the projects return profile will be overstated. When reality avenges itself, the results speak for themselves.

james b. longacre January 16, 2011 at 2:32 am

why is it false??? it never happened ‘false’ or just a bad signal??

“tells a business borrower, for example, that his project that could earn say 8%…if the business is borrowing at 3%…will provide a 5% return above the borrowing cost.”

isnt that way oversimplified??? if the project gets more market share whether it turns out to be 6 or 8 it may be the right move anyway??

what has reality done??? falling prices for many many goods?? increased living standards???

could the same occur by pulling metal out of the ground once the new money hits the market??

are continuous artifical rates bad if they stay artificial and not switch to reality??

m2 went up a bit over a trillion from 1992 to 1999 (www.economagic.com) was it that unpredictable??

james b. longacre January 16, 2011 at 2:49 am

excess credit?? i what is excess about it…isnt it just new??

james b. longacre January 16, 2011 at 2:59 am

a price is a false signal??

james b. longacre January 14, 2011 at 10:33 pm

what can a bank do with credit from th egovt?? certain conditions on its use??

Chris January 16, 2011 at 1:24 am

What a strange line of questioning. Almost as if you think there are no consequences to artificially low rates and monetary expansion. As if causes do not have effects.

james b. longacre January 16, 2011 at 2:23 am

consequences sure. but i doint know that they are all bad. i dont think you do either.

james b. longacre January 16, 2011 at 2:44 am

did the tech bubble (if it ever even happend?) set the stage for the current level of tech advances better than some other money advocated here (whatever money that is)???

some companies lured people to giving them money and failed many survived and have grown by leaps and bounds providing levels of new commerce at an exponential level amazon?? etc.

even the failures of the bubble part…was IT infrastructure perhaps put in place to ensure better office buildings even though they went vacant during the alleged bubble??

“a FALSE signal to lenders and borrowes alike and spurs more lending and borrowing than would otherwise exist.”

dont bankers know this by now…and expect it??

james b. longacre January 16, 2011 at 2:56 am

can more proinvestmet come about than the alleged malinvestment that takes place with teh current money/currency system…and has that been the reality that asserted itself

Mashuri January 18, 2011 at 1:07 pm

James,

You’re asking a lot of what is considered rudimentary questions here at Mises. I strongly suggest you read Rothbard’s “What Has Government Done to Our Money” to get your answers. Go to this URL for a free online version of the book:

http://mises.org/money.asp

Mashuri January 18, 2011 at 1:17 pm

I would also suggest “Mysteries of Banking” by Rothbard as well:

http://mises.org/books/mysteryofbanking.pdf

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