Chapter 11 of Debunking Economics explores economists treatment of money, interest and finance. Keen travels from Adam Smith and Jeremy Bentham’s 18th century battle over usury, to Irving Fisher’s recantation of the idea that finance is stable after the 1929 crash, and then to modern economic theories, such as the Efficient Markets Hypothesis (EMH), which reject both Smith and Fisher’s lessons.
Smith believed that a cap should be set on the interest rate – an outright ban would probably have perverse consequences, but a cap would serve as a way to ensure the money was not lent to “prodigals and projectors,” who Smith thought would “destroy” the capital of a country. Bentham, on the other hand, countered that surely no rational person would be so stupid as to borrow (or lend) money at a high rate of interest, only to have it destroyed.
Despite the historical record of bubbles under capitalism, subsequent economists leaned more towards Bentham’s logic. A prime example was Irving Fisher in his original financial theories, who abstracted from money altogether and wrote that interest merely “expresses a price in the exchange between present and future goods.” Therefore, lenders had a low preference for current goods as opposed to future ones, whereas borrowers preferred more goods today, to a degree reflected by the interest rate. These two ‘schedules’ of time preference, as usual, could be thought of as the demand and supply for loans. Economists were back in familiar territory.
There were, of course, differences, but none such that they could not be assumed away! Fisher had to add the ancillary assumptions that all debts were paid, and that the market cleared with respect to every time interval. Despite these assumptions (and before Friedman), Fisher’s faith in his theories was pretty strong – so much so that his initial response to the crash was ‘don’t panic.’ Fisher’s rationalisations for soaring stock prices will be familiar: a new era of technological development (in those days it was electricity, chemistry and metallurgy); suddenly increased time preference due to consumers rationally anticipating higher future income; changes in the way risk was managed. It took a crash of 90%, which bankrupted him personally, to shake his faith in his theories.
Fisher’s experience gave birth to his alternative theory of interest, speculation and finance, which emphasised dynamic change and systemic violation of equilibrium, which Fisher came to regard as practically irrelevant for study. Fisher’s hypothesis can be stated quite simply:
- On the back of a boom, investors get themselves into more debt that can feasibly be repaid.
- When the bubble bursts, investors sell at reduced prices to try to cover their losses.
- These falling prices mean that the real debt level rises, even as nominal debt is reduced.
- This causes further bankruptcies and losses, and has knock on effects for the economy as a whole.
It’s easy to see from this argument why Fisher thought that the problems with overinvestment and speculation only became significant when individuals were overindebted. This argument – and the events that conform to the story – suggest Adam Smith was correct about a cap on interest rates.
Despite this, Fisher’s arguments were generally ignored: 90% of academic referrals to Fisher refer to his pre-depression work, with its palatable focus on rational individuals, equilibrium and a moneyless economy. This wrongheaded approach was what gave rise to the madness of the EMH.
‘Efficient’ in the context of the Efficient Markets Hypothesis does not necessarily mean that financial markets are perfect. It just means that they act quickly to process all available information, and hence share prices reflect fundamentals. In its strongest form, it effectively says that bubbles can’t happen, but weaker forms also exist, allowing its proponents to weave between the different types, effectively endorsing the strong form but falling back onto the weak one when questioned. The very weakest version – that financial markets are ‘pretty good’ at processing information – doesn’t really lead to any testable predictions and as such cannot be considered a scientific proposition. The stronger versions, however, have many problems.
The fact is that the core of the EMH contains some incredibly ridiculous assumptions. All expectations are presumed to be fulfilled; all investors are presumed to have the same expectations; they all have access to unlimited funds on the same terms. The originator of the hypothesis, W.F. Sharpe (yes, not Fama, even though he is cited as the originator in most textbooks!), predictably appealed to Friedman-esque arguments to justify these. However, as we’ve seen, this is a dangerous perspective. Keen notes that, under Musgrave’s formulation, Sharpe’s assumptions can only seriously be considered domain assumptions, where the theory is true only as long as they are true. But these conditions are not fulfilled in real life: investors have different opinions, can gain only limited funding and on different terms, and expectations are regularly not met (unless economists are arguing investors who are wiped out were so as part of some sort of long term utility maximisation plan).
However, aside from assumptions, there are some obvious observations that thwart the EMH. The first is that, if the EMH were true, we’d expect financial markets to be reasonably stable, fluctuating only when new information were released. This is clearly not the case. The second is the conception of risk pays too much attention to the variation of investments over their performance. Sharpe’s model effectively said that, even if an investment has a higher return in a worst case scenario, the very fact that it is volatile will cause it to be rejected over an investment that could potentially yield a net loss, but is more stable. This is clearly not rational for most investors, who will opt for avoiding a loss every time. The third is the absence of true uncertainty – to which we can attach no probability – and subsequent reliance on Keynes’ mechanisms by which to cope with this: rules of thumb, past performance, heuristics and social conventions.
Keen ends this chapter by noting that the staying power of the EMH is possibly due to the fact that it predicts the market will be ‘hard to beat’ – which it surely is, but probably for reasons other than those presented by the EMH. Keen discusses some alternative theories in a later chapter, which I will, of course, cover in a future post.