Archive for September, 2012

Exogenous and Endogenous Money: Room for Reconciliation?

A common response made by economists to my previous post on the overwhelming evidence for endogenous money is: ‘so what?’ Economists rarely disagree about the mechanics, but assert that there are no major implications of endogenous money that differ from their theories.  This is a mistake. Reality is so complex that seemingly small errors in a model can have a big impact on its conclusions. As I will show, endorsement of the exogenous money theory causes economists to miss some key features of a capitalist economy.

It is worth noting that the names are perhaps misleading, as both theories contain endogenous and exogenous elements. In the case of exogenous money, the central bank expands the supply of base money, and the reaction of banks to this – how much they ‘lend out’ – is in large part endogenous. In the case of endogenous money, banks create loans as they please, except for an exogenous constraint (the interest rate), set by the monetary authority*. Clearly there is a large crossover between the two theories, but there are also subtle differences, which lead to important conclusions.

A point emphasised by endogenous money proponents is the robust correlation between private debt and other key variables such as growth, stocks and house prices:

Obviously correlation doesn’t equal causation, but it is based a theoretical link Keen often mentions – Minsky’s observation that, in order for aggregate demand to increase, planned spending must be greater than current income, and therefore credit must fill the gap. This is a pithy observation, but it seems to me that, contra Keen/Schumpeter/Minsky, the exogenous money model can account for this: the central bank fills the gap by increasing the money stock. This can cause both an increase in debt and an increase in aggregate demand, but, in contrast to the endogenous story, the increase in debt does not cause the increase in aggregate demand.

In other words, the exogenous story is that central bank expands the money supply, and this increases both debt and AD. The endogenous story is that banks expand credit, which expands aggregate demand and forces the central bank to expand the money stock. Thus both are compatible with the correlation between private debt and growth, although the exogenous story would not necessarily have the correlation so tight, or have private debt moving first every time.

In any case, given the other evidence – that credit money expansion precedes base money expansions, that central banks have failed to control base money in the past, and that anyone who actually works in a bank will tell you they make loans independently of the number of reserves they have – endogenous money appears to have the mechanics correct.

So why does this matter? Well, the exogenous story has the causality backwards: it assumes that banks receive reserves and then ‘lend them out,’ whereas what they actually do is make loans and then balance their reserve requirements afterwards. Obviously this means economics textbooks are wrong about the causal mechanics, but economists will likely plead that it doesn’t really matter. However, it matters for a couple of reasons.

The first is stability: if banks have adequate reserves before they make loans, a bad loan will cause problems for the bank that lent them out. But if the banks depend on each other for reserves, and look after the loans have been made, then bad loans can quickly destabilise the entire system as the availability of reserves dries up, triggering a positive feedback loop rather than a return to normality. Thus the system is highly interlinked, and far more vulnerable to systemic crises.

Even more crucially, endogenous theory means that money is effectively created and destroyed by the banking system. This is because debt-based assets and liabilities expand and contract simultaneously as debts are repaid; in other words, the loan-ee is both the saver and the borrower. When the loan is created it is deposited in the recipient’s bank account; as this is paid down both the asset and liability are discharged. Reserves are a secondary consideration and the availability of them does not affect lending decisions. It is true that, in name, the reserves ultimately come from the central bank. But really the expansion of spending power is an endogenous decision, though the central bank influences it via setting the price of reserves.

Simply put, debt does not cancel out at the macro level; it scales up. Just as it is true for a household that income can be scarce relative to debts, it is true for the economy**, which as a whole can find itself over-indebted.

Economists often realise that disequilibrium and finance are important, but their faulty view of the banking sector causes them to miss the mark. Take neoclassical models such as Krugman’s, which argue debt is merely a redistribution from savers to borrowers, and have to add ‘special case’ considerations to make debt matter. But this is misguided – debt always matters, because money enters the economy primarily as new debt, which the economy must expand to service. Hence, debt must go into productive investments, which create future income streams, rather than bidding up the price of assets. I doubt economists such as Krugman would object to the policy implications of this argument, but their models do not imply it is important.

Thus, the name for endogenous money strongly implies its conclusions: the system is easily destabilised endogenously, and the money stock endogenously expands and contracts to accommodate activity (thus rendering the ‘neutrality of money‘ an absurd proposition in any time frame). The differences in the fundamentals are perhaps more subtle than endogenous money proponents make out, but the conclusions are extremely different, and have strong implications for equilibrium analysis, crises and the relationship between finance and the real economy.

*They can also be constrained by regulation, but that is another story.

**This is the only time I will use a household analogy to communicate a point about the economy as a whole.


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Endogenous Versus Exogenous Money, One More Time

Few debates are as central to the heterodox-mainstream divide as endogenous and exogenous money theories. Neoclassical economists side with the exogenous ‘money multiplier’ idea, which says the banks receive reserves from the central bank, which they then lend out. Endogenous money proponents – generally post-Keynesian – side with another story, which says that banks create loans ‘out of nothing’ first, then the central bank more or less passively accommodates their demand for reserves.

In a final bid to demonstrate to economists that there is a difference between the two theories (and that theirs is wrong), I’m going to go through the age old scientific method known as ‘falsification,’ analysing each prediction of endogenous and exogenous money, and asking whether or not it corroborates with the data.

#1: exogenous money predicts reserves, or base money, would move first, followed by broader, credit based measures of the money supply as this was ‘lent out.’ Endogenous money predicts reserves would move last.

The relevant data was, ironically, put forward most conclusively by none other than the Real Business Cycle theorists Kydland and Prescott:

There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.

By some measures the broader money supply moves many months before the monetary base. This is in keeping with the endogenous theory of money.

#2: exogenous money predicts that the central bank can control the quantity of base money at will. Endogenous money predicts it must play the role of passive accommodation, otherwise the economy will implode.

As John Kenneth Galbraith put it, “Milton Friedman’s misfortune is that his economic policies have been tried.” Monetarism was tried in the early 1980s: in the UK, the US and Chile. But the central banks consistently undershot their money targets and interest rates went wild. The policy certainly succeeded in increasing unemployment and therefore taming inflation, but the attempt to control the money base failed completely. Again, this is evidence in favour of endogenous money.

#3: exogenous money predicts that reserves factor into bank’s lending decisions; endogenous money predicts that they do not, and decisions about reserves are taken after loans are made.

Anyone from the real world – bankers, lawyers, accountants – will tell you banks do not consider reserves when lending. They use double entry bookkeeping to simultaneously create an asset (your loan) and a liability (your deposit, in which the loan is ‘stored.’) The books are balanced; if they need reserves they will borrow them from other banks or, failing that, the central bank.

That the central bank could say no means some might interpret endogenous money as a policy issue, but it isn’t – as I explained in my previous post, it reflects the reality of capitalism: banks must make lending decisions based on endogenous activity, and the central bank must accommodate this. If it does not, the credit markets will simply not work, and credit crunches will ensue.

#4: exogenous money predicts that only the distribution, not the level of private debt matters

In the exogenous story, banks act as intermediaries between savers and borrowers. Money is deposited; the bank lends this out. It does this until it either does not want to lend out for whatever reason, or until it hits the limit of how few reserves it can hold. Private debt simply represents a distribution from one person to another; the level alone should not have much macroeconomic impact.

In the endogenous story, banks create purchasing power out of nothing by crediting their customer’s accounts. This implies that an increase in private debt will add to nominal aggregate demand, and hence that private debt expansion will precede nominal growth, and also be correlated with other economic variables:*

We might expect some correlation between economic activity and private debt in the neoclassical model. But a correlation as robust as this, with private debt moving first, strongly supports the endogenous money theory.

#5: exogenous money predicts that increases in the money base will have an impact on bank’s lending and other economic indicators (with some qualifiers). Endogenous money predicts this will be minimal (though reserves may ‘oil the wheels’ of the system somewhat).

Ben Bernanke’s unprecedented doubling of the monetary base obviously did not lead to a massive surge in lending. Neoclassical economists do have some explanations for this, namely that the ‘money multiplier’ collapsed – in other words, banks do not want to lend out the reserves, or there is a lack of demand. This is believable, but really it’s just a tautology – if reserves will increase lending except when they won’t, economists have told us nothing. We do not have a scientific proposition.

Overall I’ll put this one down as ambiguous, but its certainly not a falsification of endogenous money.

I’ve always sided with endogenous money because it is supported by the evidence. If anyone can offer me contrary evidence about the above or other relevant hypotheses, I’ll be happy to listen. But economist-y special pleading about how, even though exogenous money is wrong, the economy behaves as if it is right, or about how I’m not allowed to refute ‘centuries of theory,’ is simply not enough when the evidence is this strong.

*If you are wondering what the ‘credit accelerator’ is, it is the change in the change in debt (acceleration), which is what matters when you do the basic calculations. For more, see here.

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Debunking Economics, Part X: Causes of the Great Depression (and Great Recession)

Chapter 12 of Steve Keen’s Debunking Economics is a critique of a pervasive neoclassical interpretation of the Great Depression (and, by extension, the Great Recession): that the severity of the downturn can be attributed to contractionary monetary policy at the Federal Reserve. As you’d expect, this doesn’t mesh well with the endogenous money theory to which Keen (and I) subscribe, which says that the money supply is largely controlled by private banks.

Keen begins by cataloging Ben Bernanke’s evaluation of the Great Depression, which built on Friedman and Schwartz’ A Monetary History of the United States. From the quotes Keen presents, Bernanke’s offering really seems to be neoclassical economics at its reality denying worst:

the failure of nominal wages (and, similarly, prices) to adjust seems inconsistent with the postulate of economic rationality


[On Minsky’s FIH] I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.

Having said that, the case that the Federal Reserve exacerbated the Great Depression by contracting the money supply does have some substance to it, and is worth discussing.

There is no denying that the Federal Reserve contracted base money at the onset of the Great Depression. But it is a leap to suggest this was the primary cause of the prolonged slump – firstly, the contraction of base money was less than 2% on average. Secondly, there has been one other occasion where base money has contracted nominally (1948-50), and six other occasions where it has contracted when adjusted for inflation. All of these – bar one – were correlated with recessions, but none were correlated with depressions.

Keen presents a graph showing a complete lack of correlation between unemployment and M0:

Instead, there is a much clearer correlation with broader, credit-based measures of the money supply:

From this, it’s quite clear from that the primary cause of the Great Depression was a collapse in aggregate demand, caused by a contraction of credit by private banks. Bernanke and other neoclassical economists are reluctant to accept this conclusion, because it conflicts with the neoclassical vision of the economy as inherently stable, bar perhaps a few frictions, and also renders invalid many of their preferred modelling techniques. For someone like Friedman, the conclusion is simply unacceptable, because it conflicts with his insistence that ‘the government’ is the cause of most significant problems.

The money multiplier, again

Keen catalogues the evidence against the money multiplier story that lies behind Bernanke and Friedman’s interpretation of the Great Depression. In this story, the Central Bank (CB) expands reserves, and private banks then make loans, keeping a fraction of the reserves so that they can accommodate demand for money from customers. These loans are then deposited, and a fraction is kept, and this process continues until no more can be lent out. The amount of loans is that inverse of the fraction banks are required to hold as reserves.

What are the problems with this story? First, the observed reality in banks is that they create loans and deposits simultaneously, and as such do not require reserves before they lend. Second, the change in credit and broader measures of the money supply precedes changes in reserves, rather than the other way around. Third, the failure of monetarism – a disastrous policy used in the 1980s where the CB tried to stabilise money growth, but consistently overshot their target. Fourth, Bernanke’s increases in base money during 2008, which resulted in little to no change in economic activity:

For a more in-depth treatment of the money multiplier by Keen himself, see here.

It is worth noting that it is strictly true that the CB controls base money, and as such some might interpret the endogenous interpretation as one of policy. But the fact is that endogenous money reflects the reality of capitalism: firms need capital before they make sales, and banks must accommodate this to keep the economy moving. The CB – though it has some discretion – simply has to play the role of passively accommodating endogenous activity, otherwise capitalism will not work.

Onto the Great Recession

Keen ends the chapter by documenting a few papers that have attempted to understand the Great Recession – McKibbin and Stoeckel (2009); Ireland (2011); and Krugman and Eggertson (2011). The first two, unfortunately, do not even attempt to create a role for private debt. Instead, the recession is due to a series of external shocks – such as changes in preferences and technology – whilst its length can be attributed to factors such as wage and price rigidity, which get in the way of capitalism’s underlying tendency to stability.

Krugman and Eggertson’s, on the other hand, commendably notices how important private debt seems to be, but only gets as far as modelling it as a special case, in which ‘patient’ agents save, and ‘impatient’ agents borrow. In some ways this observation is true – when money is paid back, it disappears into extremely ‘patient’ agents: banks, who have an MPC of 0. However, banks create rather than save this money, and hence it is added to aggregate demand. This process is, unfortunately, something Krugman says he “just doesn’t get.”

Ultimately, Krugman’s paper is the same story as the others: a one-off event, imperfection, special case, creates a problem in an otherwise stable economy. All three papers fit Bob Solow’s characterisation of New Keynesian models – they fit the data better because economists add “imperfections…chosen by intelligent economists to make the models work better.” All briefly reconsider building new theories from scratch, before simply reasserting the neoclassical core. There really needs to be more soul-searching from economists than this.

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Why Prefer Preferences?

Nick Rowe offers a summary of the Cambridge Capital Controversies that, though it is tongue in cheek and should not be taken too seriously, substantively leaves a lot to be desired. He states that the debate started because “some economists in Cambridge UK wanted to explain prices without talking about preferences.” This is false – the debate started because Joan Robinson and Piero Sraffa took issue with a production function that used an aggregate capital stock k, measured in £, with a marginal productivity. However, despite the faulty summary of the controversies, and to Rowe’s credit, some good discussion followed in the comments.

Sraffa built up an entire model just to critique neoclassical theory. It followed neoclassical logic, but replaced the popular measure of capital with a more consistent one: summing up the labour required to produce it, and the profit made from it. His model of capitalism started with simplistic assumptions, but increased in complexity. Within the confines of his own model, he showed several things: the distribution between wages and profits must be known before prices can be calculated; demand and supply are not an adequate explanation of prices, and the rate of interest can have non-linear effects on the nature of production. I cover this in more detail here.

Rowe’s primary criticism of Sraffa is that his model did not use preferences, which is a criticism also made by others.  But eliminating preferences is a neglibility assumption: we ignore some element of the system we are studying, in the hope that we can either add it later, or it is empirically negligible. As Matias Vernengo notes in the comments, Sraffa was deliberately trying to escape the subjective utility base of neoclassical economics in favour of the classical tradition of social and institutional norms, so he assumed preferences were given. This is just a ceteris paribus assumption, which economists usually love! In any case it turns out that preferences can be added to a Sraffian model, with many of the key insights still remaining. Indeed Vienneau’s model (and, apparently, the work of Ian Steedman, with whom I am unfamiliar) invoke utility maximisation and come to many of the same Sraffian conclusions about demand-supply being unjustified.

Rowe also criticises Sraffa’s approach because it puts production first, over the consumer sovereignty upon which neoclassical economics is built. Should preferences provide an explanation of decisions? It appears Rowe does not take seriously the ‘chicken and egg’ problem with neoclassical models – surely, production must occur first, yet models such as Arrow-Debreu take prices as a given for firms, before anything is made.

In a modern capitalist economy, it seems illogical to say that the demand for a particular good comes first, then the supply follows as firms passively try to accommodate it. If it were true, advertising wouldn’t exist, or would be incredibly limited. It is fair to say that, independently, people have a ‘preference’ (though I’d say instinct) for food, shelter, clothing, security and other creature comforts. However, demand for most goods and services beyond this is certainly generated by advertising, marketing and other exogenous factors – advertising and marketing are one of the two primary expansion constraints experienced by real world firms (the other is financing, which, incidentally, neoclassical models often assume away too, but I digress).

An alternative way to model human behaviour would be an institutional/social norm perspective: while people instinctively want to subsist, what exactly they choose to subsist on is in large part dependent on their surroundings. There is the example of tea consumption in Britain, which started as a luxury and took decades to filter down to the lower classes. Similarly, if I had been born in India, I would probably have more of a taste for spicy foods. It’s hard to deny these things are largely dependent on social surroundings, rather than individualistic consumer preferences. Similarly, Rowe’s focus on the time-preference explanation of the interest rate seems to ignore that this will be largely dependent on institutional factors such as the state of the economy.

From an individual perspective, perhaps Maslow’s Hierarachy is a useful way of understanding purchasing decisions: after people have obtained basic needs such as food and security, things they buy are to do with identity and emotion. Don’t believe me? These concepts are exactly what firms use to try to expand their market base (for a longer treatment, see Adam Curtis’ documentary). If people don’t buy products because firms associate them with ‘self actualisation,’ then firms are systemically irrational.

Overall, I don’t think there are there any cases in which we can evaluate individual’s preferences outside a social and institutional context. Sraffa considers the economy as a whole, and leaves subsequent questions about consumers to be answered later – which they have been. Conversely, putting preferences first and having firms passively accommodate their demand runs into several logical problems, and does not corroborate with what we know about both firms and people in the real world.

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Value Judgments in Economics

Simply stated, economics is the science of how society produces and distributes scarce resources. In this sense, economics necessarily requires that economists make value based judgments when prescribing economic policies – is this method/pattern of distribution desirable? Says who?

Despite this, mainstream economists generally insist that their science is value free. In this post I will discuss some of the main value judgments I believe are implicit in economics, though I will not really evaluate them – the post is mainly aimed at establishing value judgments exist in economics.

I consider much of what I am claiming about economic theory uncontroversial, so I will not offer extensive supportive evidence, but am happy to if any claims are disputed.

Economists emphasise the distinction between normative and positive economics, but they often forget that – even presuming we can reliably separate the two – the decision to study one over the other is itself a value judgment, and therefore a normative decision. This is, quite simply, because a value judgment is about whether something is desirable or not – if we believe it is more desirable to study either positive or normative economics, we have made a value judgment. So from the beginning, value judgments enter into the equation, no matter how hard we try to make it otherwise.

Furthermore, the decision about which area to study has normative implications, even if it is studied from a purely positive perspective. It is important which questions economics asks. Does economics ask questions about either work or consumption? Does economics ask questions about recessions, or booms? Time itself being a scarce resource, the economist must choose what to study. This too implies a judgment about how time should be distributed – studying something implies the area is important; not studying it implies the opposite.

The assumption that efficiency is desirable is a core value judgment in economics. Efficiency generally translates as ‘more stuff for cheaper,’ at least in the absence of externalities, and is sometimes equated with social welfare. Policies are often judged on the grounds of whether or not they are ‘pareto efficient’ – whether nobody can be made (materially) better off without making somebody worse off.

So, according to economists, why is a higher quantity of goods and services at a lower price a good thing? Because people gain utility from consuming goods and services – utility is, by definition, a good thing, as it represents people’s underlying ‘preferences’ – what they judge that they want.

By extension, choice is good because it allows consumers more avenues by which to maximise their utility. Markets, as well as capitalism, are generally desirable, because they provide choice and utility for consumers. Competition is generally presumed to increase the quantity of goods provided and lower the price. Again: this is more ‘efficient,’ and efficiency is good, so competition itself is good. Growth is good on similar grounds (though also on other ones, such as creating employment). Even though economists admit that there may be negatives to growth, it is generally presumed that we’d want growth in absence of these negatives: taken in isolation, growth is desirable.

However, as the above quote shows, the desirability of policies is not limited to a lower price and higher quantity. If externalities are present, then we shift from merely ‘higher quantity, lower price’ to ‘the right quantity and price.’ Another value judgment – that imposing costs (benefits) on others must be disincentivised (incentivized) – has entered the equation, and textbooks generally presume that these injustices must be corrected.

Economists often counter that efficiency is simply studied technocratically, and the judgment about it being desirable is external. But, as above, that efficiency is deemed the appropriate criterion by which to study a market economy is already a judgment. And most textbooks/lecturers make the jump from descriptive to prescriptive:

First we show how a perfect market economy could under certain conditions lead to ‘social efficiency.’ … [we then] show how markets in practice fail to meet social goals. These failures provide the major arguments in favour of government intervention in a market economy.

‘Social efficiency’ here is defined as above – more stuff for cheaper; with externalities, the ‘correct’ amount of stuff at the correct price.

There are also some obvious economic value judgments which are so ingrained into everyone’s minds that few would disagree with them (Austrians might take exception to the 2nd): too much inflation is bad, deflation is bad, and too much unemployment is bad. Economic theory emphasises the (supposed) ‘trade-off’ between inflation and unemployment, and where we want to draw the line is also a value judgment.

I don’t think it is possible to study economics without some value judgments. But these should not be cloaked in the guise of objectivity and inevitable economic ‘laws,’ which usually contain judgments about how important efficiency and production are (‘it will impact the consumer’). Instead, economists should be open about the values implicit in their subject, and how these impact their analysis and policy conclusions.

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Debunking Economics, Part IX: Interest, Stocks & Debt Deflation

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 Markets

‘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.

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