The Crisis & Economics, Part 2: The EMH-Twist

This is part 2 in my series on why and how the 2008 financial crisis is relevant to economics. The first instalment discussed why the good times during the boom are no excuse for the bad times during the bust. This instalment discusses the use of the Efficient Markets Hypothesis (EMH) to defend economists’ inability to forecast the movements of financial markets, hereafter referred to as the ‘EMH-twist’.

Argument #2: ““The EMH claims that crises are unpredictable, so the fact that economists didn’t predict the crisis is not a problem for economics at all.”

As far as I’m aware, this argument was first used by John Cochrane, and it has reappeared multiple times since then: for example, it was more recently referenced by Andrew Lilco, who was sadly echoed by the generally infallible Chris Dillow. The idea is that financial markets process new information faster than any one individual, government or institution could, and so for most people they may seem to behave unpredictably. However, economists can not be expected to understand these sudden movements better than anyone else, so expecting them to foresee market crashes is absurd. As Cochrane puts it, “it makes no sense whatsoever to try to discredit efficient market theory in finance because its followers didn’t see the crash coming”.

However, this logic is completely circular. The mere fact that a theory exists which claims crises are unpredictable does not mean that, if a crisis is not predicted – particularly by the proponents of said theory – this shows the theory is correct. If the EMH had, to the best of our knowledge, been shown to be correct, then the EMH-twist might hold some water, but we must establish this truth separately from the the fact its proponents didn’t predict the crisis (David Glasner recently made a similar point about the ubiquitous use of rational expectations in macroeconomics). While Cochrane does claim that the central tenet of the EMH “is probably the best-tested proposition in all the social sciences”, he fails to reference supporting evidence, and in fact goes on to add substantial qualifications to the empirical record of the EMH, admitting that market volatility might happen “because people are prey to bursts of irrational optimism and pessimism”.

It is not necessarily my aim to establish the truth or falsity of the EMH here: it has been discussed extensively elsewhere. However, there are a couple of key tests for whether or not it applies to 2008. The first is whether or not anybody – both adherents and detractors of the theory – foresaw the crisis. While the EMH claims nobody could, this is clearly wrong: some people in finance made a lot of money; some economists not only called it but had frameworks that explained it well once it happened; quite a few people (even mainstream economists) at least noted the existence of a housing bubble. The EMH can attribute these predictions to simple luck, but now we’re back to circularity: assume the EMH is true, then appeal to it to rationalise any possible market movement. The second test of the EMH, since it depends on new information to trigger volatility, is to ask exactly what new information became available just before the crash. However, the financial instruments key to 2008 were used by investment banks for a good few years prior to the crash, so it’s quite difficult to claim that new information about these suddenly became available in 2007-8. Instead, what happened was a collective realisation that everyone knew very little about the products they’d been trading, resulting in a classic panic.

In fairness, there is an element of truth to the EMH-twist. Financial markets are incredibly difficult to understand, and the argument that economists don’t yet understand them, along with a mea culpa, might be acceptable – there are many things natural scientists still don’t understand, such as dark matter, or what happened ‘before’ the big bang. However, the EMH-twist as used by Cochrane et al is phrased more strongly: it is the assertion that economists can’t and shouldn’t understand the movements of financial markets, simply because the EMH allows them to wash their hands of the task. We wouldn’t accept this kind of attitude from any other field, so I can’t help but feel Cochrane’s claim that “the economist’s job is not to ‘explain’ market fluctuations after the fact” can only be met with: “then what is the economists’ job, exactly?”

The next instalment in the series will be part 3: econoracles.

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  1. #1 by J. Edgar Mihelic on June 12, 2014 - 10:20 pm

    Why the scare quotes when you talk about time prior to the big bang? Was time created then? Do you not need linear time to function?

    • #2 by Unlearningecon on June 13, 2014 - 10:35 am

      The answer to all of these questions is ‘I have no idea’.

    • #3 by petermartin2001 on June 14, 2014 - 4:53 am

      The theory is that there was no time before the big bang. That’s the real big bang and not just some banking jargon!

      Its quite counter-intuitive. The big bang theory is accepted as the consensus in Physics not because anyone has a a philosophical liking for that concept, but because it helps explain observable facts.

  2. #4 by chdwr on June 13, 2014 - 2:16 am

    Private Finance is a glaring monopolistic inconsistency existing within alleged competitive free market theory. Look for where such asymmetries of power and wealth are and there you will find what to analyze and correct. The crisis in economics is indeed a crisis for economics. Economic theory is like a zen koan. If economics is the study of scarcity, the true goal of economics should properly be….to destroy economics. Contemplate that…and you’ll realize that a higher state of mind…provides the correct answer…How do you destroy scarcity? By creating abundance. So long as Finance rules….abundance will is but a fantasy.

  3. #5 by rjw on June 13, 2014 - 1:46 pm

    Hard to take Cochrane’s capacity for deep insights all that seriously after the following debacle. The original piece by Cochrane is worth reading in all it’s majesty.

    http://delong.typepad.com/sdj/2012/01/john-cochrane-says-john-cochrane-used-to-be-a-bullshit-artist.html

    Of course, he isn’t alone. Way too many people out there that believe that mastery of the technical details of modern financial theory make you a good economist.

    What is more distressing, is that 2007/8 hasn’t taught enough people enough humility.

    • #6 by Unlearningecon on June 16, 2014 - 12:13 pm

      Cochrane is one of those guys who sometimes comes out with interesting points (though I can’t be bothered to trawl through for examples right now), but intermittently falls back on overstated freshwater political opinions from the 1980s, ones that nobody should really take seriously. It’s always disappointing to see those who quite clearly know better make glib arguments about perfect crowding out or inflation.

  4. #7 by petermartin2001 on June 14, 2014 - 5:01 am

    I suppose you could say neither can the theories of tectonic plate movements can’t be used to predict earthquakes. But at least Geologists have a theory of why earthquakes do occur!

    If the EMH is literally true then there is no reason to expect markets to be other than self regulating and there is no reason to expect there should be any severe financial crises anyway.

    So is like Mainstream or Classical Economics in the same hapless state that Geology would be in if they had no theory whatsoever of why Earthquakes did occur?

    • #8 by petermartin2001 on June 14, 2014 - 5:04 am

      Should be “neither can the theories of tectonic plate movements be used to..”
      and “So is Mainstream or Classical Economics…”

      • #9 by Unlearningecon on June 16, 2014 - 11:50 am

        I’m no seismologist, but my understanding is that earthquakes cannot be predicted because we cannot detect the relevant plate movements (there are too many, or they are too deep into the earth’s crust). If we had the technology/computational power, then we’d potentially be able to foresee earthquakes, at least conditionally or over short horizons. Conversely, the EMH is simply claiming that understanding the movements of markets is impossible and we shouldn’t try. So seismologists’ and economists’ approaches are a world apart, even if their conclusions seem similar at first.

        It’s also worth noting that we don’t have any control over tectonic plates, whereas financial markets are, like everything in the economy, a social and political construct.

  5. #10 by Robert Nielsen on June 14, 2014 - 3:42 pm

    I find that most discussions of the EMH revolve around whether or not markets are predictable, with implication being that if they are not, then the EMH is correct. But surely the opposite could just as likely be the case? Surely markets could be unpredictable, not because they are efficient, but because they are inefficient and people are irrational? It could be possible that there is no logic to be seen behind market movements because they are driven by irrational forces.

    • #11 by Boatwright on June 14, 2014 - 11:49 pm

      How about this?

      Markets are COMPLEX and CHAOTIC. This does not mean they are irrational. Individual actors can be rational or irrational, sometimes both, but not markets.

      I think it time we stop attributing human consciousness (as many do) to a social mechanism. Talk of market rationality, as if the market has its own consciousness, leads to all kinds of foolishness.

    • #12 by Unlearningecon on June 16, 2014 - 11:56 am

      Yes, there are numerous reasons financial markets could be difficult to predict that differ to the EMH. For example, it could be that markets are irrational. Alternatively, it could be that there is, in principal, a model that predicts market movements, but the initial conditions are so sensitive to tiny changes that you need absurd degrees of accuracy to predict far into the future (like weather).

      I’m sure there are countless other possibilities.

    • #13 by said on June 16, 2014 - 9:00 pm

      Also, While we can’t predict when earthquakes will happen understanding why i.e. tectonic plate movements helps us predict where we expect to experience earthquakes and if nothing else move populations away from building there… or monitor closely if for example they are out to sea and predict possible after effects.

      Comparing economics (as it stands today) to natural science theories is apples to oranges since physicists, geologist dont make assertions without evidence and experiments.

      Economists it would appear, like weathermen, can be wrong every day of the week and still keep their jobs.

  6. #14 by Boatwright on June 14, 2014 - 11:25 pm

    The circular arguments of EMH adherents look particularly ridiculous when one considers that there are economists who offer testable hypothesis — with evidence, with congruence to actual economic history, with rigorous math, etc. — that proceed to explain and predict economic instabilities and boom and bust cycles. The Keen/Minsky model is a contemporary example. How about not forgetting John Maynard Keynes either.

    EMH disciples are simply cranks who pursue a simple reductionist idea to absurdity.

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