Posts Tagged Finance
This is the final part in my series on how the financial crisis is relevant for economics (here are parts 1, 2, 3, 4, 5 & 6). Each part explores an argument economists have made against the charge that the crisis exposed fundamental failings of their discipline, with the quality of the arguments increasing as the series goes on. This post discusses probably the strongest claim that economists can make about the crisis: they do understand it, and any previous failures were simply due to inattention or misapplication, rather than fundamental problems with the theory itself.
Argument #7: “Economists had the tools in place, but we overspecialised and systemic problems caught us off guard.”
Raghuram Rajan was probably the first to take this sort of line, arguing that overspecialisation prevented economists from using the tools they had to foresee and deal with the crisis. But while Rajan’s piece also made a number of other criticisms of economics, over time the discipline seems to have reasserted this argument more strongly: not too long ago, Paul Krugman argued that although “few economists saw the crisis coming…basic textbook macroeconomics has performed very well”. Similarly, Tim Harford claimed at an INET conference last year that the tools necessary to understand the crisis already existed in mainstream economics, and the problem was simply one of knowing when and how to use them. He compared financial crises to engineering disasters, which were understandable using current knowledge but happened nonetheless, due to negligence or oversight on the part of the engineers.
So how true is this claim? Certainly, a number of economic models exist for understanding things like panics, liquidity problems and moral hazard. The most well known of these are the Diamond-Dybvig (DD) model of bank runs – which shows what happens when banks have liquid liabilities (such as demand deposits) which must be available at any time, but have illiquid assets (such as loans) which are not fully convertible to cash on demand – and the Akerlof-Romer (AR) model of financial ‘looting’, which shows that deposit guarantees may create moral hazard as investors gamble other peoples’ money. If you combine tools like these, which help us understand the financial sector, with tools like IS/LM, which tell us how to escape a downturn once it happens, in theory you have a pretty solid set of tools for dealing with the recent crisis.
The first objection I have to these models is that many of their insights could be considered trivial, or at least common sense. The DD model came to the conclusion that deposit insurance might be helpful way to prevent bank runs, which is hardly a revelation considering it came 50 years after FDR and the general public figured out the same thing. The AR model came to the conclusion that deposit insurance and limited liability might create perverse incentives as banks gamble ‘other peoples money’, which again must have been obvious to the policymakers who put Glass-Steagal and other financial regulations in place. Perhaps this point is a little harsh, and I don’t want to overstate it: on the whole, these papers are asking important questions, and in the case of AR they answer them well. Nevertheless, there’s no point in economic theory if it can’t tell us things we didn’t already know. Even the idea that central banks should provide emergency liquidity to banks in trouble is quite obvious, and it predates modern economic theory by a good while.
However, this is not the most important point. The issue I have with these models is that in many of them everything interesting happens outside the model. In Krugman’s favoured IS/LM, a ‘crisis’ is represented by a simple shift in the IS curve, which in English means that a decline in production is cause by…a decline in production. Where this decline came from is presumably a matter for outside the model. Even the most sophisticated macroeconomic models often follow a similar tack, merely describing what happens when the economy suffers from a shock, without exploring possible causes for the shock. Likewise, the DD model suggests bank runs happen because everyone panics, but what causes these panics is not explored: it is assumed depositors’ expectations are exogenous, whether fixed or following a stochastic (random) pattern. Yet studies such as Mishkin (1991) find that bank runs generally follow periods of stress elsewhere in the economy, a fact which DD simply cannot capture.
Economic models are narrowly focused like this because they are generally designed to answer straightforward questions about causality: does the minimum wage cause unemployment; does expansionary fiscal policy cause growth; does a mismatch between illiquid assets and liquid liabilities cause bank runs. But the crisis was an endogenously generated process in which different aspects of the economy – the housing market, the financial sector, government policy – combined to create something bigger than the sum of its parts, and in which it is not possible to isolate a single cause. Consider: the collapse of Lehman Brothers may have triggered the worst of the crisis, but was it really to blame? The economy was already in a fragile place due to systemic trends that can’t necessarily be traced to a single law, institution or actor. Just like the murder of Franz Ferdinand in World War 1, we have to look beyond the immediate and focus on the general if we truly want to understand what happened.
To sum up, the economists above want to argue that they are only culpable insofar as they overspecialised and failed to focus on the right areas in this particular instance. However, the reason for this was not just because of personal myopia; it’s because their chosen methodology means they lack the tools to do so. A model of one aspect of the economy which takes the effect of other areas as exogenous will fail to detect potential positive feedback loops and emergent properties. A model which takes the crisis itself as an exogenous ‘shock’ is even worse, and in many ways is hardly a model of the crisis at all, since it offers no understanding of why crises might happen in the first place. Are there alternatives? I have previously written about how post-Keynesian and Marxist models offer more comprehensive understandings of the financial crisis and antecedent decades; I shan’t repeat myself here. Other promising areas include network theory, evolutionary economics and Agent-Based Modelling. All of these share that they take the system as a whole instead of focusing on isolated mechanics.
I see the crisis in economics as a shock (!!) which hits macroeconomics hard and reverberates throughout the discipline. Regardless of the pleas of some, such events can be seen coming, and they cannot be handwaved away as part of an overall upward trend. And even if individual economists are not in control of policy, key economists have substantial influence, not to mention the theories and ideas in economics as a whole. Recent developments in macroeconomics still leave a lot to be desired, while previously existing tools suffer from similar problems: a lack of holism; a wooden insistence on microfoundations; and attempt to understand everything in terms of simplistic causal links, often relative to a frictionless baseline. Finally, although many areas of economics are not directly indicted by the crisis, many of them share key problems with macroeconomics, and as such the crisis should prompt at least a degree of introspection throughout the discipline.
The Efficient Markets Hypothesis is pretty much indefensible. It is based on ridiculous assumptions: all investors have access to money at the same interest rate, have the same information and interpret information in the same way. It also has counterfactual implications: according to the EMH, markets would stay in equilibrium and move only when new information became available (which they don’t); people would not consistently outperform the market (which they do); and in its strongest form, it actually implies that bubbles can’t exist. The only defence its proponents seem to be able to muster is that it can’t predict anything (and sometimes, that economists full stop can’t predict anything). I could go on, and have, as have others. But what’s more important is exploring the many available alternative theories of finance. This is the purpose of chapter 15 of Steve Keen’s Debunking Economics. Keen goes through and assesses the major alternatives to the EMH on by one.
First, Keen mentions the obvious choice: behavioural finance. But he doesn’t really explore all the different heuristics and biases that people experience in financial markets – that would and has taken entire books. Instead, he objects to the way that EMH proponents initially defined ‘rationality.’ Apart from basically meaning prophetic, it was based on a misreading of John von Neumann, the creator of Game Theory, who said that his definition of rational would only apply when games were repeated enough times. A game with an unlikely but large loss as one of the possible outcomes looks less appealing when you do it once than if you play it 1000 times, allowing the losses and gains to even out.
Hence, Keen touches on something that others have mentioned: the whole idea that behaviour is either ‘rational’ or ‘irrational’ is not a useful way to think about human behaviour. In fact, behavioural finance retains some unfortunate implications carried over from economics: that we need to reduce everything down to individuals making choices, and that if only people behaved how economists think they should, then financial markets would be efficient. Having said that, behavioural finance is promising and useful field, though so far it is still in its early stages with no clear forerunning theories.
There are, however, a few theories which have been fully developed, and look incredibly interesting. The additional bonus is that they are complementary to each other (and to behavioural finance).
A fractal is a pattern that looks the same no matter how much you zoom in or out (see above). So it’s no surprises that one of the implications of the fractal markets hypothesis is that markets display similar patterns of behaviour over a day, month, business cycle or what have you. The fractal markets hypothesis models price movements as a function of previous price movements, which explains the emergent fractal pattern, and also means that stock markets will exhibit a tendency for volatility to produce more volatility, something contrary to the EMH.
A skeptical reader might suggest that this implies future price movements are easy to predict, if only one had the relevant formulas. But a system as complex as this would be highly dependent on initial conditions: just a tiny error in the initial values would soon produce results that were wildly offbase. This is what happens with weather models, and is why weather predictions are more likely to be right the closer you are to the day. It is actually probable that calculating prices accurately ould be computationally impossible using a fractal model.
But this might beg another question: why is the stock market not more chaotic? This is explained by dropping one of the assumptions of the EMH: that investors trade with identical time horizons. Similarly to von Neumann’s observations, a trade that looks bad for a day trader due to large potential losses at any one time, could look good for a long term trader if it has net positive yields over a given period. Hence, introducing heterogeneity makes the model more realistic. A highly promising theory.
The Inefficient Markets Hypothesis (IMH)
Provocatively named by its originator Bob Haugen, who has written three books full of data contrary to the EMH. The IMH suggests that markets systemically overreact to price movements, and hence cause incredibly inefficient allocations of resources.
Haugen identified three sources of price movements: event-driven, error driven and price driven. The EMH assumes away the second two, but Haugen has calculated that the third one accounts for up to 95% of stock market volatility, because price movements create a self-perpetuating spiral as investors seek gains or cut losses. Haugen has concluded that the stock market in its current form is a serious drag on investment, and suggested reducing the length of the trading day or simply having one auction per day.
Physicists have recently turned their hand to economics, and, due their strong empirical bent and the relative lack of data in economics, have been drawn to finance, where streams of data are readily available. Keen comments that much of Econophysics would perhaps be better named ‘Finaphysics.’
There has been a plethora of suggested approaches from the physicists, mostly applying their various chaotic theories to economics: earthquake models, power laws, the Fokker-Planck model. Keen does not go into much detail here because, again, it would take an entire book. He briefly goes over Didier Sornette’s earthquake model, which has been used to make explicit predictions about the future of stock markets. Keen directs the reader to this website, which supposedly tracks its predictions, though I cannot find anything after a quick look.
So there are many alternatives to the EMH, and each involve making explicit predictions and drawing on data, rather than handwaving ‘the market is volatile we can’t do anything about it’ statements. Personally, I consider the fractal markets hypothesis the most promising framework, and it is also one that can easily incorporate elements from the other approaches. I look forward to future developments in all of thee theories.
As many readers of this blog will know, Steve Keen is generally the economist credited with best foreseeing and warning about the 2008 financial crash. The 13th chapter of his book is dedicated to showing why his framework foresaw it, and what he did to warn of the coming crisis.
I have seen a few people saying that Keen didn’t really predict the crisis, and what predictions he did make were ‘chicken little’ predictions – repeating “there will be a crisis” until there was one. This is simply not true.
He certainly had the appropriate framework to foresee the financial crisis. His 1995 paper on Minsky and financial instability contains a model prone to endogenous fluctuations, and he concludes that any period of tranquility in a capitalist economy should not be accepted as anything other than a lull before the storm.
The key ingredient in Keen’s framework is, of course, private debt. Since banks create credit ‘out of nothing,’ new private debt adds to nominal aggregate demand. It follows from this that aggregate demand is current income plus the change in debt. I will quote Keen’s numerical example in full to explain why:
Consider an economy with a GDP of $1000 billion that is growing 10% per annum, where this is half due to inflation and half due to real growth, and which has a debt level of $1250 billion that is growing at 20% per annum. AD will therefore be $1250 billion: $1000 billion from GDP, and $250 billion from the increase in debt.
Imagine that the following year, GDP continues to grow at the same 10% rate, but debt growth slows down from 20% per annum to 10%. Demand from income will be $1,100 billion – 10% higher than the previous year – while demand from additional debt will be $150 billion.
Aggregate demand this year will therefore be $1250 billion – exactly the same as the year before. However, since inflation is running at 5%, that will mean a fall in output of 5% – a serious recession. So just a slowdown in the rate of growth of debt can be enough to trigger a recession.
For an economy to grow, either income must increase or private debt must
increase at an increasing rate accelerate; this means that even a slowdown in the rate at which debt is decreasing can create a recovery (as with the US in 2010). The higher the level of private debt relative to income, the more dependent the economy becomes, and the more vulnerable it can be to even a mild slowdown in the rate of change of debt. Thus, in the mid 2000s, when Keen looked up the levels of private debt in developed economies, he was taken aback by the exponential increase:
At this point he went public – most of the evidence for his warning of a coming crisis is from the blog he started, and the monthly reports he released on there, tracking the level of private debt and explaining why it mattered. These reports first analysed the Australian, and then the US economy. He also spoke at a number of events, as well as a few TV and radio appearances which I cannot find online (although the media didn’t really start to take notice until the crisis began).
As a brief aside, I’ve seen a few people mention his failed prediction of the Australian housing crash, and his subsequent having to take a long hike. It is true that he got this one wrong, but there is quite an easy explanation: the government injected a large amount of money into the housing market in the form of first time buyer grants. Coupled with Australia’s resource boom, and the demand from China, this has kept their economy afloat so far.
So the charge that Keen did not predict the crisis, or simply shouted ‘there will be a crisis’ for 10 years until there was one, is false. He has a clear analytical framework that has performed incredibly strongly empirically, both before and throughout the crisis, and he got the dates approximately right (he said 2006). In my next post I will take a more in-depth look at his models and their implications for where we are now.
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.
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.
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.
Simon Wren-Lewis discusses the large gap between mainstream and heterodox economics, and asks why the heterodox economists are so willing to throw out almost every aspect of neoclassical theory. Allow me to offer an explanation.
The reason heterodox economists remain dissatisfied with mainstream economics, no matter how many modifications the latter adds to its core framework, is that there is always an implication that, in the absence of various real world ‘frictions’, the economy would function like a smoothly oiled machine. That is: assuming perfect information, mobility, ‘small’ firms, no unions, flexible prices/wages and so forth, the economy would achieve full employment, with near perfect utilisation of resources, and stay there, perhaps buffeted by mild external shocks.
New Keynesians and New Classicals sometimes act like bitter rivals, but mainly they only differ on which ‘frictions’ should be present or not (this is an oversimplification of the disagreement, of course). The original New Classical models started with economies that are always in equilibrium, preferences are constant, and competition is perfect. New Keynesian models add imperfect competition, sticky prices, transaction costs and so forth. The newest papers go further and add heterogeneous agents (which generally means two), changing preferences, and other ‘frictions.’ However, it is assumed that if the economy were rid some specific features/characteristics, it would function similarly to one of the core Walrasian or Arrow-Debreu style formulations.
So is it not true that real world mechanics prevent things from going as smoothly as they might do in absence of those mechanics? Well, partially. But according to heterodox economists, capitalism has inherent tendencies to crisis, unemployment and misallocation anyway.
A key example of where this is evident is finance. Generally the mainstream analyses of why finance is unstable focus on irrationality, imperfect information, externalities and other such modifications. If only everyone had access to information, if transactions were cost less, and if people were rational self maximisers, then finance would be stable.
Minskyites, on the other hand, argue that this isn’t the real problem. Even if the economy starts stable, the resultant strong returns on investments will cause capitalists/investors to take more risk. This process will continue and the economy will endogenously destabilise itself as higher returns are sought and more risk is taken on, until eventually the capacity to make a return on these risks is outrun and we face a collapse. There is no need to invoke a specific ‘friction’ for this process to occur.*
Another prominent example is the labour market. Generally, economists presume that without ‘search costs’, oversized firms/unions and sticky wages, the economy would achieve full employment. But heterodox economists disagree on a number of counts: the Marginal Value Product Theory is faulty, so higher wages will not necessarily cause unemployment to rise; wages are also an essential component of aggregate demand, so reducing them may well be counterproductive. In fact, Keynes argued that sticky wages were far from a barrier to full employment; they actually stabilised aggregate demand. Steve Keen’s model also produces less severe business cycles when sticky wages and prices are added.
So the reason heterodox economists want to throw the proverbial baby out with the bath water (and also redecorate the bathroom and possibly even move house, or something), is that they think the core of mainstream economics has dug itself too deep into a ditch. The inevitable ad hoc modifications of ‘perfect’ models sometimes have so many ‘frictions’ introduced that the supposed ‘deep’ mechanics that underlie them become questionable. But they are still never abandoned. Heterodox economics is not just about adding a few real world mechanics here and there; it’s about throwing out the entire core and starting over.
*It could be said that this might not occur if Knightian uncertainty were not a factor in the real world, but I think calling this a ‘friction’ jumps the gap between friction and fundamental reality.
Differences between ideological factions can often be exaggerated by political polarisation and rhetoric. People are, after all, programmed to win arguments, not to seek truth. However, it strikes me that there are some significant policies that are supported by those at almost any point on the political spectrum. These are the main ones that spring to mind:
An LVT is a great idea
This is the lost ‘free lunch‘ of classical economics. It is unavoidable, because you can’t move land. It cannot be passed on, as it falls entirely on economic rent. The best way to think of this is that the tax is paid whether or not it actually exists as a tax. Since the supply of land is fixed, the price is determined by what tenants are willing to pay. The tax itself does not change these factors – it just means the revenue accrues to the treasury rather than into private hands. In fact, the tax actually encourages use of land and generates growth, as landowners who do not utilise their land for a productive purpose are still charged and so are forced to sell the land or do something that creates value. Hawaii had to repeal theirs because it resulted in too much development.
Since it creates growth and raises revenue, I’m sure we can all agree that is a win win, particularly in our current situation.
The war on drugs has failed
From whichever perspective you view this, it’s hard to defend the war of drugs, at least in its totality. From a utilitarian perspective, it has created massive black markets, crime, and drug use is still widespread. From the perspective of individual freedom, it is obviously a restrictive state intervention. Even from a purely economic perspective, it costs a lot of money and also misses out on a lot of potential tax revenue. Politically it’s potentially explosive but the anti-government narrative is so strong that it could well be harnessed for legalisation.
Naturally, I wouldn’t advocate lifting all restrictions instantly and favour a more pragmatic approach, but even from a libertarian perspective, that’s better than the current situation.
Financial institutions in their current state are an abomination
What effectively happened here was that the half of the New-Deal era regulations that restrained banks, such as Glass-Steagall, were removed, whilst the half that were designed to protect consumers, such as guarantees, remained. This resulted in hybrids that were allowed to exploit the welfare they received from government without having to remain responsible and prudent elsewhere. They grew so big that they were not allowed to fail and their losses were socialised. As John Lanchester puts it, this is nobody’s idea how the world should work. Whatever is to be done, it will involve taking on these institutions head on, and reforming the financial sector. Whilst people disagree on the details of the second step, the first is a necessary prerequisite that can be supported by all.
Patent law is awful
I am overstepping my bounds here in that I know very little about patent law. However, what I do know is that:
– In its current state, British patent law is so complex that you can technically sue yourself.
– Patent law is not only complex in practice, but also in theory. It is vulnerable to the Tragedy of the Anti-Commons, where individual actors find it impossible to negotiate as there are so many different pieces to put together. This results in some goods never making it to market.
– Patents lead to large amounts of lawsuits, and companies are created solely to extract rents from their copyrights, without actually producing anything.
– Large corporations are generally the main benefactors, as they can afford lawyers and large amounts of patents, making it incredibly difficult for rivals or potential rivals to navigate the market and innovate.
The right might like to frame this as a ‘government granted monopoly privilege’ and the left as just another failure of capitalism, but I know that both oppose it, from those at Mises.org to post-Keynesians like Dean Baker. Intellectual property really needs a clean up.
Inflation targeting doesn’t work
The Bank of England has actually spend a reasonable amount of time outside its implicit 1-3% inflation boundary for the past decade, which makes me question how much control they really have over inflation. More importantly, however, the policy has not created macroeconomic stability – far from it. So a new monetary policy target is required, and whilst I (strongly) favour low long-term interest rates, I would be happy if the world’s Central Banks and governments at least acknowledged the failure of inflation targeting and started to consider alternatives, whatever they may be. I suspect that I am not alone in this, as even the inflation hawks at the ASI have highlighted some of the problems with inflation targeting.
Issues like this should be placed into the limelight, as they are areas where genuine progress could be made. Many of them, funnily enough, favour big business, which makes me suspect that’s why debate is steered away from them in a ‘divide and conquer’ style strategy. In fact, the differences between ideologies are greatly exaggerated elsewhere, too – once people actually consider issues rather than rhetoric, they generally find themselves in more agreement than they expected.
*If Dubai came into your head you are confusing two definitions of land. In the economic sense, land includes the sea, the air, and the rest of the ‘space’ part of the space-time continuum.