Don’t Pick- up that $100 bill. It isn’t really there. Defending Efficient Markets

A guy sees a $100 bill on the sidewalk and walks right by it. A Keynesian comes up to him and asks him why he didn’t pick it up. The guy answers that he believes in the Efficient Market Hypothesis (EMH) – and the bill must not be real or someone else would have already picked it up! This joke is a real knee-slapper for academics. It is meant to demean the EMH. This not only shows why academics are not allowed to mingle with normal people but it also irks me that my fellow academics have too much fun beating a straw horse.

Why defend the EMH?  One reason is because it is 95 degrees and Betty will have me doing tasks in the back yard if I don’t pretend to be doing something in my nice cool basement office/laundry room/ junk room.  The other reason is that it needs defending from people who would use this as part of their rejection of markets and capitalism. Some experts believe that our recent financial crisis proves the EMH is wrong.  Even worse, it gives them a high horse to preach for more stimulus and more regulation.  So I would like to give them a little piece of what is left of my mind.

Before getting into the particulars we should take a step back and think about the whole idea of learning and hypotheses. You don’t have to have a PhD  to see the importance of hypotheses. As a young parent you believe that you should keep a close eye on your two-year-old. You have a hypothesis that if you completely ignore your child, a problem could arise – perhaps even something terrible could happen. I remember when we once saw our neighbor’s child on the roof of their house. They blinked one minute and somehow he was on the roof. It scared the crap out of all of us. Hypotheses like this one lead to action items or policy prescriptions. If the hypothesis is true, then you need to have rules for vigilance. You need to be a very active parent. We usually frown on leashes for children but I know of some parents who have resorted to such things.

Financial economists have a hypothesis about the prices of assets like stocks and bonds – and houses. The hypothesis states that the price you observe in the market for GM stock or for the average of all stocks is the result of buyers and sellers searching for all the relevant information, analyzing it, and then using it in their sales and purchases. This is not very sophisticated stuff. It just says we are not a bunch of LAZY LOSERS. Most of us – before we buy a refrigerator or a car or a share of stock – try to figure out what it is worth or at least find some information that would support our buying the item at a particular place and time. Suppose you do a little research and you are ready to buy the latest I-Phone when your mother comes in and says she heard that I-Phones cause pimples. But the Droid does not cause pimples… So you look in the mirror and pop a few – and then make your decision based on all the information.

This is not a crazy hypothesis to say that people try to buy as well as they can! Would you rather assume that most people are really lazy and ignorant and dumb and they just buy stuff regardless of price or other relevant information? I hope not. My father would spin in his urn.

Okay – so people – both buyers and sellers – gather and utilize information when trading various assets. This implies that the current market price, which is determined by the interactions of buyers and sellers, REFLECTS THE STATE OF RELEVANT EXISTING INFORMATION. It makes no sense that people would totally ignore pertinent information that was out there.

Basically this is what the EMH says – that current prices embody current information. It also implies that it is difficult for someone to make gains in the market that are not available to everyone else. If prices register all the current information, then it is difficult for one person to profit from the information.  If the EMH is true, it stands to reason that it is hard to “beat the market”. EMH friends advise me that I should buy an index fund and just hold it. Trying to pick individual stocks and to time the market (buy low and sell high) is virtually impossible if information is abundant.

Another implication of the EMH is that government intervention into markets is unnecessary. If prices are being driven by information flows about fundamental factors, then prices are playing their appropriate roles in a market system. Consider the recent bubble in asset prices. At the time Alan Greenspan did not think the Fed could or should do anything about rapidly rising housing and stock prices. Presently the government doesn’t talk much about a bond price bubble. Why? Because Greenspan and Bernanke believe that asset prices are being determined by fundamental factors.  They may not like these fundamental factors but by their very nature they are not easy to change or remediate with policy.

But notice that if the EMH is wrong, then perhaps phantoms or something or someone terrible is behind price changes and something should be done about it.  This creates a stronger role for government intervention – if the EMH is false. So is it true or not?

One piece of information being used these days is to point to Hedge Funds and to acknowledge that some of them have made a ton of money choosing stocks and timing the market. If you have not already, you should read Sebastian Mallaby’s “More Money than God”.  But just because there are examples of Hedge Funds or other investors who made a lot of money, this does not necessarily disprove EMH. How many Hedge Funds lost money trying to pick stocks and time markets? How many funds made a lot of money trading only to eventually lose it using the very same models and approaches? All it takes is a few very successful and very lucky pickers to get the attention of the press. A few successes do not, however, make a rule. If 10,000 monkeys are given computers and 10 monkeys print out the line – Davidson should receive a Nobel Prize – then would you nominate me for the award next year?   Hopefully the outputs of the 9,990 monkeys would have some sway with you.

Furthermore, the EMH never said that it is impossible for some people to know more than others for a time and it never said it was impossible for unscrupulous people to contrive means to fool the public. The EMH only says that ability to corner the market on information should not go on forever and once information becomes public prices will reflect fundamental forces.  

Finally, there is the paradox that if EMH is true, how is it possible that asset price changes could look so much like bubbles? You have heard all the stories of rapid price appreciation – and people wondering just how long it would keep up. In the meantime, people were buying houses and stocks at prices that seemed drastically out of line with reality. How can a story about rationality and efficiency explain buying $100,000 condos for $300,000?

The answer lies in what you consider to be the appropriate price. Should the appropriate market price consider future expectations?  You are considering buying a nice condo. Last year similar condos were selling for $100,000. Today you learn that oil has been discovered on the property and all condo owners are expected to receive $500,000 in future royalties. What would you pay for that condo today? That lovely little property that was worth $100,000 yesterday is worth more like $600,000 today. Is that irrational? That’s a big change—but it can be explained by expectations about the future. What would the condo be worth if scientists found that the property was being built on top of a former electronic factory and that the land was giving off cancerous fumes?

I hope you are getting the point that the EMH is perfectly compatible with extreme changes in price. Now, let’s apply this to recent events. There were plenty of reasons to explain why housing and stock prices were rising before 2008. No one can know the future so there were many thoughtful discussions that led many people to conclude that the fast pace of house and stock prices made some sense. There were also many people warning that the prices could not sustain such a rapid pace. All opinions were out in the public and all we can say in retrospect is that people operated with an expectation that prices would continue to rise. That expectation made more people willing to buy and willing to buy at a higher price. The expectations were self-fulfilling. At least they were until the correction came. While this suggests that bubbles do pop or corrections do come – this does not in any way disparage the EMH. EMH simply says people use information in transactions. When expectations about the future are strongly and passionately held – this is part of the information. Those prices that today seem so out of pace with reality – were efficient guesses three years ago. They used all the information.

Today we have a different set of expectations and a different and depressed level of prices. These are efficient prices for today’s information. And this leads us to the final point – what can or what should be done. Let’s not throw away the EMH – rather let’s use it to decide what to do. It seems to me that what went wrong were two things. First, regulators didn’t do their jobs. The whole credit chain fell apart as EVERYONE justified their expectations by leveraging in dangerous and illegal ways.  And the regulators let them. Second, policymakers helped to sustain the fundamental factors that led to a desire for more leverage and for higher asset price inflation. Greenspan didn’t see how low policy-induced interest rates induced a desire to take more risk in markets.  The Fed stoked the fires.  And Fannie/Freddie fanned the flames.

Now the expectations are that prices will continue to fall. That means there is a good way and a bad way for policymakers to act now. The bad way is to try to grease the wheels of credit expansion. That just gets up back into the same garlic pickle.  The good way is to approach the fundamentals. People will believe that the worst is over when policymakers earnestly address what was wrong. To do this they need to do sensible things that reduce our need to leverage ourselves beyond our ability to pay.  Regulation and policy should be addressed to sensible use of borrowing by the government and the private sector. Until they do that it is hard to see an end to the current economic slowdown. Now where did that $100 bill go?