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Why does the efficient markets hypothesis matter ?

July 23rd, 2004

Reading the discussion of earlier posts about the efficient markets hypothesis, it seems that the significance of the issue is still under-appreciated. In this post, Daniel Davies pointed out the importance of EMH as a source of pressure on less-developed countries to liberalise capital flows, which contributed to a series of crises from the mid-1990s onwards, with huge human costs. This is also an issue for developed countries, as I’ll observe, though the consequences are nowhere near as severe. The discussion also raised the California energy farce, which, as I’ll argue is also largely attributable to excessive faith in EMH. Finally, and coming a bit closer to the stock market, I’ll look at the equity premium puzzle and its implications for the mixed economy.

To recap, the efficient markets hypothesis says that the prices generated by capital markets represent the best possible estimate of the values of the underlying assets. So, for example, the price of a share in Microsoft is the best possible estimate of the present value of Microsoft’s future earnings, appropriately discounted for time and risk.

The EMH comes in three forms. The weak version (which stands up pretty well, though not perfectly, to empirical testing) says that it’s impossible to predict future movements in asset prices on the basis of past movements, in the manner supposedly done by sharemarket chartists, Elliot wave theorists and so forth. The strong version, which almost no-one believes says that asset prices represent the best possible estimate taking account of all information both public and private. For policy purposes, the important issue is the “semi-strong” version which says that asset prices are at least as good as any estimate that can be made on the basis of publicly available information. There’s a heap of evidence to show that the semi-strong EMH is false, but the most dramatic, as I pointed out recently, is that of the dotcom boom, when obviously hopeless businesses like Pets.com were valued at billions of dollars. I’ve discussed this a bit more here

An apparent, but not real, moderation of the semi-strong EMH is the formulation offered by James Surowiecki of a number of commentators, summarised by Daniel, that “whether or not markets are perfectly efficient, they’re better than any other capital allocation method that you can think of.” It’s clear that, if capital markets are always the best possible way of allocating capital then they must produce the best possible estimates of asset values, given available information, and this is just a restatement of semi-strong EMH.

A much more defensible position is that, even if capital markets are not perfect, neither is any alternative, and it is therefore an empirical question whether unregulated capital markets or some alternative, such as regulation or public investment, will yield better outcomes in any particular case. This formulation leads straight to the basic economic framework of social democracy, the mixed economy, leaving, of course, plenty of room to argue about the optimal mix.

Now let’s look at some specific cases where the EMH gives a simple and misleading answer, and where a more careful analysis leads to mixed-economy conclusions.

First, there’s the question of foreign exchange markets. As Daniel observed, the EMH implies that the optimal policy is to allow exchange rates to be determined by unregulated capital markets, in what is called a ‘clean float’. The experience of the Asian crises, and also of Chile and China, suggests that developing countries may do better with controls that limit short-term capital flows. But even among developed countries, belief in the desirability of a clean float has faded. The volatility of exchange rates since the collapse of the fixed exchange rate regime in the mid-1970s has been much greater than expected, and much more than can be explained by any sensible model of rational markets. Most central banks have come to adopt a policy of ‘leaning against the wind’, that is, buying their own currency when the exchange rate is well below the long-run average (sometimes called Purchasing Power Parity, though this isnt quite accurate) and selling when it is well-above. On average, this has been a profitable long-term strategy. A lot of economists, starting with the late James Tobin, would go further and tax foreign exchange transactions in the hope of reducing volatility. The lesson here is that neither rigidly fixed exchange rates nor a perfectly free float is likely to be optimal. You can read some more on this here

Second, there’s energy, and particularly electricity. Until the 1990s, electricity was supplied either by public enterprises (most places except the US) or regulated monopolies. These did not do a perfect job in making investment decisions. Roughly speaking, when engineers were in charge, there was “gold-plating”, notably in the form of excessive reserve capacity. By contrast when accountants or Treasury departments were in charge, capital was rationed tightly, and investment decisions were determined largely on the basis of attempts to get around the resulting artificial constraints.

The EMH implied that private capital markets would do a far better job. This in turn led to the creation of spot markets for electricity which otherwise made little sense, since, in the absence of highly sophisticated metering, most users could not respond to market signals in the required fashion (the big consumers, who could respond, typically had contracts specifying if and how much their supply could be cut in the event of a shortage). In practice, this produced huge reallocations of wealth while failing to produce either sensible signals to consumers or rational investment. Instead, the pattern in investment was one of boom and bust. As a result, there’s been a steady movement away from spot markets and towards the reassertion of more co-ordination and planning of investment. I’ve had a bit more to say about this here

Finally, there’s the equity premium puzzle, that is, the fact that average returns to equity are far higher than can be accounted for by any sensible model incorporating both reasonable risk attitudes and the efficient markets hypothesis. If you reject the efficient markets hypothesis, it’s natural to conclude that the true social cost of capital is close to the real bond rate. This in turn allows us to evaluate privatisation by comparing the profits forgone with the interest saving that arises when sale proceeds are used to repay debt. For Australia and the UK, such an analysis produces the conclusion that most privatisations have reduced welfare. Some of the evidence is in this paper (PDF file), and there’s a more rigorous analysis here (PDF). Responding to this argument, Brad DeLong observes, with customary acuteness that my argument implies that “the natural solution to all this is the S-Word:Socialism:public ownership of the means of production”.

Actually, however, while this aspect of the argument, taken in isolation, would imply that public ownership always outperforms private, there are plenty of factors going in the other direction, such as the principal-agent problems associated with the absence of an owner-manager or a threat of takeover. So, the correct conclusion, as foreshadowed above, is that the optimal arrangement will be a mixed economy.

Determining the optimal mix is a difficult task, requiring lots of case-by-case analysis, but I’ll offer the view that the optimal public share of production and consumption is unlikely to be below 25 per cent, and is typically close to 50 per cent. For a contrasting view, I’ll point to my distinguished predecessor at the University of Queensland, Colin Clark, who thought 25 per cent was an upper bound. I’ll need another big post to spell out my claims here, and this will take some work. In the meantime, feel free to pitch in with your own views.

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  1. Harry Clarke
    July 23rd, 2004 at 23:44 | #1

    “…the efficient markets hypothesis says that the prices generated by capital markets represent the best possible estimate of the values of the underlying assets. So, for example, the price of a share in Microsoft is the best possible estimate of the present value of Microsoft’s future earnings, appropriately discounted for time and risk”.

    Is the “So” here right?

    I thought the first sentence was the EMH, that stock prices were a random walk — the history of prices doesn’t tell you anything more about future prices than does the current price.

    The second sentence I thought was the “fundamentalist” theory that stock prices mainly reflect expectations of future earnings.

    I thought these were different claims.

  2. July 24th, 2004 at 03:04 | #2

    i see no reason to have currencies floated against one another. the standard example of candians buying american cars if they are cheaper there, and thus raising the US dollar seems unnecessary.

    with one fixed currency, the price of goods would simply fluctuate, and we wouldnt have the perverse situation of China, (and apparently Japan before it) of keeping the US dollar high so they would buy lots of exports from these countries.

    furthermore, hot flows of money, as you point out are merely speculative and do nothing for anyones economy.

    also, it has been claimed, the stock market has become increasingly speculative, and an increasingly poor at achieving its original goal: raising capital finance. i’ll have to think over these more.

    nice piece.

  3. July 24th, 2004 at 05:42 | #3

    A 50% mix of public and private enterprises would not be capitalism, since by definition, capitalism is a system of wealth creation and distribution by private individuals or corporations. Perhaps “cooperative capitalism” might serve as a moniker for a 50% mix.

    EMH may be the rational behind privatisation, but I don’t think the theory alone explains the push towards increased privatisation.

    Interest rates have been engineered to levels below the inflation rate. Easy credit creates more liquidity which in turn ignites asset inflation. Riskier speculation increases as players race to borrow below the rate of inflation to leverage acquisitions of inflating assets. Banks are only too happy to accomodate, including their role as counterparties to derivatives, which abets even more speculative behaviour. As a mania takes hold, public ownership and government regulations seem anachronistic, and the temper of the times puts pressure on both.

    I would add that, at least in theory, the cost and supply of money is controlled by the central bank, and more so these days, GSE’s. These are government sponsored agencies, not free markets.
    I have difficulty imagining how EMH might be applied when the medium of exchange, the unit of measuring value, is determined by a handful of people as opposed to millions of people participating in an open market.

  4. July 24th, 2004 at 16:37 | #4

    I tend to sympathise with Mill who, in his Principles of Political Economy, enunciated a constrained version of the classical liberal theory of government:

    the burden of making out a strong case…[should be] on those who recommend, government interference. Laisser-faire, in short, should be the general practice: every departure from it, unless required by some great good, is a certain evil.

    This allows for social-democratic style government interventions, judged on their case by case merits. But the presumption should be in favour of private initiative.

  5. spencer
    July 25th, 2004 at 04:43 | #5

    jo — i have problems with your real interest rate analysis as the relationship between the stock market PE and real rates is much weaker than with nominal yields. Real rates are lower now than in the bubble, but the PE is also lower now than in the boom.

  6. tipper
    July 25th, 2004 at 12:43 | #6

    John wrote:
    “This formulation leads straight to the basic economic framework of social democracy, the mixed economy, leaving, of course, plenty of room to argue about the optimal mix.”
    As Professor Julius Sumner Miller would say “why is that so”?
    Riddle me that and I will try to explain the paradoxes of the EMH which are really simple to understand but do require a major change in thinking. A good starting point would be here

  7. tipper
    July 25th, 2004 at 13:36 | #7

    John wrote:
    “but I’ll offer the view that the optimal public share of production and consumption is unlikely to be below 25 per cent, and is typically close to 50 per cent. For a contrasting view, I’ll point to my distinguished predecessor at the University of Queensland, Colin Clark, who thought 25 per cent was an upper bound.”

    I’ve just read your link. Lord Skidelsky explicidly rejected the state as an owner or planner of economic activity. He does however point point out that as a spender it is alive and kicking and getting more bloated (scheloric?) as time goes by.
    So are you equating “government spending” of which redistribution to favoured pressure groups is a major component, with “production and consumption”
    If so, yeah, I’d settle for 30%.
    But I can’t see any relationship to EMH, so I’m curious about why you keep raising the issue.

  8. John Quiggin
    July 25th, 2004 at 18:53 | #8

    Harry, the random walk claim is the “weak EMH”. The claim that stock prices provide the best estimate of value is the basis of the semi-strong (best estimate based on public info) and strong (best estimate based on all info) versions.

    Tipper, it is important to distinguish cash transfer payments from public production and consumption. It should be clear, I think, that the EMH generally implies that public production is undesirable, which is the link you seem to be missing.

  9. July 26th, 2004 at 04:32 | #9

    Spencer- assets include real estate. Leveraged speculation has moved to playing the mortgage spread trade, where the appetite for higher yields on mortgages provides cheap liquidity to the housing market, and in places like California, sales volumes are up, in some cases, by 64% from last year.

    Regarding PE’s, the last time I checked (I’m not an investor or economist), the top ten Nasdaq companies were trading at a “mere” 40. While PE’s are a measure of price, they are not the only way to gauge market efficiency. Dollar trading volume, a measure of the velocity of money flowing through the stock markets, can be expressed as a percentage of GDP. In 1929, DTV was 133% of GDP. In 2000, it was 350%, and 2004 it is 250%(Alan Newman, Decision Point). These percentages show an alarming decline in efficiency. It appears that ever increasing amounts of capital is required to create, as of July, even mediocre results in the markets. If liquidity is provided in significant amounts by mortgage refinance, then it also means that more and more debt is required to generate returns on investment.

    As far as I can tell, efficient market hypothesis works like the theory of natural selection. The best prices survive becuase they are the “fittest” in a dynamic, competitive environment. By focusing exclusively on prices, to the exclusion of debt/liquidity levels, an important measure of capital efficiency seems lost.

  10. Fyodor
    July 26th, 2004 at 09:59 | #10

    JQ,

    You’ve identified three problems with markets, namely that: 1) the foreign exchange market is volatile; 2) electricity privatisation in California was bungled; and 3) the equity risk premium is surprisingly high, relative to the risk free rate.

    None of these points immediately suggest to the reader that the government should provide 50% of the goods and services in the economy. Taking each point in turn:

    1) Forex: the historical experience of governments setting exchange rates is not great. We can point to a couple of successful recent examples in East Asia, but the experience of developed countries (e.g. the 1970s stagflation) suggests that fixed rate regimes cause as many problems as they solve.

    2) Electricity: California was a farce, but you didn’t mention the experiments with privatisation in other countries, including Australia. The experience here has’t been great, but nor has it been a disaster. It could be that electricity is a natural monopoly best left to the government. However, that doesn’t mean that 50% of the economy falls into the same category.

    3) Equity risk premium: I don’t think that the existence of an equity risk premium doesn’t, of itself, mean that markets are inefficient, nor does the magnitude of the premium.

    The question comes down to this: what is the best/optimal/most efficient way of pricing resources in our society? Experience shows that in many (most?) cases, the best medium of pricing and distribution is a well-run market.

  11. Fyodor
    July 26th, 2004 at 10:34 | #11

    jo,

    I don’t really understand why the rising volume of trading should impede the efficiency of a market. If anything, more trading activity tends to make markets more efficent, not less.

    I’ve seen a number of posts on JQ’s blog – from JQ and others – citing some stock’s PE to be “too high” and declaring the market to be thus inefficient. For Yahoo! to have a PE of 60x next year’s earnings does not NECESSARILY mean the stock is inefficiently priced. What it means is that the market in aggregate (and many, many people individually) expects this company to generate a very high rate of growth in earnings, thus justifying a high share price. This increase in earnings may come to pass or it may not. If you think that is a ridiculous idea, because you have superior information or judgement to those market morons, I challenge you to short the stock. You may get fabulously rich or you may lose your shirt.

    We only hear about the stocks that are too expensive. Has anyone ever told you about how Westfield Holdings was grossly under-priced 15 years ago? That’s because it was only trading on a PE of 20x then, but has since increased its value 30-fold (yes, that’s right: its shares are worth 30 times what it was worth then). In hindsight it obviously should have traded on a vastly higher multiple (maybe 40x?), but the market didn’t think so at the time.

    The thing is, we know in hindsight that a stock was too expensive or too cheap, but it’s very difficult to know right now. In the context of this discussion, the question is not whether the market gets it 100% right all of the time, but whether an alternative price-discovery mechanism would do it better. Any suggestions?

  12. John Quiggin
    July 26th, 2004 at 10:41 | #12

    Fyodor, I don’t think I’ve ever referred to a stock’s PE as too high without also discussing potential for earnings growth, as in my post on Google.

    As regards short-selling, the market can stay irrational longer than you can stay solvent

  13. Fyodor
    July 26th, 2004 at 10:52 | #13

    JQ,

    Apologies if I misquoted you, however, your concerns about irrational pricing suggest that that was your meaning. That is, that you did not believe Google was worth the mooted asking price.

    I’m still curious to know how you would price equity securities. Can you suggest a better alternative than a market?

    P.S. liked the quote – very true.

  14. John Quiggin
    July 26th, 2004 at 11:32 | #14

    Fyodor, I don’t think Google is worth the estimated price, because I don’t think it’s likely that it can deliver the sustained earnings growth necessary to justify it.

    On alternatives to the market and the role of government, you’ll have to wait for my longer post for the detail. I would say that, for the kinds of things they have typically done (infrastructure and so on) governments and regulated monopolies have done a better job than capital markets. Given the difficulty of the task, both have done pretty badly.

    I agree that Australia has done better than most other places as regards the performance of electricity markets, but it still hasn’t been very good, as South Australian readers wil probably tell you.

  15. ml
    July 26th, 2004 at 14:19 | #15

    Isn’t it (the EMH discussion) all the wrong question? Sure the market might act as the best (least-worst) clearing house for those who wish to participate, imperfectly informed, within its assumptions. And government is often good value for money within its assumptions.But if the assumptions of the market and government are both grossly and increasingly wrong in terms of the whole (i.e., the externalities are big compared to what is treated (always true for social externalities, now gigantic for environmental externalities),so what? Don’t markets and governments become necessary but, as currently run, far from sufficient? And so, the better markets/governments work as currently constituted, aren’t we optimising the sub-system and therefore sub-optimising the system?

  16. tipper
    July 28th, 2004 at 00:09 | #16

    JQ said:
    “Fyodor, I don’t think Google is worth the estimated price, because I don’t think it’s likely that it can deliver the sustained earnings growth necessary to justify it.”

    So basically you are saying that you belong to the anti-semi-strong school.
    That’s why the market will always out perform the doubters.
    Put your money where your mouth is.

  17. July 28th, 2004 at 04:48 | #17

    Fyodor-

    Markets need to be liquid if they are to function. They also need to be creating wealth. Bubble markets like the Tulip or the South Sea became illiquid not because they created wealth but because they created inflation, drawing in more and more capital, to the point where they represented a malinvestment. The capital could have been used productively, but instead, was wasted in undue speculation and outright gambling.

    As an investor looking at a particular market, I want to know if rising prices are the result of wealth building or the result of inflation, because if it is inflation, then I know wealth is being, or will be destroyed through the over issuance of credit and concomitant debt.

    I read the articles of Doug Noland at Prudent Bear and I quote him here because he summarizes how excess credit invalidates theories based on rational economic thought and action.

    “There is this notion that financial operators, all acting in their own individual self interests somehow – through an alchemy produced by some “invisible” hand – create a financial system that operates in society’s best interest as well. I believe this is dangerous and opportunistic dogma. Adam Smith’s recognition of the wonders of free market trade in economic goods just does not apply to financial excess. Rather, I would argue that a stable and controlled Credit system is a fundamental requirement of a sound Capitalistic system. Importantly, Credit and speculative excess distort the free-market pricing mechanism. Left unchecked, there is a strong inflationary bias that will increasingly distort, corrupt and impair the system over time. “

  18. Fyodor
    July 28th, 2004 at 10:35 | #18

    Joe,

    I agree with most of what you say, and very little in Doug Noland’s comment. “Excess” credit is by definition a problem, and that’s why we have central banks as an important feature of market regulation.

    Financial bubbles are obvious, substantial and – thankfully – rare instances of market failure. It’s at times like the South Seas bubble, tulipmania, the Internet bubble and the occasional property boom that we realise that economics is as much a discipline concerned with individual and mass psychology as it is a “science”.

    That doesn’t mean that markets don’t work, or that markets aren’t efficient, most of the time. They may not meet the “strong” form of the EMH, but they work most of the time and there’s no better alternative.

    I keep making this point, and nobody’s taken up the challenge: if you’ve got a better alternative to a well-regulated free market, speak up. Humanity has waited millenia for it. Until we get it, we’ll just have to work on improving the best option we have: free markets.

  19. Harry Clarke
    August 5th, 2004 at 00:10 | #19

    The collapse of the Long-Term Capital Management Fund in 1998 staffed by Nobel Prize Winners Myron Scholes and Richard Merton says something interesting about the EMH. The fund was based on identifying inefficiencies in the pricing of options and utilising arbitrage to profit. The arbitrages should have helped drive prices toward efficient levels. The assumption was that, on balance, markets were efficient.

    I was reminded of this as I read Leon Levy’s “The Mind of Wall Street”. Levy devotes a chapter to LTCM and draws 2 conclusions. (i) never employ more than one Nobel Laureate as a partner in a hedge fund! and (ii) the market while often ‘pretty efficient’ is prone to ‘manic changes of moods at unpredictable moments’. Its a balanced sane view.

  20. adam higgins
    August 11th, 2004 at 23:57 | #20

    in veiw of the fact that the market is efficient in the semi strong form, there is no value to investors in companies publishing accounting reports, because the information is already impounded in share prices before that information is published. discuss.

    a financial management paper i have to do. any advice or info would greatly appresheated. thank you.

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