EMH&SS Part II
After a longer break than I’d planned, I’m back for the second and final instalment of my series on the efficient markets hypothesis and its implications for Social Security reform and other issues. The first instalment is here.
Last time, I pointed out that, under the strong assumptions needed for the efficient markets hypothesis to hold, the diversion of social security funds to personal accounts makes no difference at all, since everyone can already choose their optimal portfolio, borrowing if necessary to finance equity investments. A more realistic version with borrowing constraints or high borrowing costs implies that either private accounts or diversification of the holdings of the Social Security Fund can be beneficial, and also that a range of other government interventions will be beneficial. (See also Matt Yglesias
In this post I want to look at the case I think is actually relevant, namely, where the efficient markets hypothesis is violated in so many ways as to be a poor guide to economic policy of any kind.
To begin with, why do I think this is the relevant case? Because the efficient markets hypothesis is way out in its predictions of the key variables it is supposed to explain: the relative prices of bonds and equity and the volatility of asset prices. Compared to the EMH, asset prices are several times too volatile, average returns to equity are several times too high and real rates of interest are much lower than they should be.
In addition, even defenders of EMH admit that the vast majority of the markets that would be required for the hypothesis too hold either don’t exist or are subject to large transactions costs. I’ve already mentioned the transactions costs of borrowing, but an equally important factor is the absence of insurance against job loss or business failure caused by recessions. In effect, defenders of the EMH look at the complexity and sophistication of corporate capital markets and assume that all the other risks and contingencies in the economy are irrelevant.
On the assumption that the difference between rates of return to equity and to government debt are largely due to market failure, the immediate implication is that the government should hold more equity, use its tax power to spread the resulting risk, and thereby achieve a massive risk arbitrage. One way to achieve this is for the Social Security Fund to invest in equity, as was proposed under Clinton. Alternatively, if the central bank holds foreign reserves for whatever reason, there’s a case for holding equity as well as debt, and it looks as if this is happening. Finally, the government can own enterprises outright, for example in the infrastructure sector.
Each of these approaches to public holdings of equity has advantages and disadvantages. Holding a diversified portfolio of small shareholdings raises the problems of ethical investment: what if some members of the public object to investments in some particular company. Ted raised this issue a while back in relation to the default portfolio for private accounts, and its equally acute in relation to diversification of the Social Security Fund.
Investments by governments in overseas equity raise a bunch of political issues in both the investing and target countries.
Finally, direct ownership raises all the issues that have been tossed about in debates over nationalisation and privatisation for decades.
All of these points imply that there are limits to the optimal public holding of equity, though there’s no good theory on this (or on the related question of the optimal level, if any, of gearing for the public sector). In any case, as public holdings of equity increase, the rate of return will fall and the rate of interest will rise, ultimately eliminating the equity premium. So we end up with the mixed economy we all know and (some of us) love.
But as long as governments can realise an average return on equity investments that exceeds their cost of debt, adjusted by the (small) cost of risk in an efficient equilibrium, there’s a case for more public investment, either direct or portfolio.