What does it all mean?

There’s been a bit of discussion about what Alan Greenspan really conceded in his recent testimony. Although Greenspan was less opaque than usual, I won’t try to second-guess him any further, and will instead ask again what the crisis means for the way we think about economics and the economy. There are two big economic ideas that look substantially less appealing in the light of the current crisis.

The first is the macroeconomic hypothesis, often called the Great Moderation which combines the empirical observation that the frequency and severity of recessions declined greatly from 1990 to the recent past with the explanation that “the deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle”.

The second is the microeconomic idea, central to much of modern finance theory called the Efficient Markets Hypothesis. In its most relevant form, the EMH states that prices observed in asset markets (for stocks, bonds, foreign exchange and so on), reflect all known information, and provide the best possible estimate of the value of earnings that assets will generate.

On the Great Moderation, it is worth citing Gerard Baker’s piece from January 2007 at greater length to show how rapidly things have changed. Baker says

[Financial deregulation] gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods.

In the City of London and New York, the creation of the secondary mortgage market, cushioned banks from the effect of a sharp downturn in their core business. The globalisation of finance meant that downturns in one market could be offset by strength overseas. The economies that took the most aggressive measures to free their markets reaped the biggest rewards.

The Great Moderation offers another precious lesson in an old truth of economics: the power of creative destruction. The turmoil of free markets is the surest way to economic stability and prosperity.

I’m not picking on Baker in particular when I observe that it now seems that all of these claims are the exact reverse of the truth. Consumers have built up unsustainable gaps between income and consumption, banks have amplified their risks rather than cushioning them and the economies that took the most aggressive steps (like Iceland) are now in the deepest strife.

Of course, we have yet to see how deep the recession arising from the current crisis will be, but it already seems clear that it will be among the worst since the Depression in many countries. Typical forecasts for the US project 8.5 per cent unemployment next year, not quite as bad as the early 80s and early 90s, but worse than any other post-war recession. And there’s no guarantee that 8.5 per cent will be the peak.

Going beyond this single episode, the failure of the Great Moderation undermines, perhaps fatally, the idea that highly developed financial markets are a stabilising force in macroeconomic terms. Indeed, it suggests a reappraisal of the two decades or so since the emergence of a fully globalised international financial market from the turmoil of the 1970s. Beginning with the global stock market crash of 1987 there have been a series of financial crises and associated recessions. The link from the 1987 crash via monetary policy reactions to the recession of 1990-91 is a bit tenuous admittedly, but many developing countries experienced recessions driven directly by financial crises in the 1990s, as of course did Japan. Then there was the dotcom boom and bust in the late 90s.

After this crisis, the Keynes-Minsky view of financial markets as inherently destabilising looks a lot more appealing than the opposing view, argued most prominently by Milton Friedman. In this context, it doesn’t matter whether the financial markets caused the crisis or merely facilitated and amplified the results of excessively lax monetary policy (Daniel Davies argues strongly that monetary policy is the primary cause of the crisis, but I don’t buy the claim that financial markets were merely passive transmitters of monetary impulses).

The failure of the Efficient Markets Hypothesis is, perhaps, an even more significant outcome of the crisis than the end of the Great Moderation.

The EMH implies that, provided governments get prices right (avoiding distorting taxes, internalising externalities and so on) it’s impossible to improve on the allocation of investment capital generated by private markets. The converse doesn’t hold automatically. Even granting that private markets are subject to bubbles and fads, and that their investment decisions may not make sense in the light of publicly available information, it doesn’t necessarily follow that governments can do better. Still, for large scale infrastructure systems, the case for leaving investment planning as, in Keynes words ‘the by-product of the activities of a casino’, looks a lot weaker now than in did before this crisis. Of course, for anyone who cared to look, the ludicrous investment decisions made during the dotcom boom had already undermined the EMH.

Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century. I’ve written a more detailed version of this argument here here

At a more trivial level, until the severity of the crisis became apparent, Eugene Fama, the leading proponent of the EMH, was the hot favourite for the Nobel Prize in Economics. I think it’s safe to say that Robert Shiller, author of Irrational Exuberance, is now a much stronger candidate to get the next Nobel to be awarded to a finance theories.

21 thoughts on “What does it all mean?

  1. Once again there is no Nobel prize in Economics. But they can give it to The Daily Shows Jon Stewart who held a full-length farewell show in Greenspans honor, named “An Irrationally Exuberant Tribute to Alan Greenspan” comedy and economics are pretty much the same deal to me :0)

    Great Moderation is 180 degrees wrong and thus falsified. (also linked in with this is decoupling)

    I take the counter intuitive position, there was more volatility not less, precisely because More real volatility is what is needed to achieve the correct market price outcome thus Efficient-market hypothesis cannot be achieved and is still to be falsified.

    We saw what we wanted to see.

  2. Your definitions of central planning and laissez faire economies are both wrong for the same reasons, you seem to be using caricatures, based on both the fundamentalism of Marx and Rand, real life is much more dynamic than static systems of economics suggest.

  3. As for the notion that the market price of assets represents the most reliable measurement of underlying value and earnings potential, I can see why some would be skeptical of this.

    For example, only a fool would seriously believe that the current real estate prices in much of Australia reflect an accurate and realistic assessment of underlying value and future economic potential. Although the real estate market has been heavily distorted by government intervention, in the form of tax breaks, the FHOG, and state governments inflating the cost of new housing construction.

    I suspect a free market with little or no government distortion compared to other sectors of the economy would still be slightly overvalued, but not nearly as much.

    Another interesting example: international evidence shows that betting markets and political futures markets tend to be more accurate predictors of election results and other significant events than opinion polls or expert analysis.

    So it seems that although the market does not always get it right, it usually gets it right more often than other sources.

    The one advantage of markets is that if people are forced to put their money where their mouth is, they have a bit more incentive to get it right.

  4. You make a number of assumptions. Take CDS’s and CDO’s. You assume that a regulator would have understood these investments better than the actual investors and prohibited them. It is also possible that they would have not understood the risk involved, especially in investments that involve shifting risk to a third party or magnifying risk, where the problem of magnifying risk is partly trying to figure out the amount of collateral needed. I agree that we could have taken a look at these investments sooner in the U.S., but I’m not sure that regulators would have done a better job. Of course, you might be arguing that insurance like standards should have been applied to them from the first, and that might have worked. In any case, regulations need to be clear and effective, and need competent regulators.

    Second, and here’s my biggest disagreement, the system of implicit government guarantees played a part in the creation of this crisis, and encouraged taking on more risk than was advisable. My main reason for believing this is how the markets behaved to Lehman, which showed that investors and banks were counting on a bailout, and had no plan B if the government didn’t intervene. Of course, the government did.

    I call this moral hazard Bagehot’s warning. In the end, if you put certain institutions in place, they will be the final guarantor. In other words, there are certainly situations where the government will have to step in, as it has done here. However, a certain amount of minimal and effective regulation, real moral hazard for investors and banks in normal times, and very onerous conditions should a bailout be necessary, could well keep such a crisis from occurring.

    In the current case, we had poor regulation, no moral hazard until the worst was upon us, and certainly less than onerous conditions, e.g., TARP.

    Keynes believed such crises as this can be avoided. I know that most people will disagree with me, but a very minimal but well planned and executed regulation, clear bailout terms and conditions from the government, and better oversight from investors themselves could have kept this from occurring, with little bother to the market economy. The result of such negligence has been, as Greenspan said:

    “It is important to remember, however, that whatever regulatory changes are made, they will pale in comparison to the change already evident in today’s markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime.�

    In the end, we should view regulation and oversight like value investors view the market, and be most vigilant and frightened when things are going well.

  5. Maybe the present crisis is not the real problem. What this all means depends on analysis of long-run underlying trends.

    While media headlines all focusg on debt and sharemarkets, these are just symptoms.

    Debt is always needed to clear a capitalist market, and in America, household debt has been steadily increasing (constant dollars) since 1900. The Sunday New York Times produced a useful data set in June this year at:

    Economists who focus on some supposed new trend that commenced in the 1970’s (so the story goes) miss the point. They also imply that earlier capitalism was somehow without debt problems. This view contradicts the NYT data available for the USA.

    Debt is required to boost final consumption expenditures only because of the distorted prices capitalists seek on markets.

    But as this is a requirement of capitalist profit, this trend must be repeated for each cycle of capitalist production – consumption.

  6. Professor Quiggin, I too think you’re being a little unfair on Fama. In interviews I’ve seen, he has always been less doctrinaire than his critics accuse him of being. He’s not saying prices are always right, so much as he’s saying it is impossible for any individual to profit consistently from how they are wrong. The EMH is a model, he says, and like any model it can only ever be an approximation of reality. Financial markets are unpredictable, as we are now discovering. And there’s a tendency among economists to brand markets as “irrational” when they can’t explain they way they are priced.

    The bigger criticism, in my view, is the application by libertarian ideologues of efficient markets thinking to ALL markets – not just the financial ones. Indeed, the hostility to the EMH is a reflection of the perversion of its principles in the general policy area. The risk in all this is that you throw the baby out with the bathwater and resort to a model where government interventions only make the problem worse. This is not to argue against the recent “bailouts”, by the way. These were necessary to stabilise the system, but at some point governments are going to have to stand back and let risk assets find their own price.

    For an individual investor, starting with the assumption that market pricing is correct (even when it isn’t) is probably the best step. It allows them then to choose low-cost, diversified passive investment options that aren’t dependent on the hunches of some guru hedge fund manager that charges alpha fees for beta returns. In that sense, the EMH is a more social democratic tool than most people imagine.

  7. With regard to the Great Moderation, I’d suggest waiting 12-18 months and seeing what happens to the real economy before drawing any conclusions.

  8. i think your being too technical john,

    extreme imbalance is always readjusted eventually

    illusions are always shattered eventually

    debt is not wealth

    and buying something you cant understand is not in your own interest

  9. I’m concerned that there is too much faith being put in Government in this instance. If Government agents were perfect, benevolent dictators, then they would likely have produced outcomes superior to those that the market has produced in recent history. But this is clearly not the case.

    I think we need to look at the poor standard of Government that our system has produced in so many areas throughout the past decades (and the US system seems to be even more perverted), and really think about whether Governments could have done a better job in this case. I think we can’t just automatically say “The market failed in this instance, therefore Government must be able to do better”, as that line of thinking has gotten us into some serious trouble in the past. The systematic and steady deregulation of a lot of these markets/bodies produced some fantastic results across a variety of measures, and thus there was a clear (non-ideological) justification for them. It’s likely that the goals were overshot in a number of areas, and that the process may have gone too far, but to propose a full-scale reversal of this process (like the full nationalisation of the financial sector) that has been going on for decades might be overshooting it in the other direction.

    A question that I would like to ask Prof. Q. is; free of intervention in this case, what is your expectation of the market “learning” from this catastrophe (indeed this was probably the most prominent point raised by Greenspan in his testimony)? As a simple example, if allowed to fail, the investment banks (who must bear a significant proportion of the blame in this case) would have disappeared, and given their painful demise, isn’t it doubtful that others would pop up in their place to make the same mistakes again (would investors be willing to foot the bill again, for example)? Just because the child fell off their bike, should we be so hasty as to run and put the training wheels back on; might the training wheels make it harder for the kid to learn how to ride on their own?


  10. Another intelligent posting, John. Kepe up the good work.

    As an aside (for reasons which I find it a bit hard to work out) Nick K @ 3 says:
    “international evidence shows that betting markets and political futures markets tend to be more accurate predictors of election results and other significant events than opinion polls.”

    In one sense this is trite, because the betting markets incorporate opinion poll data into them and other data as well, and of course more information is better. But what happens when the two are consistently at odds? Lst year we had a good test. Thrughout the year the opinion polls were showing John Howard would lose Bennelong, the betting markets almost to eletion day showed he would win it. I’d like to thank the betting markets for their imagined superiority on this one as they made me a litle bit richer.

  11. Pat, I’m not accusing Fama of being an extreme dogmatist on EMH, just saying that the whole idea looks a lot less Nobel-worthy than it did a year ago.

    Sean, no one cares.

  12. I do not understand the need for regulation yet. All of the commentry on CDO’s is all very well and good, but it it all based on a market that seems to be untracable. The big issues to be that know one knows where the debt is actualy held. So we don’t know which bank or insurance group or other business will be the last man standing when the money is needed. thus we have a lot of banks to scared to lend out money just in case the borrower is that last man.

    Instead of regulation to control the maket for CDOs. How about we creat a intenational registered clearing house for CDOs. Then we would be able to see what the maket is and who has the debt. If then we do know the maket for these things is over heated we could simple “tax” them in the same way as goverments treat stamp duty based on the face value of the contract. That would add cost to the market and slow it down.

  13. Advocating a mixed economy (somewhere between lassiez fair and central planning) entails a broad range of possibilities. It is always easier to defend generalities than specifics. Personally I think we need more lassiez fair in terms of interest rates and more control in terms of fixing the value of our fiat currencies. Does this make me a central planner or a free market advocate? I’d argue the latter but in many ways it’s a relative question. In any case the current mess is the product of a mixed economy.

  14. Its sorta funny that whilst some debate particular “interesting points” of the Efficient Markets Hypothesis the market efficiently deals with the hypothesis by ignoring it – the market exists and we need the market to exist and be efficient and despite the best intentions of govt and their central bankers the market is downgrading the value of assets as we speak

  15. Its just staggering that it takes the collapse of a large part of the world’s financial system and hundreds of billions of dollars for economics in general to start rejecting the strong form of the EMH. I know there is widespread disagreement within the profession on this and the support for the strong EMH is limited and qualified, but it is also accepted as a valid hypothesis throughout the profession. It now looks so obviously wrong that one has to question how any self respecting intellectual field of inquiry could continue to hold such a flawed idea as worthy of respect for so long or, indeed, still be debating it.

    It is wrong. Reject it and move on.

    That is the approach taken to incorrect hypothesis in the real science’s and they have made staggering progress over the last few centuries with this ruthless approach to under performing ideas. The strong form of the EMH makes very bold claims that are easily disproved. Why the need to keep discussing it? You don’t find a chapter on the “music of the spheres” in astronomy textbooks today because they realised it was wrong and stopped studying it.

    Forgive the rant, but economists and economic thinking have a very strong influence in deciding how our society is organised. Economists are not shy in using their position of intellectual authority to give advice on what should be done. It is however, becoming increasingly clear that the intellectual authority of the profession is simply not justified. When the world’s most powerful central banker could not forsee an obvious crisis predicted by many amatuers, the credibility of the entire profession is put at risk. The public is starting to notice that the experts (the econmists in their eyes) often don’t really know they’re doing, or that the claims of the experts are often completely wrong. If the whole world has to live through a crisis because the “experts” could not see the obvious then economists risk ranking right along side journalists, astrologers and psychics in terms of public esteem. This would be completely unfair on the likes of Professor Quiggin who have been on top of this for a long time, but not unfair to the profession as a whole.

  16. Lukas at 11, You provided one example of where the opinion polls turned out to be right and the betting markets wrong.

    But there is plenty of evidence to suggest that the opposite is true. When the polls and the betting markets are at odds, the betting markets tend to be more accurate.

    For example, in the 2004 federal election the polls for most of the year consistently showed Labor doing better. Yet the betting markets had the Coalition on much shorter odds.

  17. This is precisely where economics proves it is not a science IMO. I find it amazing that some economists still want to try to argue against the evidence against the EMH theory. In science you only adopt a theory if it cannot be proven false. If evidence turns up contradicting the theory you discard it.

    Yet in economics, not only are theories adopted without anything approaching the degree of reliability required in other disciplines, but when evidence turns up that refutes a theory, people just try to argue with that evidence.

    It seems to me in this dispute that the burden of proof lies with the EMH camp. They are saying that markets are ALWAYS the best solution. That is a big claim, capable of refutation if false. Keynsians aren’t saying that markets never work – they are saying that there seem to be some cases when markets don’t work, when a regulator is required. If you accept markets at all (and I do) then it would seem rational to stay a Keynesian unless there was reliable proof to accept EMH. Counter examples (like now) disprove the validity of EMH.

  18. Intellectual osmosis, nice concept,

    Except this is like reverse osmosis,
    The weakest ideas overtook the strongest

    This has at least two crucial implications for the financial world. First, as volatility returns with a vengeance to the investing world, many market players are experiencing a profound psychological shock. After all, in recent years many investors had bought into the “Great Moderation� argument, either deliberately or by intellectual osmosis. Many of them had never before seen a world where almost all asset classes could swing wildly in value.


    Lengthy quote trimmed – JQ

  19. Rudd’s economic management, deja vu NSW’s labours incompetence.

    As I’ve previously advised other posters, don’t repost slabs of stuff from elsewhere. And while I welcome interesting links, pointers to news.com columnists you endorse don’t quite cut it. Surely, you can write something on this yourself if you want to.

  20. The ‘great moderation’ was always a non-starter for mine. It’s funny how how people’s views are so often shaped by their most recent experiences, this being just another example. The GM is, in fact, a paradox, and actually breeds instability from within. Funny that. It just happened.

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