Krugman Launches the Attack
The efficient-markets hypothesis (EMH) comes in many forms of varying strength. Much like evolution, it is difficult to debate the issue because people can switch the definition in mid-argument. In evolution, not even a TV evangelist would deny that “organisms evolve over time,” while on the other hand, many biologists would recognize that Richard Dawkins goes too far when he thinks that the theory of evolution by itself virtually disproves the existence of God.
This same problem exists when it comes to the EMH. In its weakest form, it simply means that new information tends to get incorporated quickly into stock prices, meaning that there can’t be any obvious arbitrage opportunities lying around (since someone would have exploited them already). However, the most fanatical EMH advocates come close to saying that financial bubbles are literally impossible.
The EMH is associated with the Chicago School of economics. It has been understandably condemned after the financial crisis — especially since the statists have done a good job pinning the blame on “deregulated free markets.” Paul Krugman summed up the anti-EMH view nicely in this pop article in the New York Times magazine.
In response to Krugman and other critics of neoclassical economics, the mainstream defenders have left their ivory castles to repel the invaders. Although Austrian readers are naturally sympathetic to anyone who picks a fight with Paul Krugman, we should be careful in choosing our allies. Elsewhere I have pointed out the serious flaws (from an Austrian perspective) in John Cochrane’s response to Krugman. In the rest of this article, I’ll highlight some of the sillier defenses offered by other neoclassical apologists of the EMH.
Robert Lucas
In a lengthy and very serious piece, Nobel laureate Robert Lucas defends mainstream economics (and the EMH in particular) from the scurrilous charges:
Macroeconomists in particular were caricatured as a lost generation educated in the use of valueless, even harmful, mathematical models, an education that made them incapable of conducting sensible economic policy. I think this caricature is nonsense and of no value in thinking about the larger questions: What can the public reasonably expect of specialists in these areas, and how well has it been served by them in the current crisis?
One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama’s “efficient-markets hypothesis” (EMH), which states that the price of a financial asset reflects all relevant, generally available information. If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier.
Lucas’s arguments here are typical in this debate. He offers a seductive mixture of assertion and non sequitur to make his case. First, the EMH is itself under dispute, so it hardly helps to cite the EMH and its implications. (This is akin to a Christian quoting the Bible to an atheist to prove the authority of Scripture.)
Now, in what sense has it “been known for more than 40 years” that it’s impossible to predict sudden falls in asset values? Didn’t Mark Thornton and others warn us that the housing bubble was too good to be true several years before the crash? What more could an Austrian cynic do to disprove the EMH, than to predict that “the market” was all wrong when it came to housing prices, risk premiums, and so forth? Investors who heeded the warnings of Thornton and others got out of the stock market, didn’t buy houses to flip in 2005, and, otherwise, managed to outperform other people who were caught up in the euphoric boom. If that’s not “beating the market,” what is?
Notice, there is a flaw in Lucas’s argument. He is saying that if an economist could reliably predict a crash in a week, then everyone would know it now and the crash would happen immediately. There are two problems here. First, an economist can accurately predict a crash, but it doesn’t follow that everyone else will automatically follow suit. In the real world, some economists are bullish and some are bearish at the same time. So, which way is the market supposed to move?
The EMH fan would probably say, “Aha! That just proves how right the EMH is. We don’t have any reason to suspect the market will go up or down, because the current price reflects all available theories and information.” Yet, the market price will go up or down, showing that at least one forecaster was wrong. (The other one might have just been lucky, so we can’t say for sure that his prediction was really correct in the grand scheme.)
The second major flaw in Lucas’s neat little demonstration, is that he assumes the formula for an impending crash must be very time specific. But what if someone like Mark Thornton says, “This situation is unsustainable. Housing prices cannot continue to rise at these rates”? That is still an accurate prediction. It is definitely useful to investors, especially if the forecaster gives a broad period, within which the move will occur.
In this situation, where some forecasters make qualitative predictions, Lucas’s quick argument falls apart. We are back in the conventional world, where different forecasters rely on different theories to make different recommendations. The investors who listen to the bad ones lose money, while the investors who heed the more accurate theories make money. You can “beat the market” if you invest based on more accurate predictions. Is this really that strange a concept?
Lucas goes on to argue that the EMH is not a mere tautology; empirical testing backs it up:
Mr Fama arrived at the EMH through some simple theoretical examples. This simplicity was criticised in The Economist‘s briefing, as though the EMH applied only to these hypothetical cases. But Mr Fama tested the predictions of the EMH on the behaviour of actual prices. These tests could have come out either way, but they came out very favourably. His empirical work was novel and carefully executed. It has been thoroughly challenged by a flood of criticism which has served mainly to confirm the accuracy of the hypothesis. Over the years exceptions and “anomalies” have been discovered (even tiny departures are interesting if you are managing enough money) but for the purposes of macroeconomic analysis and forecasting these departures are too small to matter. (emphasis added)
Wait a second. Lucas has now considerably weakened his defense. Earlier he said that beating the market was an impossibility; moreover, an impossibility that had been known for 40 years. Yet in his discussion of the falsifiable tests, he admits that there are departures from the theory. So, now we have Lucas himself admitting that the EMH fails in the microscopic particulars. I still maintain that it failed spectacularly in the recent housing bubble, as well as the earlier dot-com bubble (which many Austrians also called, before it popped). What would it take for Lucas to admit that the EMH isn’t true?
Before moving on, let’s quote one more gem from Lucas:
The Economist‘s briefing also cited as an example of macroeconomic failure the “reassuring” simulations that Frederic Mishkin, then a governor of the Federal Reserve, presented in the summer of 2007. The charge is that the Fed’s FRB/US forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring. Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period. There was a recession under way, led by the decline in housing construction. Mr Mishkin’s forecast was a reasonable estimate of what would have followed if the housing decline had continued to be the only or the main factor involved in the economic downturn. After the Lehman bankruptcy, too, models very like the one Mr Mishkin had used, combined with new information, gave what turned out to be very accurate estimates of the private-spending reductions that ensued over the next two quarters. When Ben Bernanke, the chairman of the Fed, warned Hank Paulson, the then treasury secretary, of the economic danger facing America immediately after Lehman’s failure, he knew what he was talking about.
Mr Mishkin recognised the potential for a financial crisis in 2007, of course. Mr Bernanke certainly did as well. But recommending pre-emptive monetary policies on the scale of the policies that were applied later on would have been like turning abruptly off the road because of the potential for someone suddenly to swerve head-on into your lane. The best and only realistic thing you can do in this context is to keep your eyes open and hope for the best. (emphasis added)
Let’s put aside Lucas’s funny defense of Mishkin and Bernanke, which says they’re very good at predicting economic conditions, except for those pesky financial disasters. Beyond that side splitter, Lucas is simply making stuff up in the excerpt above. Ben Bernanke, most assuredly, did not convey that he had any inkling of what lay ahead for the US economy. Watch this incredible compilation of Bernanke’s consistent errors from 2005 to 2007, where at every stage he either failed to see the coming storm, or predicted that the trouble would soon end.
Again, I ask Mr. Lucas, What would Bernanke have to say for him to be guilty of what his critics accuse? Would we have to have Bernanke on tape saying, “I am 100 percent certain that no financial crash will occur”? It seems Lucas has set the bar really low for our Fed chairman.
David K. Levine
In an open letter to Paul Krugman, David Levine offers physics as an analogy to exonerate his macro colleagues:
The predictive failure is not a problem of the field — it is a problem for those who are under the impression that we should be able to predict crises. Do you number yourself in this bunch? Do physicists get it wrong because their theory says that they cannot predict where a photon shot through a sufficiently narrow slit will land? Economic models are like models of photons going through slits. Just as those models predict only the statistical distribution of photons, so our models only predict the likelihood of downturns — they do not predict when any particular downturn will occur. Saying “most economists failed to predict the downturn” is exactly like saying most physicists failed to predict the impact of the twelfth photon passing through the slit.
Anyone familiar with the incredible precision — and experimental confirmation — of the forecasts of quantum physics should recognize the absurdity of Levine’s analogy. It’s a bit like comparing a Euclidean proof to a closing argument by Johnny Cochrane. A better analogy for Levine would be a bunch of particle physicists inviting you over to look at their super collider, and then calling you the next week to say they exposed you accidentally to a lethal dose of radiation.
Jeremy Siegel
In a recent WSJ op-ed, Jeremy Siegel defends the honor of the EMH. Like any fanatic, he manages to transform vice into virtue:
The EMH, originally put forth by Eugene Fama of the University of Chicago in the 1960s, states that the prices of securities reflect all known information that impacts their value. The hypothesis does not claim that the market price is always right. On the contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is not at all easy to say whether they are too high or too low. The fact that the best and brightest on Wall Street made so many mistakes shows how hard it is to beat the market. (emphasis added)
Siegel is to be congratulated for his masterful stroke here. During the bubble, when investment bankers were earning multimillion-dollar bonuses, the defender of the EMH would have said, “It’s crazy for an average investor to try to beat the market. Some of the brightest minds in the world have enormous computers and an army of mathematicians at their service, squeezing every ounce of mispricing from the market. Don’t bother trying to compete with those experts. Put your money in an index fund instead.”
Yet, after many Austrians (and others from different schools of thought) predicted that the market would crash, and that investors should get into cash, Siegel points to the monumentally incompetent investment bankers as proof of the wisdom of “the market.”
William Easterly
I’ve saved my favorite for last. The Queen of England famously asked why none of the economists had seen the crisis coming. Here’s what William Easterly said in reply:
[E]conomists did something even better than predict the crisis. We correctly predicted that we would not be able to predict it. The most important part of the much-maligned efficient-markets hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market.
Now c’mon — that’s just plain funny.1
Conclusion
The efficient-markets hypothesis comes in various forms. There is, indeed, a large empirical literature, in which Fama and others conducted falsifiable tests. However, as I hope I’ve demonstrated with the quotations above, in practice the efficient-markets hypothesis is actually a tautology, or a way of viewing the world.
There’s nothing wrong with using a priori mental frameworks to parse economic reality; indeed that is one of the defining characteristics of Misesian praxeology . However, as the quotes show, many of the EMH apologists think they’re independently confirming the EMH, when, in fact, their goggles simply force all evidence into conformity with their presuppositions.
- 1In fact, Tyler Cowen told me by email that he thought Easterly was joking. Given that the rest of it sounded perfectly serious — and was not apologetic about the state of mainstream macro — I thought he was being serious. (Unfortunately Easterly’s column is no longer at the URL where I originally read it, so all I have is the quotation I have put in the text above.)
