Two perspectives on EMH: Biz Skool vs. Econ Dept

A theory is like a tool: whether it is right or wrong depends on what job you want to use it for. From the Econ Dept perspective, watching the players play, the Efficient Market Hypothesis makes a lot of sense. From the Biz Skool perspective, as one of the players playing, the EMH makes much less sense.

First year students sometimes ask me: "What is the difference between Business and Economics?" I give them a simple answer: the Business question is "How can I maximise profits?"; the Economics question is "When you put a bunch of people together, each one trying to maximise profits, what happens?". It's a crude caricature of both Economics and Business, of course, (which is why I say "Econ Dept" and "Biz Skool"). But it's good enough for my purposes.

Here's a couple of other examples where the perspective affects whether a theory is right or wrong.

Macroeconomists often construct theories in which government spending is exogenous, while private spending is endogenous. That makes perfect sense if you are trying to see if an increase in government spending would help the economy escape a recession. It makes no sense at all if you are trying to forecast what will happen in a recession; because government spending will almost certainly respond to the recession.

If you want to ask whether cuts in money wages would reduce unemployment, it also makes sense to assume that money wages are exogenous, even if you believe money wages in fact respond to other variables in the model. One economist (I can't remember who, sorry) argued that Keynes' assumption of fixed money wages in the General Theory was indeed a policy prescription, rather than a statement of fact; the whole point of the General Theory was to show it would be better to have monetary policy respond to deficient demand, rather than money wages.

I think it was Arthur Laffer who said (something like) "No free lunch in economics? Nonsense! Our job as economists is to find free lunches and eat them!". That's an economist speaking from the Biz Skool perspective on EMH -- the perspective of a policy entrepreneur.

The Biz Skool student says "I'm going to start a hamburger stall on Main street; it's a great profit opportunity!". The Econ Dept student should not reply "Don't be silly; if it were profitable to start a hamburger stall there, someone would already have done it!". The Biz Skool student is merely doing what the Econ Dept student's theory says he will do: hunting for profit opportunities. And if all the Biz Skool students did follow the Econ student's advice, then there would be an opportunity for profit, and the Econ student's theory would be wrong. As Hayek(?) said, the market is a discovery process, and the Econ student should observe that process in action, not say it never needs to happen because it must already have happened.

But the Biz Skool student should nevertheless listen to a sensible warning: double-check your market analysis, or explain why you can do or see something that nobody else can do or see, because it would otherwise be surprising if nobody else has responded to this profit opportunity, if it exists. But there may be an answer to that question: perhaps the Biz student has a comparative advantage in selling hamburgers; or perhaps he has better information; or perhaps the opportunity has only recently opened up, and nobody else has yet crunched the numbers. Information and number-crunching are not free. And some people have a comparative advantage in getting information and crunching numbers, as well as in selling hamburgers. If you don't have a comparative advantage, then just throw a dart at the Yellow Pages when deciding what business or career you want to enter.

EMH applied to markets for financial assets is no different from EMH applied to markets for hamburgers. Are you a player/entrepreneur? Or an observer/economist?

Again, this is sort of in response to Scott Sumner.

Comments

[Rogue]

Econ Dept: How will the market reach equilibrium?
Biz school: How can I create market disequilibrium?
Econ Dept: How will the market reach efficient price?
Biz school: How can I distort the market to get the price that I want?

[tjfxh]

From The Stalwart:

"Fischer Black was a strong believer in the so-called Efficient Markets Hypothesis (EMH) which posits that the price of a stock reflects all available information on it, and that the idea of mere stock-selection, as a means of beating the market is basically impossible. The theory does not suggest that prices are always perfect, or that there can't be major mispricings--but that manager has no real method of consistently exploiting these mispricings (This rings true in some sense. Consider the dotcom bubble. Although stocks were easily identifiable as being overpriced, for some time, there were certainly a lot of intelligent value-minded investors who got creamed shorting stocks between 1998-2000).

"To Black, the only way to beat the market is to identify structural inefficiencies and exploit the distortions they create. Limitations on lending (leverage), he noticed, caused risk-hungry investors to go too heavily into high-beta stocks, and undervalue low-beta stocks. A strategy of going long low-beta stocks, and shorting high-beta ones was found to beat the market (and also served as a blueprint for the as of yet undeveloped world of hedge funds).

"My problem with the EMH is that it is not disprovable (a fatal flaw to any theory). A manager who consistently beats the market on a risk-adjusted basis can always be credited to pure chance. An obvious mispricing will always be explained by some inefficiency. A correction is always the result of investors gaining a clearer picture of something."

http://www.thestalwart.com/the_stalwart/2006/01/efficient_marke.html

[Patrick]

Seems to me EMH is a step along the way. Sure, it's clearly wrong. But it's wrong in the same way that classical mechanics (e.g. Newton or Lagrangian mechanics) is wrong. And it's useful for the similar reasons. If you can get results that are good enough with classical mechanics, why bother with the mathematical nightmare that is General Relativity?

To torture the analogy even further, I think much of the focus on EMH being wrong is due to having just completed a flyby of an economic singularity. We're all looking at the clock on the spaceship and wondering why it's slow compared to the clocks on Earth.

[www.facebook.com/profile.php?id=611985302]

It's not a singularity. It's the logical consequence of the world's largest political economy being captured by the thieves. These events will play out again and again until

1) The US fixes its political system (which the Supreme Court just made harder)
2) The US economy damages itself to the point of insignificance to the world economy.

2) Involves huge amounts of pain. Enough pain that it will eventually drive 1)

I am thinking somewhere between 1 million and 30 million dead people (hunger, homelessness, riot, bombs, disease, ....) may be required before 1 happens.

[Frances Woolley]

So, in the cosmic scheme of things, which is more useful, what's taught in Biz Skool or what's taught in Econ Dept? Now the obvious economic response is students will rationally sort themselves until the marginal benefit per unit of effort is the same for econ and biz.

But this imaginary response ignores constraints on biz skool entry, which are typically binding.

And the question remains - which generates greater consumer or social surplus?

[Doc merlin]

"A theory is like a tool: whether it is right or wrong depends on what job you want to use it for. From the Econ Dept perspective, watching the players play, the Efficient Market Hypothesis makes a lot of sense. From the Biz Skool perspective, as one of the players playing, the EMH makes much less sense."

EXACTLY, EMH only makes sense when everyone actually trying to use the markets to their advantage assumes that they can do so. If they stop, and just buy indexes, the market becomes more inefficient.

[Nick Rowe]

Doc: "EMH only makes sense when everyone actually trying to use the markets to their advantage assumes that they can do so. If they stop, and just buy indexes, the market becomes more inefficient."
Yep. I'm just thinking about a supply and demand for EMH. I'm going to draw the picture for my next post, showing precisely that interaction.

Frances: "which generates greater consumer or social surplus?"

Total, or marginal surplus? ;-) For total, I would say Biz Skool, unfortunately. But if we didn't have the Econ Dept, who understand that, the Biz Skool grads might all be central planners?

facebook: there's a lot of ruin in a great nation. The US has pulled itself together before, and will do so again.

Patrick: yes, that's close to my perspective. EMH is a useful (for some purposes) approximation.

tjfxh: ""To Black, the only way to beat the market is to identify structural inefficiencies and exploit the distortions they create.""

And the analogy to hamburgers is that sometimes there are indeed structural features of markets that mean a firm can earn monopoly profits, etc. Or where individual profit-maximisation does not lead to a social optimum. I don't see why it should be different, in principle, whether we are talking about the market for hamburgers or financial assets. (It's surprising nobody has challenged me on that analogy, by the way.)

Good quotes, BTW.

Rogue: Is there any difference in your points, between the market for hamburgers and the market for financial assets?

[tjfxh]

NIck, I did point out in a previous post here, or maybe it was at Scott Sumner's place, that the EMH is framed in terms of financial markets in which competition is near perfect unless there is cheating (and there is), while business markets are not completely flexible because they no longer operate on the basis of negotiated price except in the few remaining bazaars and in most significant market sectors only a few players control the pricing structure and consumers are not well informed, so they can be taken advantage of quite easily and very often are through deceptive advertising, branding, etc. It's apples and oranges, IMHO.

[Rogue]

Nick, I can't recall any earthshaking innovation in hamburgers recently so let's take the recent coffee shop experience. For a very long time, coffee was accepted as costing less than a dollar. That is, until Starbucks came along, and got everyone used to the idea of the $5 coffee. How did they know there was a market at that price? If it already seemed the market had stabilized at the $1 price point, how could a new store chain that charged 5 times as much survive? By changing the rules of the game.

[tjfxh]

Uh, Rogue, they don't sell $5 coffee. They changed their business model to become chiefly a coffee ice cream shop instead of a traditional coffee house. :)

[Rogue]

Right, I myself prefer the $1.50 Tim's anyway. So the Starbucks model doesn't work on me.

[Min]

Doc merlin: "EXACTLY, EMH only makes sense when everyone actually trying to use the markets to their advantage assumes that they can do so. If they stop, and just buy indexes, the market becomes more inefficient."

All you need is for enough people to gather information and try to beat the market, it doesn't have to be everybody. As Nick suggests, if almost everybody owns indexes, at some point they are beatable by the experts. But since the experts are few, they can profit without moving the markets much, and the result will appear to be a random walk.

[Nick Rowe]

Min: Agreed. But what I can't get my head around is: How many experts is "enough"? And what does it depend on? I think it depends on a lot of things. How dispersed is the information, and access to it (we are all "experts" on some local knowledge). How much colateral do the experts have? How risk averse are they? How much "noise trading" is going on, and how noisy is it? etc.

If (say) 10% experts were "enough", then the "demand" curve in my more recent post would be perfectly elastic at 100% until you got to over 90% of the population believing in EMH.

[Doc Merlin]

Min: "But since the experts are few, they can profit without moving the markets much, and the result will appear to be a random walk."

Hrm, I wonder if thats what actually happens. Its a good theory, i'll have to think about it some more.

[Doc Merlin]

Nick, Min... I think we may have stumbled upon "inefficient market theory."

I suspect (just intuition) that the shape of the efficiency % is going to be like a step function but with softer edges, much like sand pile collapse models. At some point the market is extremely exploitable, and then suddenly it becomes extremely efficient. Darn self organizing criticality. Also a side note, if someone wanted to make more money off of the inefficiency they would try to convince others of the EMH framework.

[Toro]

And from a practictioner's perspective, EMH makes little sense.

[Nick Rowe]

Here's another example. What is the actual and subjective probability (p and pe) that a $10 bill lying on the ground is real? The demand curve can be defined as $10pe=MC of bending down to pick it up (where different people have different costs of bending down and picking it up). The supply curve is pe=p. So in equilibrium p=pe=MC/$10.