14 Aug 2009

The "Efficient Markets Hypothesis" Is a Mental Crutch for Economists

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In a recent post, I discussed Robert Lucas’ defense of mainstream macroeconomics. Lucas made excuses for why economists couldn’t have predicted the housing crash, excuses that drove me to declare, “I’m starting to think the efficient markets hypothesis is a state of mind, a consciously chosen way of looking at the world. I’m not sure what it would mean to really falsify it.”

I’m going to take another swipe at this, since others are adopting Lucas’ line. For example, William Easterly recently wrote:

[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.

Picture a man who had watched CNBC faithfully through 2004 and 2005, and who had borrowed against his pension in order to buy six condos in Las Vegas. Then, after everything blew up in his face–what he had previously been assured was a “six sigma” event–the man asked, “How did you economists fail to see this coming?!” Can you imagine what that guy would do, if William Easterly happened to be there to give him the above answer?

Easterly, Lucas, and other economists think they are oh so clever, yet they’re merely assuming their conclusion. They look out at the world, and see that it can be made consistent with the EMH if we assume certain other things about how the world works.

But by the same token, suppose that the critics of the economic forecasters are correct, and that groups of people–including economists and investors–are capable of making systematic errors for years at a time. Now if that alternate view of the world were correct–meaning the EMH had to be false–then what would the last five years have looked like? Well gee, they would have looked like what just happened. In other words, we can quite easily make the theory of “not-EMH” consistent with the observations.

For example, right now there are some people who are quite convinced that very large price inflation is imminent, while there are other people who are quite convinced that very large price deflation is imminent. The prices for gold, silver, and 30-year Treasurys are constantly shifting, but at any given time they do their part to balance the speculative powers in the camps of the dollar bulls vs. dollar bears. Especially in these unprecedented times, when people are unsure even what framework to use when anticipating the future, it is rather misleading to think in terms of an “equilibrium price” for a one-year put on oil futures. At any time, the put’s price should be interpreted as a ceasefire, not as a “best guess.”

Now let’s suppose that the people worried about collapsing credit lines (e.g. Mish) turn out to be right. The CPI falls by about 10% a year for the next four years. If that happens, I promise that I will say, “I was wrong and Mish was right.”

I’m not going to say, “I didn’t predict this coming, but then again no one did. If Mish thinks he predicted it, he’s sadly mistaken. His arguments and graphs were all taken up by the market, and yet gold remained above $900. Therefore Mish just got lucky; he really couldn’t have known for sure that this would happen.”

I am not being cute or making an analogy; I think the above paragraph is literally what Lucas and Easterly have done, albeit they could point to formal models with Greek letters to make their case less blatant. Even so, they are imposing the EMH on the world, and they don’t even realize it.

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