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David R. Henderson

Bio of Eugene Fama

David Henderson
His major early contribution was to show that stock markets are efficient (See efficient capital markets). The term "efficient" here does not mean what it normally means in economics--namely, that benefits minus costs are maximized. Instead, it means that prices of stocks rapidly incorporate information that is publicly available. That happens because markets are so competitive: prices now move on earnings news within milliseconds. If someone were certain that a given asset's price would rise in the future, he would buy the asset now. When a number of people try to buy the stock now, the price rises now. The result is that asset prices immediately reflect current expectations of future value.

One implication of market efficiency is that trading rules, such as "buy when the price fell yesterday," do not work. As financial economist John H. Cochrane has written, many empirical studies have shown that "trading rules, technical systems, market newsletters and so on have essentially no power beyond that of luck to forecast stock prices." Indeed, Fama's insight led to the development of index funds by investment management firms. Index funds do away with experts picking stocks in favor of a passive basket of the largest public companies' stocks.

Fama's insight also has implications for "bubbles"--that is, asset prices that are higher than justified by market fundamentals. As Fama said in a 2010 interview, "It's easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. . . . People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong we ignore them."

This is from "Eugene Fama," which has recently been added to The Concise Encyclopedia of Economics. It is a propos, given the recent discussion of stock prices on Econlog (here and here.)

Bryan Caplan

Scott on Victimology

Bryan Caplan
Scott against me on victimhood:
Or let's take another case; you decide to violate the law by jaywalking, crossing the street in the middle of the block. You are struck and killed by a car. (This happened to a Bentley student a couple years ago.) Are you going to claim this person was a "victim" when she was clearly violating the law? Um, actually yes, I sort of do view her as a victim. Now you might say that my example is quite different from infidelity. Well, pardon my French attitude, but aren't chainsaws also kind of different?
I brought up chainsaws as an existence theorem.  If you admit that a guy who cuts off his own hand while trying to chainsaw your neck is no "victim," it's possible that other sufferers aren't victims either.  The point of the hypothetical isn't that victims don't exist, but the non-victims DO exist.

None of this means that people who suffer horribly as a result of committing minor offenses aren't victims.  I don't think that.  I jaywalk, and I don't deserve to die.  When people seriously suffer as a result of committing major offenses, however, I call that just deserts.

I know that utilitarianism says I'm wrong here.  Utilitarianism's denial of desert is another reason I'm not a utilitarian.
CATEGORIES: Economic Philosophy

I've always had a visceral distaste for dividing people up into victims and villains. Thus I wasn't happy to see this analogy by Bryan Caplan (when talking about the Ashley Madison affair.)

Constructing hypotheticals with blameworthy pseudo-victims is easy enough. Imagine someone attacks you with a chainsaw because you failed to kiss his feet. When he misses your head, he accidentally saw offs his own hand. Telling him, "This is your fault" as he clutches his bloody stump is not victim-blaming. Or to take a less egregious case, suppose a worker feigns sickness so he can go to the basketball game. Co-workers spot him on t.v. in the audience and he gets fired. If he decries is fate, "This is all on you" is the bitter truth.

Or, to get a lot less hypothetical: Imagine you swear a solemn vow of fidelity to your alleged one true love. Then you get bored and sign up for an adultery website. Your life seems fine until hackers steal your information and publicly post it. Your spouse discovers your betrayal and divorces you. The obvious victims in this story are the betrayed spouse, children, and other family members who trusted and depended on you. Not you, the adulterer who's sorry he got caught.

Or let's take another case; you decide to violate the law by jaywalking, crossing the street in the middle of the block. You are struck and killed by a car. (This happened to a Bentley student a couple years ago.) Are you going to claim this person was a "victim" when she was clearly violating the law? Um, actually yes, I sort of do view her as a victim. Now you might say that my example is quite different from infidelity. Well, pardon my French attitude, but aren't chainsaws also kind of different?

On a related topic, I've always been annoyed by identity politics, which divides whole classes of people into victims and villains. You might be thinking, "He would say that, as he's an upper class non-gay, non-handicapped white male, so he's in with the villains, not the victims." But what makes you think I have an American attitude toward victimization? Maybe I have a Russian or Arab or Chinese or Chilean perspective. Maybe I'd rather say I came from an aristocratic family than a humble log cabin.

I tend to associate this identity politics with the left, but the right also does it. People are labeled "illegal aliens" or "heroin addicts." "Why give them clean needles, you are just encouraging them to break the law."

I think we are all victims and villains, although obviously in vastly different proportions. But not as different as it's now fashionable to assume. There is no level of victimization that precludes one from also being a villain. Read about life in Stalin's gulags, even among the inmates there were victims and villains. And no life is so charmed that one avoids being a victim (think JFK, or Marie Antoinette.) Historians reduce the people of the past to crude caricatures. They increasingly refuse to give our ancestors the dignity of being considered complex fully rounded human beings, just like us. The proletariat were just "victims." Actually throughout all of human history almost all humans were extremely poor. At what point in the long evolutionary chain from the apes (who are also poor?) did we magically transform into victims? I suppose you could argue the transformation occurred when "public policy" could have prevented mass poverty. In the sweatshops of 1830? Good luck with that.

Here's how this shows up in economics. I'll sometimes say that extended unemployment compensation raises the unemployment rate. Actually, liberal economists used to say the same, until they moved sharply to the left after 2008. Now I get accused of "blaming the victim." But why can't it be both? Why can't someone be the victim of bad monetary policy, and also a villain by coasting on unemployment compensation? (I hope it goes without saying that I am talking about effects at the margin, not claiming all unemployed are "lazy". And what does the word 'lazy' even mean? Prefer not to work? Then I'm lazy.)

I'm not going to even comment on the Ashley Madison case. I've found that Americans are so deranged when it comes to matters of gender, race, and sex that it's almost impossible to have an intelligent conversation on those subjects. So I generally try to avoid those topics. (Actually Bryan is one of the few people I know with whom I could have an intelligent conversation on any topic, if no commenters were listening in.) But I will say that I think the wisest view is usually to regard broad classes of 33 million people as being composed of both victims and villains, in varying proportions.

PS. Suppose you had time to read 33 million 6 volume novels about each of those 33 million lives. Karl Knausgaard or Elena Ferrante-type novels. Do you think that might change the way you regard those 33 million people?

Jonathan Ichikawa joins Jason Brennan in the philosophical symposium on the Ashley Madison hack.  He begins innocuously:

Here is a sadly familiar story: a teenage girl sneaks out of her parents' house, goes to a party, and gets drunk. A man rapes her. Here is another sadly familiar story: a black man in the wrong neighbourhood shouts angrily at a police officer, who kills him. While this isn't yet settled ground in the culture at large, I suspect that most reading here will agree that victim-blaming in cases like these is both morally repugnant and practically dangerous...

Victim-blaming comes in stronger and weaker forms--the stronger straightforwardly asserts that the victim is responsible for the harm undergone; we also recognize a weaker form of 'victim-blaming' where one focuses inappropriately on the victim's actual or perceived wrongdoings: she shouldn't have drunk so much; he should have been more deferential to the police officer. Whether or not these criticisms are true, they are highly inappropriate under the circumstances...

Are these analogies apt?
In case it needs saying--I hope it doesn't--in the vast majority of cases, I do not think that the harm the Ashley Madison victims are suffering is equivalent to rape or murder; nor are Ashley Madison users systematically oppressed in the way women and black people are. But victim-blaming is problematic, even for lesser and more episodic harms... And the harm done to many of the current victims is by no means trivial. Families are being broken up. People will lose jobs. It's not at all hard to imagine that lives will be lost. For many, it is all too easy to trivialize these harms and blame the victims: 'I have no sympathy for cheaters,' or 'the real victims are the spouses.'
Strangely, Ichikawa never addresses the obvious question: When would it be appropriate to "blame the victim"?  If you say, "Never.  Victims by definition should not be blamed," you'd be right.  But only trivially right.  Since victim-blaming is never appropriate, attacking "victim-blaming" is as pointless as attacking "evil."  The real question isn't "Should we do evil?" or "Should we victim-blame," but "What's evil?" or "Who's a victim?"

Constructing hypotheticals with blameworthy pseudo-victims is easy enough.  Imagine someone attacks you with a chainsaw because you failed to kiss his feet.  When he misses your head, he accidentally saw offs his own hand.  Telling him, "This is your fault" as he clutches his bloody stump is not victim-blaming.  Or to take a less egregious case, suppose a worker feigns sickness so he can go to the basketball game.  Co-workers spot him on t.v. in the audience and he gets fired.  If he decries is fate, "This is all on you" is the bitter truth.

Or, to get a lot less hypothetical: Imagine you swear a solemn vow of fidelity to your alleged one true love.  Then you get bored and sign up for an adultery website.  Your life seems fine until hackers steal your information and publicly post it.  Your spouse discovers your betrayal and divorces you.  The obvious victims in this story are the betrayed spouse, children, and other family members who trusted and depended on you.  Not you, the adulterer who's sorry he got caught.

Ichikawa does point to potentially mitigating circumstances:
While there are individual cases deserving of little sympathy--one name in particular comes conspicuously to mind--I think it's a mistake to have this reaction in general, for many reasons. One is that many of the 33 million users whose privacy has been violated weren't cheaters: they signed up, had a look around, and left and forgot about it; or they were just there for the thrill of thinking about the possibilities, with no intentions of any physical connection.
This is a weak defense when you reflect on the fraction of Ashley Madison customers who didn't cheat because they couldn't find anyone who wanted to cheat with them.  (In fact, it looks like Ashley Madison facilitated near-zero cheating, because near-zero women ever used their accounts!)  But even for all the purely thrill-seeking customers, dire familial consequences are a strong sign that merely signing up is a major betrayal. 

Suppose you ask users with no intention of cheating, "What would your spouse think if they knew what you were doing?" They answer, "They'd want to divorce me."  The obvious reaction is, "Then it's a major betrayal, you shouldn't do it, and if you get caught you only have yourself to blame."
Some were in ethical open relationships;
A solid counter-example.  But if they're really in open relationships, there's little reason to fear dire relationship consequences.
[S]ome were closeted LGBTQ people who needed discretion.
Conventional marriages are solemn vows of fidelity and commitment.  If that conflicts with your LGBTQ orientation, you should marry someone that wants an unconventional marriage, or stay single - not enter a conventional marriage and cheat.  "What if you have to marry under false pretenses to save your life?" is a fair question for Saudi LGBTQs to pose, but it's bait and switch for all the LGBTQs who's lives are patently not on the line.
And even when we're talking about the actual adulterers, it's a serious lack of empathy broadly to vilify them or consider them unworthy of privacy protections. People cheat for many reasons, some of them very understandable.
People also feign illness to attend basketball games for many reasons, some of them very understandable.  Like, "My job is boring and I like basketball."  But we appropriately give their reasons little weight.  Conventional jobs provide two recourses for disgruntled employees: negotiate with your boss or quit.  Conventional marriages provide two recourses for disgruntled spouses: negotiate with your partner or divorce.  If you find these rules draconian, negotiate a prenup or don't marry.  Don't pretend you want the conventional deal, then break it because your reasons are very understandable.

Scott Sumner

Confirmation bias?

Scott Sumner

I agree with David Henderson's new post, which starts off with this Bob Murphy quote on the recent stock market decline:

As shocking as these developments [drops in stock prices and increased volatility] may be to some analysts, those versed in the writings of economist Ludwig von Mises have been warning for years that the Federal Reserve was setting us up for another crash.
I find Murphy's statement rather puzzling. What was "shocking" about the stock market decline? Isn't the US stock market normally pretty volatile? Hasn't this been a relatively non-volatile year until last week? Isn't it normal for stocks to decline 10% or 20% every so often? I'm not being sarcastic here, I honestly don't know what we are supposed to find "shocking" about an occasional period of stock market volatility.

Murphy seems to suggest that the fact that Austrian economists were not surprised by the volatility is a point in their favor. But why? Who was surprised? If you had asked me a year ago "Do you expect occasional volatility, up and down?" I would have said yes, and also that I had no idea when that volatility would occur, or in which direction the market would move. (Actually in periods of extreme volatility price declines are somewhat more common.)

Now perhaps Murphy is making a stronger claim, that the Austrians weren't just unsurprised by the fact of volatility, but also the timing. That they saw it coming last week. That would be impressive. So let's go back to August 2011, and see what Murphy had to say:

Investors the world over are still reeling from last Thursday's massive plunge in the US equity markets, in which the major indices all gave up more than 4 percent. It was the worst day for the US stock market since December 2008.

None of this should surprise those conversant with Austrian economics. The "fundamentals" of the economy have been and remain awful because the government and Federal Reserve are consistently doing the wrong things. The apparent recovery, fueled by Bernanke's sheer money creation, has been bogus all along.

Bubble, Bubble, Bubble

For some reason, people still cling to the vague hope that -- at least if we wait long enough -- the market always goes up, and "buy and hold" is a great strategy.

This sounds pretty similar to the recent comment, but also equally vague. If Austrians want to claim they can predict markets, they'll need to be more specific. As far as I can tell Murphy seemed to be rather pessimistic about the prospects for stocks, and the early August 2011 drop was a sort of "I told you so" for Austrian economics.

A commenter named Charlie directed me to this older Murphy post, and added this helpful information:

Since the article:

S&P 500 is up 60%
Gold ETF (GLD) is down 33%
Silver ETF (SLV) is down 64%

Now in fairness to Bob, the earlier post did include this disclaimer:

Knowledge of Austrian economics doesn't render someone an expert investor, but it certainly gives advance warning of the major trends in the economy.
But Charlie also found this warning about the economy:
In this environment, someone relying on fixed-income investments (such as private annuities or, heaven forbid, government retirement checks) could be wiped out by massive price inflation.
Austrians aren't the only ones who think they have something useful to say about future trends in asset prices. Keynesians and others also like to talk about "bubbles", which I take as an implied prediction that the asset will do poorly over an extended period of time. If not, what exactly does "bubble" mean? I think this is all foolish; assume the Efficient Markets Hypothesis is roughly accurate, and look for what markets are telling us about policy.

One other point. If the sharp decline early in the week told us something deep and meaningful about the wisdom of ABCT, then does the recent rebound weaken that argument, or was that rebound also consistent with the model.

Paul Krugman and Larry Summers have recently argued that the Fed should not raise rates later this year. I agree, mostly because I believe it will prevent them from hitting their announced inflation target, but also because it slightly increases the risk of another recession. If anything Summers and Krugman seem even more concerned about recession risk than I am. Here's Krugman:

Larry Summers argues that a Fed rate hike would be a big mistake; I completely agree. Yet he also suggests that the Fed "seems set" to do this foolish thing. . . . I'm with Larry here: this attitude has the makings of a big mistake. Think Japan 2000; think ECB 2011; think Sweden. Don't do it.
Rather than focus on the risk of recession, I'd like to use this example to illustrate a point that causes endless confusion. (Partly because it really is confusing.)

Tyler Cowen mentioned to me that Krugman's worry that a 1/4% rate increase might push us into recession seems at odds with his frequent claim that the 1/4% interest on reserves can't explain very much. In those earlier posts, Krugman seems to suggest that just a quarter point isn't all that important. And yet the 2000 increase in Japanese interest rates was just a quarter point, and the 2011 ECB rate increase was just 1/2%. Krugman cites both examples, and I think he's right to do so. In both cases a small interest rate increase seemed to tip weak economies back into recession.

To make things even more confusing, I often argue that interest rates tell us nothing about the stance of monetary policy. So how can I argue that a quarter point increase risks tipping us back into recession?

I'll try to explain this with an example. Suppose what really matters is the difference between the Fed target rate (fed funds rate) and the Wicksellian equilibrium rate, which is the interest rate setting that would produce macroeconomic stability (perhaps defined as 4% NGDP growth.) Now here's the tricky part. When the Fed tightens, it slows the economy and reduces inflation. And this reduces the Wicksellian equilibrium interest rate. If the Fed doesn't later cut its target rate, the gap begins to widen, and monetary policy becomes tighter and tighter.

Now in practice the Fed generally does realize its mistake, and begins cutting rates. But not fast enough to close the gap, at least initially. And this leads to a strange paradox, in most cases monetary policy is tight when the Fed is cutting rates, and it's usually expansionary when the Fed is raising rates. That's why I always say that interest rates are not a reliable indicator of the stance of monetary policy. And yet on any given day, money is tighter if the Fed raises rates than if they don't. In the very short run the conventional view is right, but we are mostly living in the long run, when peoples' intuition is backwards.

Because the Wicksellian equilibrium rate is unobservable (at least without an NGDP future market), it's difficult to be certain how much impact any quarter point change in rates has on the economy. All we know is that is could be highly consequential, or it might not. For instance:

1. The increase in reserve requirements in 1937 effectively pushed up short-term rates by a quarter point. We now know that policy was far too contractionary, but don't know the extent to which that would have been true without the reserve requirement increases.

2. The institution of IOR in late 2008 initially raised rates by more than 1/4%, but soon after settled into a 1/4% higher IOR (relative to pre-October 2008.) We also know that in retrospect policy was far too contractionary, but don't know the extent to which policy would have been far too contractionary without the higher IOR.

3. We know that, in retrospect, the 2000 decision of the BOJ to tighten policy was a mistake, as was the 2011 decision of the ECB to tighten policy. But we don't know the extent to which the small interest rate increases caused that tightening, and to what extent it was errors of omission.

If the Fed raises rates later this year, and we then go into recession, critics will rightly point out that policy was too tight. But we won't know the extent to which the interest rate increase itself caused that tightness, we'll just know that it was a mistake--the Fed shouldn't have been tightening.

My only real complaint with Summers and Krugman is that they need to be consistent. If a 1/4% increase in rates could set in motion cumulative forces with vast consequences, and it's certainly possible that it could, then one should not discount the possibility that the October 8, 2008 institution of IOR (which the Fed did for reasons that even it admits had a contractionary intent) might have been a very consequential error that dramatically worsened the recession. Perhaps it even created the liquidity trap. We simply don't know.

Interest rate changes may or may not have big effects; it depends on what's happening to the Wicksellian equilibrium rate. But one thing is clear; one should never discount the importance of an interest rate change by a central bank merely because it looks small.

Some pretty big avalanches have started from a small pebble being dislodged.

PS. In fairness to Krugman, in some of those earlier posts he was also making a separate point, that a liquidity trap could form even without IOR. That's true. But what is not true is the implicit suggestion that a mere 1/4% IOR couldn't plausibly have big effects. For instance, here's a typical quote by Krugman:

Incidentally, small nerdy note. Some people argue that the concept of the monetary base has lost its relevance now that the Fed pays (trivial) interest on reserves. I disagree. Reserves and currency are fungible: banks can turn one into the other at will. But the total of reserves and currency is fixed by the Fed -- nobody else can create either. That, as I see it, makes them a relevant aggregate -- and anyone who believes that all those reserves are sitting idle because of that 25 basis point reward is (a) silly (b) ignorant of Japan's experience, where the BOJ sharply increased the monetary base without paying interest on reserves, and what happened looked exactly like our own later experience.

This post certainly leaves the impression that if the number were larger, than the argument would no longer be "silly." And that's also Steve Waldman's reading, commenting on this quote:

Perhaps there are people in the world who think that paying 25 basis points of interest on reserves means that base money doesn't matter, but I have not met any of them. I certainly agree with Krugman that those 25 basis points have a pretty negligible macroeconomic effect now.

Again, the 1/4% might be irrelevant, as we saw Japan fall into a zero rate trap without IOR, or it might be really, really important. But the fact that it's only a measly 1/4% is not the deciding factor.

Austrian economist Robert P. Murphy writes:

As shocking as these developments [drops in stock prices and increased volatility] may be to some analysts, those versed in the writings of economist Ludwig von Mises have been warning for years that the Federal Reserve was setting us up for another crash.

The key words in this quote are "have been warning for years."

Let's say that you warn people that a price will fall. It keeps rising. Finally, years after your warning, the price falls. But it falls to a level well above the level it was at when you made your warning. How useful, then, was your warning?

I think not very.

Notice that the closing index for the S&P 500, a better measure than the Dow-Jones, which measures only 30 stock prices, was 1104.49 at the end of February 2010. As I write this, it's at about 1,890. Which means it has fallen to about the level it was at--in April 2014.

Question for Bob Murphy and other proponents of the Austrian Business Cycle Theory: is there any evidence conceivable that, if you believed it, would convince you that your theory is wrong?

David R. Henderson

Bio of Oliver Williamson

David Henderson
The turning point in Williamson's thinking about markets and firms happened when he was an economist in 1966-67 with the Antitrust Division of the U.S. Department of Justice. In his biography at the Nobel site, Williamson writes:

Although the leadership and staff of the Antitrust Division in the late 1960s were both superlative, the prevailing attitude toward nonstandard and unfamiliar contractual practices and organization structures was that such "abnormalities could be presumed to have anticompetitive purpose and effect." Indeed, given that the prevailing price theoretic orientation effectively disallowed economies of a non-technological kind, it could hardly have been otherwise. That economies could result from organizational and contractual design was simply outside the canon.

Williamson changed "the canon." Drawing on 1991 Nobel laureate Ronald Coase's work on why firms exist, Williamson showed that these voluntary institutions solve problems that arms-length market transactions have trouble solving. Take, for example, a coal mine that depends on a railroad line to ship its coal. Before the mine owner develops the mine, he wants to be assured that the railroad owner won't charge him a monopoly price. Before the potential railroad owner builds the spur, he wants to be sure that the coal mine owner, his only customer, will pay him a price that compensates for the high cost of building the railroad. Once the railroad is built, that cost is sunk. The solution in this case is to vertically integrate: that is, the railroad owner is also the mine owner. Thus, firms serve as a means of resolving conflicts.

This is from the bio of Nobel prize winner Oliver Williamson, recently posted on The Concise Encyclopedia of Economics.

I've long scorned mainstream media for their relentless, misleading negativity.  Now the NYT publishes a gloriously positive story - and I wish it hadn't.  This is Huemerian civil disobedience in action:
The tens of thousands of migrants who have flooded into the Balkans in recent weeks need food, water and shelter, just like the millions displaced by war the world over. But there is also one other thing they swear they cannot live without: a smartphone charging station...

Technology has transformed this 21st-century version of a refugee crisis, not least by making it easier for millions more people to move...


In fact, the ease and autonomy the apps provide may be cutting into the smuggling business.

"Right now, the traffickers are losing business because people are going alone, thanks to Facebook," said Mohamed Haj Ali, 38, who works with the Adventist Development and Relief Agency in Belgrade, Serbia's capital -- a major stopover for migrants.

Originally from Syria, Mr. Ali has lived in Belgrade for three years, helping migrants and listening to their stories. At first, he said, most migrants passing through Serbia had paid traffickers for most or all of their trip.

But as tens of thousands completed their journeys, they shared their experiences on social media -- even the precise GPS coordinates of every stop along their routes, recorded automatically by some smartphones.

For those traveling today, the prices charged by traffickers have gone down by about half since the beginning of the conflict, Mr. Ali said.

Why do I wish this story hadn't been written?  Because laws this evil are made to be broken - and NYT-level publicity raises public pressure to make immigration enforcement even more draconian than it already is.

P.S. Of course now that the cat's out of the bag, I see no harm in further discussion here on EconLog.

As a rule, news is a distraction from worthy intellectual pursuits.  But Jason Brennan manages to thoughtfully filter the Ashley Madison hack through the lens of his new Markets without Limits (co-authored with Peter Jaworski):

Most people believe what Ashley Madison did was wrong, because they profited from immorality. I agree what they did was wrong, but the problem wasn't that they profited. Peter Jaworski and I have a book on commodification, Markets without Limits, coming out next month. Our thesis is that any service or good that you may give away for free, you may sell for money. The only types of goods and services that are not properly objects of sale are the things you shouldn't do or have anyways. In our view, most of the objections to commodifying this or that are really objections to how the thing is sold, not what is sold.

So, for instance, we agree that child pornography and nuclear weapons ought not be bought and sold, but that's because people ought not have them in the first place. If people were distributing these goods for free, it would still be wrong...

Ashley Madison provides a nice illustration of our central thesis... [T]he problem with Ashley Madison is not primarily that it helps people break promises for profit. It's that it helps people break promises, period. If Jaworski and I were to set up the Help You Secretly Cheat On Your Spouse Charitable Foundation, an NGO that matches would-be paramours, the service would also be wrong. The wrongness here doesn't originate in the market, in the buying and selling of the service. It originates in the activity itself.

In surveying the various books on the limits of markets, we find that about half of the so-called "contested commodities" or "noxious markets" that the authors discuss concern cases like Ashley Madison, where the good or service in question is something people should not have or do anyways. Sure, if some behaviors are wrongful or some products bad, then we generally don't want to industrialize providing them. Still, we need to be clear what the issue is. Markets in bad things are bad because bad things are bad, not because markets are introducing badness where there wasn't any.

There's been a lot of discussion about the recent Chinese stock market crash. Most observers view the events through the lens of the "bubble" model of financial markets. This view claims that there are sharp price run-ups caused by irrational exuberance, and that rational observers can spot when the prices are out of line with fundamentals. In contrast, I believe it is very difficult to spot market irrationality at the time, and sometimes even in retrospect.

In some ways the recent Chinese boom and bust looks a bit like the 1987 stock market in America, when prices soared over the first 9 months, and then fell very sharply. At the time almost everyone thought it was a stock bubble, and they seemed pretty confident that the "wrong" price was at the peak, not the subsequent trough.

You would think that with the benefit of hindsight we'd learn who was right. We'd learn which of the two prices were clearly out of line. But a comment left by Brian Donohue a couple months back shows that even today it's really hard to figure out who was right:

If you bought the S&P 500 at the peak (10/5/87) you've earned a 9.3% CAGR over the past 28 years.

If you bought at the subsequent trough (12/4/87) you've earned a 10.8% CAGR.

Note that the S&P500 fell 31.75% over that period. Both of those subsequent returns look fairly reasonable to me. If you forced me to guess, I'd say the 9.3% return seems a bit more consistent with market efficiency (recall that inflation and nominal interest rates have fallen since 1987). And if I'm right this would imply that prices were more "rational" at the peak of the "bubble." But either way, I think any fair observer would admit that even today it's really hard to know what stock market valuation (S&P500) was appropriate in 1987---328.08 or 223.92.

Now imagine you were thinking about where Chinese stocks would be 28 years from today. Also recall that rates on alternative investments are now much lower than in 1987. Does anyone seriously believe it's possible today to know which recent Chinese market valuation will be viewed as being more rational in 28 years, 5000 from a few weeks ago, or roughly 3000 today?

So I don't find the "bubble" hypothesis to be useful. But just to be fair and balanced, I do believe that 1987 provides a very powerful argument against the EMH, indeed one of the most powerful arguments that I have ever seen. Not because 1987 was a bubble (it probably wasn't), but rather because the more than 20% stock crash on October 19, 1987 was not accompanied by any new information that could justify such a sharp re-evaluation of equity values in 24 hours.

To summarize, there are pieces of evidence that seem inconsistent with the EMH. But the specific bubble argument is much weaker than most people assume.

PS. And don't forget that while seeing which price was clearly wrong in retrospect is a necessary condition for the bubble hypothesis, it is not sufficient. For instance, in retrospect NASDAQ was overpriced in 2000, but perhaps that reflects new information about growth in IT.

PPS. The closing price on October 19, 1987, was 224.84, so virtually all of the crash occurred in a shorter period than Brian considered.

PPPS. And notice that there was no recession in America after the 1987 crash. Will China have a recession? Maybe, maybe not.

David R. Henderson

Ask What Changed

David Henderson

Many people are trotting out their pet theories for why the stock market has crashed in the last week. Some of them may even be right. But there's one question we should ask of all of them: What changed?

Here's what Charley Hooper and I write in the chapter "Ask What Changed" in our book Making Great Decisions in Business and Life:

Have you ever had a conversation like this? You point out to a friend that the stock price of Hunky Chunky Potato Chip Company doubled in the last six months. Then your friend explains, "Yeah, that's because people love potato chips. Their love borders on addiction." Or you comment that far fewer people are attending Major League Baseball games this year, and your friend's explanation is that baseball is so boring.

Your friend explained nothing. If people love potato chips so much, didn't they love them last year too? Then why wasn't Hunky Chunky Potato Chip's stock just as high six months ago? If baseball is so boring, why were so many people attending last year? To explain a change in some variable, you have to point to something else that changed, not to something that stayed the same. What did change? Are people disgruntled over the baseball strike? Did ticket prices go up? Have people fallen in love with another sport? Something caused the change you're observing. The trick is to identify the key elements that changed and not the fundamental elements that didn't. We doubt that baseball has gotten less exciting or that people just recently discovered potato chips. It is entirely possible that the popularity of potato chips and baseball ebbs and flows, but then the variable that changed is the popularity itself.

Why did the stock market fall? Could it be something that happened in China? Absolutely. Could it be a change in sentiment? Absolutely. But it has to be a change.

Alberto Mingardi

RIP Nathan Rosenberg

Alberto Mingardi

Nathan Rosenberg died on August 24th. Read the obituaries by Joshua Gans on Digitopoly and by Richard Langlois on Organizations and Markets.

Together with lawyer L.E. Birdzell, Rosenberg wrote a book that is a true must read: How the West Grew Rich. Consistent with its title, the book is a splendid tour-de-force that investigates the basis of the development of Western countries and reasons elegantly on the drivers of the industrial revolution. How the West Grew Rich was published in 1986, a few years after Jean Baechler's The Origins of Capitalism (which first appeared in French in 1971) and E.L. Jones's The European Miracle (1981). These three books had a great impact among social scientists but also, I would dare say, on the general public. In a short book that is a treasure trove for the historian of ideas, Baechler advanced the thesis that capitalism emerged because of a particular institutional setting: Europe was never turned into a monolithic, top-down "Empire" but allowed for political pluralism. Jones likewise stressed the importance of institutional pluralism, which allowed for a limitation of the predatory behaviour on the part of sovereigns. Rosenberg and Birdzell saw the development of industrial capitalism as strongly intertwined with what we call "economic freedom". Of course, events as complex as all those occurrences that we like to cluster under the label "industrial revolution" have multiple causes. But these three books help in focusing some essential factors.

Rosenberg is remembered as a historian of innovation. How the West Grew Rich emphasizes the importance of innovation in Western growth. This is indissolubly linked to the persistence of a system of decentralised decision making--aka capitalist firms in a free market. In the ever more prosperous West

the economic enterprise had become a unit for making a wide range of economic decisions, and its gains and losses from decisions were expected to accrue to the enterprise or, less abstractly, to its owners. Virtually without thought or discussion, the West delegated to enterprises the making of a decision basic in the innovation process: which ideas should be tested and which should be allowed to die. For economic innovation requires not only an idea, but an experimental test of the idea in laboratory, factory, and market. (...) Markets determined who won the rewards of innovation and the quantum of the reward. The response of the market was the test of success or failure of an innovation.

The narrative of How the West Grew Rich was in itself "an argument for capitalism," noted Deirdre McCloskey in 1986, "in the same way that the successes of Hong Kong or the failures of Moscow are arguments for capitalism." If you haven't read it yet, perhaps you should.

CATEGORIES: Obituaries

In a recent post I argued that government monopolies often offered worse service to customers than competitive private firms. In this post (which will have something to offend both progressives and conservatives), I'll look at a different, but related problem.

A few days ago there was a big debate about a New York Times expose on working conditions at (BTW, it would have been useful for the NYT to compare labor practices at the Seattle company to working conditions at firms operating in the Amazon region of Brazil.)

Many liberals were appalled, while conservatives often wondered why, if working conditions were so bad at Amazon, people didn't simply "get another job." I have sympathy for both sides, but probably a bit more for the conservative side.

One liberal objection might be that it's not easy to get another job. And perhaps that's because monetary policy since 2008 has been too contractionary. And perhaps that's because conservatives have complained about the Fed's QE/low interest rate policies, which has made the Fed reluctant to do more.

Regardless of how you feel about monetary policy, it's clear that if employers feel they have a "captive audience" of workers, who are terrified of losing their jobs, it would be easier for the employer to crack the whip and drive the employees to work extremely hard. One advantage of a healthy job market is that workers have more power to negotiate pleasant working conditions.

But progressives also have some major weaknesses in this area. They tend to favor policies such as New York City's rent controls, and the new $15 minimum wage being gradually phased in in some western cities. I like to think of these policies as engines of meanness. They are constructed in such a way that they almost guarantee that Americans will become less polite to each other.

In New York City, landlords with rent controlled units know that the rent is being artificially held far below market, and thus that they would have no trouble finding new tenants if the existing tenant is unhappy. So then have no incentive to upgrade the quality of the apartment, or to quickly fix problems. They do have an incentive to discriminate against minorities that, on average, are more likely to become unemployed, and hence unable to pay the rent. Or young people, who might damage the unit with wild parties.

Wage floors present the same sort of problem as rent ceilings, except that now it's the demanders who become meaner, not the supplier. Firms that demand labor in Los Angeles in the year 2020 will be able to treat their employees very poorly, and still find lots of people willing to work for $15/hour.

Even worse, this regulation will interact with the migrant flow from Latin America, to produce another set of unanticipated side effects. In some developing countries there is a huge army of unemployed who go to the cities, hoping to get one of the few high wage jobs available in the "formal" sector of the economy. With a $15 minimum wage, migrants will come from Mexico until the disutility of waiting for a good job just balances the expected utility of landing one of those good jobs. You'll have lots more angry, frustrated young Mexican illegal immigrants, with lots of time on their hands.

What could go wrong?

One reason that I am what Miles Kimball calls a "supply-side liberal" is that I believe my preferred policy mix (NGDP targeting plus free markets) is most likely to produce the sort of "nice" society I grew up with (in Madison, Wisconsin.)

Alberto Mingardi

Man, Economy, and Science

Alberto Mingardi

The Mises Institute just published in book form a 1959 monograph by Murray Rothbard, "Science, Technology and Government." The manuscript was discovered among the Rothbard papers and first published on in 2004. Alas, I didn't read it back then --and I am very sorry I did not. This is Rothbard at his best: radical and logical. As David Gordon points out in his introduction, the book "contains an astonishing wealth of insights."

The circumstances in which Rothbard wrote this piece may seem radically different than ours. As Gordon puts it,

When Murray Rothbard wrote "Science, Technology, and Government" in 1959, supporters of the free market needed to confront a challenge that remains relevant today. In 1957, the Soviet Union launched its "Sputnik" satellite, thereby defeating the United States in the race between the two countries to be first into space. Did this victory show, or at least suggest, the superiority of Soviet centrally-planned science to the American market economy? Critics of the free enterprise system like John Kenneth Galbraith (one of Rothbard's least favorite economists) claimed that scientific research and development required government planning and control.
The idea that the market's decentralised decision making cannot make up for "greatness" (in this case, "greatness" in scientific research) is not new--and it is extremely resilient. Marianna Mazzucato, the author of "The Entrepreneurial State," made herself famous by arguing that markets have "no vision" (whatever that means) and that government R&D is the true source of ALL innovation, while private companies are just riding its coattails. See here her "Lunch with the FT" for a quick summary of her views. Note that the word "consumer" doesn't come up in the article, not even once.

Murray Rothbard2.jpgRothbard's text is a sobering read . It begins from a definition of the "economic problem":

The crucial economic question, and one of the most important social questions, is the allocation of resources: where should the various and numerous productive factors: land, labor, or capital, be allocated, and how much of each type to each use? This is the "economic problem," and all social questions must deal with it.

This is the proper setting to discuss investments in R&D. How can we make sure resources are properly allocated? This is a question worth asking both for applied and basic research. In the Soviet Union, Rothbard explains, "government planning of science, is bound to result in the politicisation of science." The politicisation of science means the substitution "of political goals and political criteria for scientific ones." Think about it in the quest to allocate resources to produce innovation. The consumer gets completely evicted from the picture: it is other goals that government investments are serving (which doesn't mean, of course, that they cannot yield byproducts or have unintended consequences).

Rothbard also deals with "military research by government" and he basically suggests to "buy" instead of "make" it. "The exact circumstances under which it was written have not yet come to light", writes Gordon, but in two instances Rothbard seems to be advising the Republican Party. Eisenhower was to give his "Military-Industrial Complex" speech the next year. He warned against the danger that "public policy could itself become the captive of a scientific technological elite," too. Eisenhower seemed nostalgic for "the solitary inventor, tinkering in his shop" who "has been overshadowed by task forces of scientists in laboratories and testing fields".

Building on research by John Jewkes and others, Rothbard wrote that "The worthy individual inventor is far from helpless in the modern world. He may, in a free enterprise system, become a free-lance consultant to industry, may work on inventions on outside grants, may sell his ideas to corporations, may form or be backed by a research association (both profit and non-profit), or may obtain aid from special private organisations that invest risk capital in small speculative inventions."

Was Rothbard too optimistic? Are innovations today coming mainly from big organisations? On the other hand, I wonder if the "user entrepreneurs," that is "individuals who create an innovative product or service because they need it for their own use and subsequently found a firm to commercialize their innovation" (see this) aren't but the grandsons of the inventors Rothbard had in mind.


Some intriguing Psychology & Economics of the media from post-libertarian Joshua Hedland:

"If Muslims are peaceful, why don't they condemn terrorism?"

This is a common question in some philosophical corners in response to headlines about attacks by radical Islamists.
After providing a long long list of Muslim condemnations of terrorism, Hedland explains the origin of the perceived denunciation deficit:
Denunciations about terrorist attacks face multiple handicaps. First. people being killed tends to attract more attention than people talking. The latter is less likely to be introduced as "breaking news" or front-page headlines. Regardless of how prominently it is introduced, it is less likely to propagate through clicks, shares, comments, and general discussion.

Sometimes people talking about big events can attract more attention due to the connection to the big event. But a second handicap is that Western media and its Western consumers tend to pay more attention to Western people, especially those who are Important. That's how Obama not going to France - a non-event that would normally register even less attention than Obama talking about something - was apparently a bigger deal last week than hundreds or thousands of Nigerians killed by Boko Haram. If dying Africans can't compete with Obama's travel plans, what hope do talking Arabs have?

A third handicap is that we tend to pay more attention to events that elicit emotion than events that absorb emotion. An article about someone condemning violence - if it finally manages to make it past the other handicaps - is less likely to elicit much reaction. Well, duh, denouncing violence is what we would expect any normal person to do. Normal expectation satisfied, emotion absorbed, not much impulse to share that story with others.

Hedland concludes:

It can be simultaneously true that there are Muslims condemning violence done in the name of Islam and that the efforts of those voices should be increased. But I think people in good faith, if they really want those moderate voices to be more successful, should not respond with derision, but by recognizing the handicaps faced by those moderate voices and helping them out by encouraging and amplifying their voices.

Wise advice despite my prescription for fighting statistical discrimination against your group.

One of the most gratifying things about blogging is seeing the quality of press reporting going up over time. One sees more and more news reports that seem to have been influenced by the debate in the blogosphere. A great example is this recent article by Kelly Evans of CNBC:

The public has been seemingly desperate for the Federal Reserve to raise interest rates.

"Savers are getting creamed here," has been a common refrain.

"Banks are getting crushed."

"Zero percent sends a bad message, it undermines confidence."

Even the experts seem upset by the inertia: "It's simply time," has become another popular phrase.

Imagine what would happen, then, if the Fed raised rates--and they dropped even lower, instead. That's effectively what's happening today.

Even if the Fed hasn't raised interest rates, it has stopped lowering them, and it has stopped the balance-sheet expansion that replaced rate cuts once its target rate hit zero.

That, combined with a stronger U.S. dollar, means despite rates still being near zero, the Fed has effectively been tightening monetary policy.

People often complain that rates are low only because of Fed manipulation of the markets. But when the ECB tried to raise rates in 2011 it simply pushed the eurozone into deflation, and longer-term rates fell lower than ever before. Here's some more:

Sometimes, all interest rates are moving higher at the same time. That's because the market thinks inflation will be higher over a longer time horizon, and so demands a higher yield on longer-term securities.

Today though, the market isn't so convinced that inflation will be higher over time.

"More than half the components of the consumer price index have declined in the past six months," observed former Treasury Secretary Lawrence Summers, who just warned that if the Fed raises rates at its next meeting, in September, it will be making a "historic mistake."

The collapse in oil and other commodity prices has added renewed downward momentum to the global inflation cycle. China, the biggest driver of global growth the past decade, is notably slowing and already experiencing deflation on the wholesale-price level. Big markets across the Middle East, Asia, and Latin America are in turn slowing too.

Market-based measures of inflation expectations in the U.S. continue dropping, now pricing in less than 2 percent annual inflation several years out. That indicates "a serious and sustained undershoot of the inflation target," said Michael Darda, chief economist and market strategist at MKM Partners, in a recent note to clients.

Great stuff. Of course I can't be sure that the improved quality of economics reporting is due to the econ blogosphere, but over the past 6 years I've met a number of reporters (including Ms. Evans), and my impression is that they do pay attention to us bloggers. For instance, Ramesh Ponnuru of the National Review has co-authored some articles with David Beckworth.

Ideas matter. I believe Shelley said something about poets being the unacknowledged legislators of the world (which I think is sort of true, if one defines 'poet' broadly), and then Keynes ripped him off with his comment about the world being ruled by the ideas of economists and philosophers. So now I'm ripping them both off with my claim about bloggers.

HT: David Gulley

Nobody in the family seems intimidated by life in Asyut, and they don't consider themselves successful; Chen and Lin often say that their factory is just a low-level industry. But, whenever I visit, I can't help thinking: Here in Egypt, home to eighty-five million people, where Western development workers and billions of dollars of foreign aid have poured in for decades, the first plastic-recycling center in the south is a thriving business that employs thirty people, reimburses others for reducing landfill waste, and earns a significant profit. So why was it established by two lingerie-fuelled Chinese migrants, one of them illiterate and the other with a fifth-grade education?
This is from Peter Hessler, "Learning to Speak Lingerie," The New Yorker, August 10, 2015.

Often, when I hear people connected with the U.S. Department of Defense talking about the Chinese presence in Africa, their tone is ominous, as if they fear the Chinese taking over. There's some of that, I'm sure. But the piece in the New Yorker quoted above gives another perspective: it's on private, for-profit Chinese entrepreneurs in the retail lingerie segment. The entrepreneurs whom author Peter Hessler discusses are relatively "uneducated." I put that term in quotation marks because it's clear from the article that, although they lack formal education and some cannot even read or write, they are educated about things that matter most for their business.

The quote above is my favorite from the piece, but the whole article is well worth reading. Especially notable is the contrast between efficient use of resources by private-sector Chinese people and the bloated white-elephant projects of China's government.

HT to Jeff Hummel.

A few days ago, I posted about a problem with government provision of information and government's mandates that private firms provide information. The problem: there's no guarantee and, moreover, no reason to think, that the government will provide or mandate the right information.

Then I came across an excellent piece by Walter Olson that makes the point well for a particular case: the case of herbal supplements. In this case, the government misled and never, once it was discovered that it misled, tried to correct the record. So it left people, including, in this case, me, thinking it had a point. I actually had started to change my sources for herbal supplements that I take because I had thought, until I read Olson's article, that many of the herbal supplement providers were as fraudulent as the New York state attorney general, Eric Schneiderman, had claimed.

Last February, Schneiderman announced a big enforcement action against herbal supplement providers. Olson gives the details:

The initial news coverage was breathless. "Many pills and capsules sold as herbal 'supplements' contain little more than powdered rice and house plants, according to a report released Monday by the office of New York state attorney general Eric Schneiderman," ran The Atlantic's report. "An investigation found that nearly four of five herbal supplements do not contain the ingredients listed on labels, and many supplements--tested from among leading store-brand products sold at GNC, Target, Walmart, and Walgreens--contain no plant substance of any kind at all."

I had read this at the time. I had been buying many of my herbal supplements from GNC and had started to switch providers.

But then the plot thickened or, as my mother used to say, sickened. Olson writes:

But the fraud turned out to be of a rather different sort. Almost at once, experts in relevant biochemical fields--including some longtime vocal critics of the herbal-supplement industry--began to speak out: Schneiderman's office had gotten nonsensical results by using an inappropriate test, one that neither the industry nor its regulators use to assay final purity. DNA barcode testing, which searches for a particular snippet of DNA distinctive to a plant, may be fine when checking the authenticity of a sample of unprocessed raw plant material. But dietary supplements are made by extracting the so-called active ingredient, which often means prolonged heating, use of solvents, and filtering that removes or breaks down the DNA. The better the purification methods used to isolate the active ingredient, in fact, the likelier that the original plant's identifiable DNA will be lost. Harvard Medical School's Pieter Cohen, a leading critic of supplement marketing, told Forbes that it was "no surprise" that Schneiderman's tests came out negative: "Even if DNA got in, we'd expect it to be destroyed or denatured." Meanwhile, GNC, the biggest player in supplements retailing, went back and retested the accused products from its line and found, Schneiderman notwithstanding, that all contained the labeled active ingredient.

We've become accustomed to government regulators shaking down the regulatees even when they have done nothing wrong. John Cochrane recently wrote at length about this. So, when a company fights back, it's a "man bites dog" story. But that's not what happened. Olson quotes from Bill Hammond of the Daily News:
The company admitted no wrongdoing, paid no fine and was allowed to go back to selling exactly the same products manufactured in exactly the same way.

The AG who weeks earlier had strongly implied that most of GNC's products were fake was now affirming that he found "no evidence" that the company deviated from federal regulations.

GNC did agree to conduct DNA testing going forward--but on its raw materials, not the finished products [emphasis added]. It also agreed to post signs explaining the difference between plants and processed extracts, in case consumers were confused about that.

As Olson summarizes:
The whole affair inflicted millions of dollars in economic damage on companies that had done nothing wrong, while sending consumers around the country into needless spasms of anger, worry, and outrage. As Hammond writes: "It turns out the one peddling snake oil was Schneiderman himself."

By "it" I mean the current stance of policy. To see why, we need to review the circularity problem. Asset markets look at the Fed, and the Fed looks at asset markets. When there is enough blood on the floor, the Fed reacts to asset markets by adjusting policy. This reaction reduces the severity of the problem. But of course markets understand this. They see deflationary shocks (actually negative AD shocks), and they see the likely Fed reaction to deflationary shocks. All that gets factored into asset prices.

Let's suppose that 30-year bond yields fall by 50 basis points, due to a deflationary shock. Also suppose the markets expect the Fed to offset 1/2 of the shock, with easier money. That means the shock is big enough to drive 30-year bond yields 100 basis points lower, if the Fed doesn't react as expected. Because asset prices already incorporate the expected Fed reaction, they understate the size of demand shocks buffeting the economy.

In a superficial sense the shock looks like it is coming from China. But that's misleading; nothing in China would have that big a direct effect on the US economy. Instead what's happening is that the Chinese investment slowdown is reducing the Wicksellian equilibrium interest rate all over the globe. Because central banks foolishly target interest rates rather than inflationNGDP growth, that slowdown is (unintentionally) tightening monetary policy all over the world (even more in Japan and Europe). As an analogy, the drop in housing investment in 2008 lowered the Wicksellian equilibrium rate, and tightened monetary policy in all countries that target interest rates.)

Under similar conditions in 1998, Alan Greenspan reduced the fed funds target and the US avoided any spillover effects. Will Janet Yellen reduce IOR? How about level targeting?

PS. The 30-year bond yield is down to 2.66%. Is there anyone who still doubts my claim that relatively low interest rates are the new normal for the 21st century? The world's central banks still rely on a 20th century Keynesian interest rate target mechanism that doesn't really work in the 21st century. How long will it take for them to figure this out? Let's hope they are getting some sensible advice at Jackson Hole.

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