Arnold Kling  

Scott Sumner's False Dichotomy

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When You Put It That Way, Scot... Unintended Consequences, Chapt...

Bryan likes what Scott says here. Read Scott's whole post yourself, so that you do not necessarily take my reading of it.

Anyway, he comes close to saying that you either have to believe in efficient markets or you ought to be rich. If so, then that is a false dichotomy.

In 2003 and 2004, I thought that markets were out of whack in several respects. I thought that interest rates were too low and the dollar was too high. So I did not believe in efficient markets. And, to some extent, I allocated my portfolio according to my beliefs. But I did not get rich.

The moral of the story is that it is easy to believe that markets are wrong. Most recently, I spelled out my differences with the market on the outlook for long-term interest rates.

But one can believe that the markets are wrong and still not get rich. The markets can be right. Or, the markets can be wrong in ways that you did not expect. As an investor, the prudent approach may very well be to act as if markets are efficient. Load up on those stock index funds and those inflation-indexed Treasury securities, and be done with it.

Sumner points out that the 1987 stock market crash was not followed by a recession. As he says, this is bad news for the theory that stock market fluctuations cause economic fluctuations. However, it is equally bad news for the theory that stock market fluctuations represent rational responses to news about economic fluctuations. What news were investors processing in August of 1987?

Sumner also points out that macro models cannot predict sharp recessions. I can think of two reasons for this, one theoretical and one statistical.

The theoreteical reason is that modelers tend to impose constraints that force the models to have long-run properties, such as a return to full employment. The way these constraints are imposed often results in mean-reversion with a vengeance--it makes the models unable to get off trend growth by a lot or for a long time.

The empirical reason is that models tend to be dominated by recent data. Given that it has been more than 25 years since we experienced a major recession, any model that fits the recent data is bound to have pretty mild cyclical properties.

So here is where I stand:

1. Macroeconometric models are pretty useless. I've said that in many times and in many ways, so I won't elaborate here.

2. Perfectly predictable financial crises should not occur. Both private sector actors and government regulators should have incentives to act on information that predicts financial crises.

3. Unlike models, individual human forecasters can make predictions that include financial crises and severe macroeconomic events. Most of those predictions will be wrong. Occasionally, a predicted crisis will come to pass.

4. I think that in 2005, even if one had known that housing was a bubble, the policy implications were not clear. We survived the Dotcom crash, so why should we not survive a collapse in the housing bubble? The real "news" in 2008 was the vulnerability of large financial institutions to the collapse of the bubble.

Even now, it is still somewhat mysterious how the housing boulder was able to cause such an enormous financial avalanche. The mainstream answer is that the financial sector had become highly leveraged and fragile. I believe that Sumner would argue that contractionary monetary policy, resulting from the decision to pay interest on reserves, caused the economic outlook to deteriorate, which in turn caused stocks to collapse.

I wonder if there is a way to test Sumner's view against the mainstream view. Maybe we can compare how financial stocks performed in this period with their typical cyclical performance. If financials fell much more relative to the market than you would have expected, then the mainstream view has support. If financials were no more cyclically sensitive than usual, then maybe Sumner's view deserves more consideration.


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COMMENTS (12 to date)
Scott Sumner writes:

Arnold, Your point about the 1987 crash is a good one. The 87 crash is perhaps the best argument I have ever seen against the EMH. In another post I argued there are several events that look (to me) like market inefficiency. The 2006 housing bubble is another. So what is my point? I do think the EMH is a good baseline assumption to start with, especially if all sorts of different markets are pointing the the same direction. But I was actually making a slightly different point in the astrology post. I think people like Lucas do believe in efficient markets--but I also think they often forget to think about market information when considering real world macro policy. I talked to lots of economists last fall and just about all of them agreed with my view that markets were signally a steep drop in NGDP. And they almost all thought the markets were correct in making that forecast. But they didn't draw the policy implications that I drew from that fact--that monetary policy was effectively highly contractionary, and needed to be much more expansionary. Indeed expansionary enough to equate the forecast and the target. I don't have a problem with people who disagree with the EMH (if I said so I withdraw the charge) instead I have argued the anti-EMH position has no policy implications. I have trouble with people who are so confident that they know more than the market that they are willing to conduct macro policy on their hunches. If the Fed wants 2% inflation, and the market expects negative 2% or 6%, I've got a big problem with that, regardless of whether markets are always perfectly efficient (and I agree they probably are not.)

Jonathan Bydlak writes:

Thanks for that post, Arnold. One of your best of the last few months, and I'm glad you held Bryan to task for a post that was uncharacteristically poorly thought out.

Greg Ransom writes:

I sort of liked what Vernon Smith said about this in the Wall Street Journal. What was your take on Smith's housing foreclosure account, Arnold?

Arnold wrote:

"Even now, it is still somewhat mysterious how the housing boulder was able to cause such an enormous financial avalanche."

GabbyD writes:

actually, people are rich right? they take advantage of market imperfections to make deals?

only the contention that EVERYONE should be rich is wrong. certainly, the fact that SOME people have super normal returns is proof that market manipluation, better information can make you rich. no?

Less Antman writes:

"Sumner points out that the 1987 stock market crash was not followed by a recession. As he says, this is bad news for the theory that stock market fluctuations cause economic fluctuations. However, it is equally bad news for the theory that stock market fluctuations represent rational responses to news about economic fluctuations. What news were investors processing in August of 1987?"

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Stock prices are, by necessity, single numbers at any point in time, but reflect the estimate of probabilistic futures. If I am holding a sealed box that has an equal probability of holding $10 or $30, the selling price of the box will be $20 right now, and after being opened there will be either an immediate 50% drop or an immediate 50% rise in price. The pricing was rational throughout, even though a radical change in price occurred after opening the box.

In 1987, there is some evidence that major moves were associated with the surprise introduction into a Congressional committee of legislation to make mergers much less favorable from a tax point of view, and activity the week of the crash could well be correlated with the best guess of the outcome. The fact that the legislation was withdrawn after (and perhaps as a result of) the crash could explain the absence of follow up and the recovery of the market.

Rational doesn't mean omniscient. There are uncertainties as to the outcome of future events, and it is as unlikely that any stock price will be accurate as it is that any particular person will die on the exact day predicted by the actuarial tables. Both are rational estimates of futures with multiple probabilities, and expecting the weighted average of all expectations to be the precise result in a rational market is silly.

As a personal financial advisor and asset manager, I can attest to the extraordinary difficulty of beating the market: I earn my fee by getting people to diversify widely and accept the appropriate level of investment volatility based on their individual circumstances.

Any true inefficiency in the market ought to be exploitable for abnormal profits. Academic studies regularly show anomalies that end up not being exploitable, usually for reasons that Professor Coase will be glad to explain.

Scott Sumner writes:

Pardon the pun, but "Less is More". I appreciate the comment Less.

GabbyD, Do you think the EMH doesn't allow people to get rich? I had never heard that one before. I wonder whether you think the laws of probability don't allow people to have long winning streaks in casinos. The first time I ever walked into a casino was in 1991. I sat down and won the first 12 blackjack games that I played. I barely knew how to play. Never have had any luck since. What does that prove?

I can't believe that people believe that if they've made a few lucky market calls it shows the EMH is wrong.

Jesse writes:

Any true inefficiency in the market ought to be exploitable for abnormal profits.

This simply isn't true. There are a number of evident limits to arbitrage.

Let's say you think the stock market is overpriced by 30%, but you don't know when the downturn will actually come. If you simply short the stock market, you may have several years of terrible returns, and if you are managing other people's money, as most market players are, you may not have this luxury. "Oh I have a master plan, I'll eventually make all these losses back and then some in a few years" is not a convincing message to most investors.

So it is entirely possible for inefficiencies to exist in the market, and for them to be recognizable but not exploitable. I understand that this is a bit of a bummer for armchair theorists who like to think that we live in teh best of all possible worlds, but what can you do?

floccina writes:

I saw the housing bubble and so I did not invest in real-estate and I sold most of my REIT stocks. I also avoided financial stocks even though the yields looked very good but I did not think to short them because I did not know when or how much they would fall. Just seeing the housing bubble was not enough in my case. I also though that the USA stock Market was too high and so I bought municipal bonds and foreign stocks. Municipal bonds and foreign stocks fell even more than homes and USA stocks. That's life. I did make some money shorting petrol from the peak by buying DUG.

gnat writes:

There were financial crisis in 1987, 1998 and 2001 all without much impact on the real economy. (BTW, the dot com economy was a pretty good argument against EMH). Its not clear to me how these fit Scott's view.

Financial disruptions in intermediation ocurred in 1929, 2008 and Japan 1990s that created large real losses. Each of the three periods were characterized by liquidation cycles (of fixed income instruments), Bernanke's credit accelerator cycle (both anti-EMH), and keynesian cyles each interacting to reduce intermediation leverage and agregate demand.

One of Scott's points has been that a fall in interest rates can reflect a tightening of credit as a result of a fall in expected NGDP therefore the Fed should not look at interest rates. This could happen in the case of intermediation disruption if intermediaries are capital constrained as now appears the case. (It could also occur if output falls e.g.,IS shifts to the left). One of the reasons the Fed targets interest rates is that they are easy to measure. I am not sure that Scott's solution of expected NGDP is praqctical.



Matt Nolan writes:

"I believe that Sumner would argue that contractionary monetary policy, resulting from the decision to pay interest on reserves, caused the economic outlook to deteriorate, which in turn caused stocks to collapse"

Hmmm, altnough it can be read like that I always read it the other way around.

I had the impression Scott was saying that the drop in the stock market was signalling a drop in NGDP and as a result monetary policy needed to become more accomodating - instead the Fed introduced interest on reserves helping to drive the depth of the recession we see now.

Less Antman writes:

Let's say you think the stock market is overpriced by 30%, but you don't know when the downturn will actually come.

There really isn't any meaning to the assertion that "the stock market is overpriced by 30%." Compared to what? One's opinion on the rate of return stocks should offer is not an inefficiency.

And as a money manager, I can tell you that there are many hedge funds following 130% long / 30% short strategies to try and take advantage of relative overpricing and underpricing without excessive risk: one isn't limited to either doing nothing or shorting one's entire net worth without a hedge.

Still, our disagreement might be over semantics: I don't deny unexploitable inefficiency resulting from transaction costs (which is why I mentioned Coase in my earlier comment). To that extent, I favor the weak version of EMH.

Boonton writes:

4. I think that in 2005, even if one had known that housing was a bubble, the policy implications were not clear. We survived the Dotcom crash, so why should we not survive a collapse in the housing bubble? The real "news" in 2008 was the vulnerability of large financial institutions to the collapse of the bubble.

It should be pointed out that it is perfectly rational to be irrational. I forget the link but the experiment went along these lines. A group of people were told at 12 PM a 'security' would pay out $20. They were set up in a trading game and told to start trading. 'Rationally', the price should have opened near $20 and inched up to $20 very slowly as the hours ticked by. Instead the price exhibited a bubble pattern. Trades shot up to $60, $70 and more...then around 11 am or so people came to their senses and the price dropped. What's happening is clearly the old 'greater fool' theory of trading. If you had brought the security at, say $15 at 9 am and surfed the internet for the rest of the experiment you would have made $5. But if you had sold out at $40, $60, or $70 you would have a huge profit so even though everyone knows its a bubble, they trade furiously hoping to time the bubble which is created by their own attempts to time the bubble.

Less
In 1987, there is some evidence that major moves were associated with the surprise introduction into a Congressional committee of legislation to make mergers much less favorable from a tax point of view, and activity the week of the crash could well be correlated with the best guess of the outcome. The fact that the legislation was withdrawn after (and perhaps as a result of) the crash could explain the absence of follow up and the recovery of the market.

I find explanations like these annoying because after the fact there will *always* appear to be some policy that you can pin the blame on. But here isn't it a fact that most studies have shown that mergers tend to have rather poor long term results compared to the market? If mergers are not very positive in the long run, why should a rational stock market care if their tax treatment became slightly less favorable?

gnat
There were financial crisis in 1987, 1998 and 2001 all without much impact on the real economy. (BTW, the dot com economy was a pretty good argument against EMH). Its not clear to me how these fit Scott's view.

1. I'm wondering if these crises are independent or part of a pattern?

2. Was that the case with the dot com economy? Yes I think bubble happened but was it all that irrational. The net was new, there was little experience with the new business models that were floated, people know the internet would dramatically change how we do things but how was hard to figure out. Looking back at who survived (say Amazon.com and Google) and who floundered (say AskJeeves, DrKoop), it doesn't strike me as easy to have predicted that from the beginning.

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