Scott Sumner  

Noah Smith and Zachary David refute the EMH

PRINT
I Win My Cruz Bet with Steve P... Peter Thiel on Foreign Policy...

Suppose markets are efficient at pricing assets. And suppose everyone believes they are efficient. In that case (some argue) no one would have an incentive to gather information, and trade on that information. But in that case, speculators and arbitragers would have no incentive to push prices to equilibrium in the first place. So the EMH would seem to be self-refuting.

But if the EMH were false, even a tiny bit false, then speculators would have an incentive to jump in and try to take advantage of any tiny imperfections. So that's an interesting paradox.

In fact, we do see lots of trading. We see speculation and arbitrage, even though asset prices are usually close to a position where risk-free arbitrage is almost impossible. That tells me one of two things, probably both:

1. The EMH is not precisely true---some people do unearth information not available to the overall market, and do profit on that information.

2. The EMH is 100% true, but people don't think it's true. These non-believers in the EMH trade assets, trying to make a profit. If Tesla is priced at $200/share, some people think it's worth $180 and others think it's worth $220 (say after some new information comes out.) These people trade shares, because there is a diversity of views.

Either of those assumptions are enough to rescue the EMH. Some economists would deny that assumption #1 rescues the EMH, but they suffer from a lack of wisdom. They put too much weight on the literal meaning of words, and not enough on the actual meaning. If the EMH is almost true, but not precisely true, it is still truer than virtually any other theory in the social sciences, including basic workhorses like "supply and demand", and "comparative advantage." A theory that is 99% true is essentially "true" in any social science.

Sometimes when people are first confronted with NGDP futures targeting, they sort of lose their minds, and engage in bizarre circular reasoning. They make arguments that they would never make for any other market. They say, "If the theory works, then why would anyone trade NGDP futures? After all, they would not expect to make a profit." Well, expected by whom? The market, or the person doing the trade?

These claims are equivalent to saying that arbitrage won't cause the interest parity condition to hold, because if it caused the interest parity condition to hold, then no one could make money by doing arbitrage. In other words, these skeptics prove too much.

In fact, people would certainly trade NGDP contracts if they had diverse views as to the future expected NGDP, and they would also trade NGDP futures contracts if (unrealistically) they all had identical views. I hope the diverse views case is obvious; so let me focus on the (far less realistic) identical views case.

Let's suppose the Fed has a 5% NGDP target, and the base is at $1 trillion. All traders have the identical view that in order to hit the 5% target, the Fed must boost the base up to $1.03 trillion. Some of my skeptics would claim that a base of $1.03 trillion is not an equilibrium as investors would not expect any profit at that money supply level. This is what they mean by the policy "not working". But that's a very narrow way of thinking about success. I've never argued that in equilibrium the market price will be precisely equal to the market expectation. Again, nothing in the social sciences works perfectly. I've always acknowledged that there would be a (probably small) risk premium embedded in NGDP futures prices. That's obvious, but is it a problem?

The basic argument for NGDP futures targeting is that the risk premium, the difference between the market price and the market expectation, would be relatively small. And by "relatively small" I mean of no macroeconomic significance. You might have a 5.0% futures price and a 4.8% or 5.2% market expectation. But that's a smashing success in macroeconomics!

In the case above, where investors thought a monetary base of $1.03 trillion was needed to hit the NGDP target, they would take a short position on NGDP futures, pushing up the monetary base, at least somewhat closer to $1.03 trillion. How close? Close enough where further trades are not worth the bother. Where the expectation of profit is just counterbalanced by the risk. Again, that's likely to involve a NGDP growth rate that's really, really close to 5.0%, just as arbitrage in foreign exchange markets keeps interest rate differentials pretty close to the forward premium or discount on a currency, but not exactly equal.

Some recent posts by Zachary David and Noah Smith criticized my Mercatus NGDP futures targeting proposal. Even if their criticisms were completely correct, it would not affect my views on NGDP futures targeting, as the plan I currently advocate (Woolsey's index futures convertibility) does not require any trading to occur. The Fed uses discretion, constrained by its reluctance to lose boatloads of money.

In fact, however, their criticisms are completely wrong, for not one but two reasons. First, even if the EMH were precisely true, people would trade because there is a diversity of views regarding future levels of money needed to hit the NGDP target (i.e. future levels of velocity). Their criticism proves too much, as it implies that no one would trade in any market for information reasons, only for liquidity reasons (say needing to sell stock for retirement spending.)

And it's even more incorrect than that, because they wrongly assume that NGDP targeting must work perfectly in order to be a sensible macroeconomic stabilization policy. An expected future NGDP that fluctuated between 4.8% and 5.2% would be a massive success. Might it fluctuate further? Sure, anything is possible, but that would trigger exactly the sort of trading that Smith and David suggest would not occur, thus limiting the fluctuation. Their criticism of NGDP futures targeting exposes a lack of awareness as to the role of arbitrage in the financial markets. It's like saying that if one opened the floodgates between two lakes with uneven levels, the water levels would not equalize, because once equalized, water would no longer have an incentive to flow to the lower lake!

They also discuss market manipulation, which I doubt would be much of a problem. After all, manipulation would open up even bigger profit opportunities for speculators making the opposite bet on NGDP futures, and side bets elsewhere. And, AFAIK, we did not see the sort of manipulation they discussed under either the gold standard or Bretton Woods, other cases where the central bank moved the money supply as needed to peg a key asset price. And finally, the version of NGDP futures that I am currently advocating (a band of 3% to 5% on NGDP futures contracts) is not at all susceptible to manipulation.

Before anyone else tells me why NGDP futures targeting cannot work, I implore them to think about how ordinary asset markets work. What causes prices to be at the efficient levels? And if they are not at the efficient levels, how close are they?

PS. Question for manipulation fear-mongers. Which big investment bank will do the manipulation, and which investment bank will be the sucker that gets taken to the cleaners? Is manipulation really as easy as it looks? Might they compete to "manipulate"?

PPS. Last time Noah Smith criticized the plan, he made the false claim that it was subject to "Goodhart's Law". Before that he suggested that asset markets are too irrational. He clearly doesn't like the idea, and no matter how many objections I shoot down, he seems to come up with another. I wonder if some of my critics are annoyed that someone from lowly Bentley College came up with a clever idea. Perhaps Zachary David would find the idea less "goofy" if endorsed by John Cochrane. Or would he say that Cochrane doesn't understand basic finance?

PPPS. In the future, I encourage people to actually read my Mercatus paper, before jumping in.

HT. Dilip, Patrick R. Sullivan


Comments and Sharing






COMMENTS (30 to date)
Chris writes:

Scott,

I just commented on your MoneyIllusion post, but since this one is more related I thought I would comment here as well.

You say "They make arguments that they would never make for any other market." Right, because no other market has a Federal Reserve willing to buy and sell unlimited quantities at a fixed price. If I think exchange rates are wrong, I buy currency at the current market price and make a profit when the market restores equilibrium. If I think monetary policy is too tight, my only option is to sell NGDP futures at 5%. My action causes monetary policy to loosen, lowering my profits.

You say "Before anyone else tells me why NGDP futures targeting cannot work, I implore them to think about how ordinary asset markets work. What causes prices to be at the efficient levels?"

It is exactly the fact that I can profit from arbitrage in a normal market that pushes prices to their efficient levels. In any other market, when I see an incorrect price and trade on that price my action pushes the market towards the correct price (assuming I was right). I profit when the market works. In an NGDP futures market where the Fed sets the price, I can only profit when the Fed fails. Is there something wrong with this logic?

RobertB writes:

Re: EMH, it's not true that market participants have no incentive to trade unless there are price inefficiencies. People also have an incentive to trade because they want to make investments or get out of investments, and those transactions have to happen at a price. If there weren't a bunch of brokers and arbitrageurs and HFT firms around, John Q. Investor would need to crack open the IBM annual report every time he wanted to buy some IBM stock in his retirement account. That doesn't happen, because rather than doing that, John Q. Investor pays a spread to a market maker/dealer/arbitrageur who makes open bid/ask offers in exchange for collecting the spread on trades.

Hedge funds engaged in stock picking are not a necessary feature of EMH. To the extent they exist and the sector makes money as a whole, that suggests that prices are less than efficient, but if they weren't there it's not true that the market system would vanish from the earth.

MikeP writes:

If I think exchange rates are wrong, I buy currency at the current market price and make a profit when the market restores equilibrium.

But you could also make a futures bet in the exchange rate market against a central bank either oversupplying or undersupplying its currency against another currency in the future. You profit if you guess correctly and lose if you guess incorrectly.

NGDP futures trading is essentially the same, but the currency is being oversupplied or undersupplied by the central bank is not priced relative to a different currency, but to an expected future value of the same currency. You profit if you guess correctly and lose if you guess incorrectly. I don't see any big difference here.

Chris writes:

MikeP,

Let's take Scott's example. The base is $1 trillion, which I (and every other trader) thinks will lead to 3% NGDP growth. Let's say everybody is right and they all decide to trade on that information. Then they sell NGDP futures and push the base to $1.03 trillion. Now expected NGDP growth is 5%. Ok great everything looks good, but let's take a step back. If I can see this chain of events occurring, why do I ever make the trades in the first place? Even though I was right that the base was too low, I have no way to profit on this information without making myself wrong. And if nobody makes a trade, the base stays at $1 trillion and we get 3% NGDP growth.

Now let's consider a stock. The price is $100, but the company just released some unexpected good news that I (and every other trader) believes will raise the price to $105. If I learn this information 2 seconds before everybody else, I can use the information to make a 5% arbitrage profit once the price goes to its equilibrium value.

Njnnja writes:

Your, and others, understanding of EMH is a little off. EMH does *not* argue that market prices are "right" - in fact it is agnostic as to even the existence of a fundamentally "right" price that the market inexorably, if stochastically, converges to.

EMH (in the standard, semistrong form) simply says that the market has incorporated all of the public information already out there in the stock price. So when genuinely new information becomes available, EMH simply states that market participants are going to act on it RIGHTNOWANDIFYOUSNOOZEYOULOSE.

And since new information is always becoming available, EMH predicts that there will constantly be market participants acting on that new information. Which is exactly what we see - active markets constantly acting on new information. There is no paradox.

As an analogy, EMH is like saying that you can't win a 100 meter dash that was run yesterday. People who see a paradox look at that fact and don't understand why anyone would ever run in a race.

DeservingPorcupine writes:

Chris, I think you're thinking too much like a "normal" trader who doesn't carry futures contracts to settlement. I believe in this case pretty much everyone will hold the contracts until settlement. The settlement price will not necessarily be the *pegged* price that the Fed makes a market at.

foosion writes:

Noah Smith has updated his post: https://noahpinionblog.blogspot.com/2016/07/criticisms-of-ngdp-futures-targeting.html

DeservingPorcupine writes:

I believe Noah's update is making the same mistake as poster Chris above.

Again, the Fed isn't an omnipotent market maker because it can't control *actual* NGDP. It can't go out and adjust cash registers and receipts and accounts. It's the sum of these values that the contract would settle against.

Dan writes:


I think you miss the point about EMH. Not that it may fail, but exactly how it fails may affect NGDP futures market.

You can build a simple model to see what the results will be in equilibrium.

I can tell you that divergence of opinion is not going to do the trick. Suppose half the traders think that NGDP growth will 0% the other think half think it'll be 10%. If, who is right is determined randomly, then the futures prices won't move and the FED will do nothing.

What you need in these types of models is uninformed (or liquidity traders) traders. Informed traders enter the market in order make money off of these uninformed traders who help determine a price that diverges from the true value. The problem is as the number of informed traders increases the less likely are they to enter the market, since the price will reflect the true value. If the price reflects true value then the informed guys can't make money because the FED will take action to make sure that they can't. Just like the EMH paradox, you need the NGDP futures market to not work perfectly in order for it to work.


But, unlike other financial assets (like stocks), it's not at all clear why uninformed investors should buy NGDP futures.

NGDP futures could still work, but how well it will would depend on a number of completely unknown variables like the number of informed traders, their risk aversion, etc.

Nick Rowe writes:

Even if EMH is precisely true, and known to be true, trade happens if different people have different preferences or endowments. Just like people trade apples for bananas.

(Of course, that raises the question of what precisely we mean by "EMH", since the equilibrium price of assets, just like the equilibrium price of apples/bananas, depends on preferences and endowments.)

Dan writes:

"Just like people trade apples for bananas."

Financial assets are different. They are pieces of papers (bits on a network these days). What matters is their risk and return. Some people could get utility from holding a certain company stock. Some investors also confuse good companies to be good stock investments because of behavioral biases. But, if that's the case there is no point to talking about EMH.

If, by preferences you mean risk aversion, then yes that could affect prices of financial assets. Same with endowment - to the extent that endowment affects risk aversion.

Nick Rowe writes:

Dan: apple producers, apples consumers, banana producers, banana consumers, all have different definitions of "risk". They might all want to trade in the futures markets even if they have exactly the same beliefs.

Rajat writes:

I think the reference to future levels of velocity in this post is really helpful. But a bit of 'concrete steppes' (love that expression, Nick!) would help the average person like me here. Scott, please tell me if this is right:

Given my expectations of velocity, I think the current money supply is too small to hit the 5% NGDP target. So I sell the 5% NGDP contract to the Fed. The Fed buys it and increases the money supply by some amount. That continues until the market as a whole believes that - given its expectation of velocity - the money supply is about right to hit the target. If I think the market is 'wrong' (in the same way that I might think the market is wrong in over-valuing Telsa shares) then I will trade. For example, if I think the market is wrong to believe that $1.03 trillion is enough to hit the target - I think $2 trillion is necessary - then I will keep selling contracts (and the market will keep buying the same amount) until I am satisfied with my exposure. Then, if actual NGDP comes in on target, no-one has made or lost any money; but if actual NGDP comes in low like I predicted, then I have made money. If, contrary to my view, actual NGDP comes in above target, I have lost money. So you're not 'betting against the Fed' at all - you're betting against the market's view of velocity. Is that it?

B Cole writes:

Good post. But hells bells, damn the torpedoes and send in the helicopters.

Now is not the time for timid tweetybirding around.

Chris writes:

DeservingPorcupine,

First, is your name a reference to Harold and the Purple Crayon?

Second, I don't think my point changes if you hold it to settlement. In fact, I don't see any alternative to holding to settlement. If the Fed is buying or selling unlimited quantities at the 5% level, why would anybody trade at any other price? One side could always do better by going to the Fed directly.

In all of my examples, I don't see how it changes anything if you hold to settlement. I think NGDP growth is 7%, so I buy at 5% from the Fed. If the plan works and the realization is actually 5%, my shares are worth precisely what I paid for them even if I hold to settlement. Again either I'm missing something very fundamental here or I think Smith and David have a point.

James Alexander writes:

Chris
"If I think exchange rates are wrong, I buy currency at the current market price and make a profit when the market restores equilibrium."
EMH says that the starting point is equilibrium. You make money on the way to a new one, that you thought was right.

"In an NGDP futures market where the Fed sets the price, I can only profit when the Fed fails. Is there something wrong with this logic."
I think you are beginning to get it.

J.V. Dubois writes:

I have read Noah's post and this excerpt immediately caught my attention:

"Why the heck would I bet good money on 10% - or 2%, or 6%, or 5.001% -- when the probability distribution of NGDP is distributed symmetrically around 5%? A negative expected return with positive risk? No thanks!"

The funny thing is that I remember old (and very good) post of Noah's titled "In Defense of EMH" : http://noahpinionblog.blogspot.sk/2013/02/in-defense-of-emh.html

There was this excerpt:

"Since people in the finance industry are doing a lot of work - watching the news like a hawk, doing constant analysis of changing numbers - chances are that the price change will happen so fast that you won't have time to get in on the action. So from the perspective of any of us who doesn't have a supercomputer in his head, prices movements must be unpredictable and surprising. They must seem random."

and this one:

"Probably the most robust findings in the field of behavioral finance is that individual investors do badly. They are overconfident. They trade too much and take losses on trading costs. They suffer from biases like disposition effect, probability mis-weighting, recency bias, etc. And as a result they lose money, relative to the wise folks who just stick their money in a low-cost diversified portfolio and watch it grow."

Actually I think Noah's defense of the EMH is so good that if I were you Scott, I would just repost it verbatim.

Brian Romanchuk writes:

Scott,

Is there an explanation somewhere publicly available that explains how you believe that futures convertibility would work?

With a normal futures contract, you enter with no money down. If you converted money into a futures contract, you would instantly lose your capital, and make back the profits on the price change. That would be be a losing trade under normal circustances.

Nathan W writes:

I'm very skeptical about market efficiency, in any pure sense, although clearly other allocation mechanisms have their inefficiencies as well (generally more inefficient for most things, would be my a priori assumption for a great many cases). So long as EMH is not approached dogmatically at all, the basic concept, and the logic which upholds it, are very useful analytical building blocks and even (especially?) staunch anti-market types should to make a good-faith representation of the arguments.

However, the thing I often find lacking from this type of consideration is the following: IT'S A MOVING TARGET. Let's say that markets are efficient at a level of adjustment of 1 hour, day or even week. So ... things change, reach efficiency. But then there are more changes, so someone says "EMH is false because there are still changes".

This is wrong reasoning. Something in the environment, i.e., something in the market (or among agents within it) changed, and now the market is trending towards that equilibrium (perhaps will often overshoot, most emphatically in the shortest term).

So, you have EMH (diluted for the fact that it's not instantaneous), allowing for, no duh, it's not "perfect" information, but perhaps pretty decent information sufficiently often for a pretty accurate market price to arise, and that as this information is updated we observe ongoing changes in the economic environment and that are continuously trending towards that ever changing new equilibriums across many markets, etc.

I call to "trending to the equilibrium with an eternally moving target" or some such thing - and, let's just say for now that we don't really have a clue why that equilibrium changes, no matter that we have good reasons to defend our various guesses. The general way of understanding equilibria, trends, targets, etc., is not contingent on detailed understanding of the specific case, rather, that there is a trend towards a moving point, and so ongoing fluctuation should not be misunderstood as some sort of evidence that no theoretical equilibrium at any specific point in time even exists, for example.

(P.S., this is the correct way to understand biological evolution too. There is no "perfection" - rather, there is trending towards "more fit" attributes, but due to moving target issues, attributes which were beneficial yesterday may not be so tomorrow. What stays constant is the fact of trending towards "fitness" / "equilibrium", not anything specific about what exactly that "fitness" or "equilibrium" is in the specific time. The present outcome is the sum of previous trends towards those diverse equilbria, not the process of an infinite regress where "perfection" has been obtained - in the meantime of all those changes, the moving target has always been ... moving.

(The conditions and strategies specific to the given situation are obviously of great interest to those operating in that environment. But, I argue, are of essentially zero interest in terms of the basic principles of (biological or market-based) evolution, trends, equilibria, targets, etc.)

Nathan W writes:

Say ... people know you can do the job, but management feels a risk of the entire management staff coming under special dark state scrutiny for the fact of working with you. (Whether or not it ultimately happens, so long as this prospective new employer might believe it.)

What do EMH people say about that kind of stuff? When everyone knows that

Sorry, that's probably an uncomfortable thought. I promise to self report to local mental health authorities to discuss whether it is possible for people to try to influence other people to not do business with 3rd parties, and whether a lack of courtroom ready evidence is itself evidence of mental illness on the part of someone who would say such a thing ...

The point not being an attack on EMH, but rather questioning whether EMH is a good vantage point from which to discuss the high economic costs of discrimination and exclusion from economic opportunity due to things like being blacklisted (formally or informally) for political, religious and/or other ideological views, etc.

Scott Sumner writes:

Chris, You have not addressed the points I made in the post. Yes, there are not many markets where central banks peg prices (although Bretton Woods was an example---does your argument also show Bretton Woods can't work?)

You said:

"In an NGDP futures market where the Fed sets the price, I can only profit when the Fed fails."

In any market, you only profit when the market consensus is wrong. Does that stop people from trading in other markets? Look, there are too possibilities:

1. People think the Fed will succeed, and don't trade. So what?

2. People think the Fed will fail, and trade.

Don't worry so much about how your trades move monetary policy. We are all much too tiny to have much impact as individuals. If we think NGDP will be too high before we trade, we probably will also think it will be too high after we trade. By analogy, If I think Tesla stock is too high, I'll probably still think it's too high after I sell it short, and nudge the price down a few pennies.

The proper way to think about this issue is the risk premium, which is the difference between the market expectation of future NGDP, and the price of NGDP futures. If that's small, the policy works. Are you claiming a big risk premium under NGDP targeting? If so, why?

And if this really is such a goofy idea, why didn't John Cochrane see the problem when he proposed something similar for the CPI? He's one of the top financial economists in the world.

Robert, You said:

"EMH, it's not true that market participants have no incentive to trade unless there are price inefficiencies."

I agree, I said there is no incentive to gather information and trade, but there would be an incentive to trade without gathering information, as I discussed in my previous post.

Chris, You said:

"Let's take Scott's example. The base is $1 trillion, which I (and every other trader) thinks will lead to 3% NGDP growth. Let's say everybody is right and they all decide to trade on that information. Then they sell NGDP futures and push the base to $1.03 trillion. Now expected NGDP growth is 5%. Ok great everything looks good, but let's take a step back. If I can see this chain of events occurring, why do I ever make the trades in the first place? Even though I was right that the base was too low, I have no way to profit on this information without making myself wrong. And if nobody makes a trade, the base stays at $1 trillion and we get 3% NGDP growth."

I addressed exactly that point in my post. You may not like my response, but don't comment as if I did not answer your question, I provided a quite detailed answer to that very issue.

Njnnja, I don't see how any of that relates to my post. Is there any specific sentence you think was incorrect?

Dan, You are missing the point. NGDP futures targeting can work just fine even if no one trades the contracts.

Nick, Exactly.

Rajat, You are betting against the Fed in the sense that they are the other side of the contract (counterparty--is that the term?) But if the Fed arranges its affairs (the base) such that it takes a roughly equal number of short and long positions, then I agree that in a deeper sense you are betting against the market consensus.

In contrast, suppose private traders take only short positions (as they might have in late 2008) and the Fed takes only long positions. Then I'd say you are betting against the Fed.


Dan writes:

"In any market, you only profit when the market consensus is wrong. Does that stop people from trading in other markets?"

This is not right. The market you describe is not like any other financial market. You keep making the analogy to stocks which is not right.

This is about price discovery. Do correct expectations about the future get embedded in the NGDP futures price? You need informed traders' expectation to be revealed in price. Otherwise, NGDP futures prices would just be random and not useful as a policy tool.

If information is revealed in the future prices than the informed traders cannot make money, because the FED will take action to make sure they don't.

This is similar to Stiglitz' theory about information being fully revealed in asset prices. If the information is costly to acquire and is fully revealed in asset prices, then no one will collect information.

That's why in these types of models you need uninformed/liquidity traders so that information is not fully revealed.

The problem for you is if you have too many uninformed traders, then prices won't reflect true expectations about the future, making the NGDP futures useless as a policy tool.

Without knowing the % of informed traders, the precision of their knowledge, and their risk aversion, you cannot say anything about the equilibrium.

Chris writes:

Scott, I think you're probably right and as you said people far smarter than me have proposed similar ideas. I don't think at all that it's a goofy idea and actually I was fully on board until recently. I'm really just trying to improve my own understanding.

I think I am starting to see what you are saying. In my examples, I assumed that your expected return was 0 since the Fed usually hits its target. By including a risk premium you allow them to make enough profit to be happy even if the Fed hits its target minus the premium. In other words when I trade the two possibilities are actually:

1. The Fed fails to hit its target and I'm really happy because I make a large profit.

2. The Fed hits its target minus the risk premium and I'm indifferent because I am exactly compensated and could not have gotten a risk adjusted return any better than I got here.

Is that right?

Dan writes:

"By including a risk premium you allow them to make enough profit to be happy even if the Fed hits its target minus the premium."

It's not clear why there should be a risk-premium if the market is dominated by informed traders and the FED always hits the target (it's also not clear why there should be a market in the first place as Noah and Zach mentioned).

If the FED sometimes misses the mark, then a risk premium may arise. But that raises other issues: why does the FED miss the mark sometimes? what does it imply about NGDP targeting in general?

Even ignoring those issues, it's not clear why the premia would be static. Suppose there is an increase in risk-aversion of the traders, without a change in their expectations about NGDP. They'll require a greater premium and hence lower futures prices, leading the FED to take the wrong action. There could be an increase in the traders uncertainty, and exogenous wealth shock, etc.

You need a model to sort out what comes out in an equilibrium.

Njnnja writes:
The EMH is not precisely true---some people do unearth information not available to the overall market, and do profit on that information.

That statement is incorrect. You are setting it up so that the first part of the statement:"The EMH is not precisely true" is equivalent to the second part: "some people do unearth information not available to the overall market, and do profit on that information." But these are not at all equivalent. Meaning, the truth or falsity of the second statement is not the same as the truth or falsity of EMH. There are 2 reasons for this, one minor, but one major.

As a minor point, it is wrong because EMH says that *public* information is already incorporated in the price (at least the typical version, the semistrong form). What happens with respect to investors who have private information "not available to the overall market" has no bearing at all on whether EMH is true, really true, precisely true, not precisely true, false, or any other epistemological status.

As a major point, it is wrong because EMH does not claim that *future* information is incorporated in the *current* price. So investors could trade on newly uncovered or released (even public) information - new being defined as information that did not exist in the past - and be profitable because that new information was not already incorporated in the existing price, and not make EMH any less true. What would make EMH "not precisely true" would be if investors were able to be profitable by trading based on information that is already widely public.

"Traders make money by acting on new information" does not refute EMH; to the contrary, it is very nearly a restatement of it!

Chris writes:

Dan,

I agree with everything you said, but I think we still might be ok. The Fed targets 5% so I'm willing to buy if I expect it to come in at 5% minus the risk free rate minus the risk premium, so that should be the result in equilibrium. If the policy works pretty well, then the risk premium is small so even though the Fed will not be exactly on target it will be close enough. It will vary over time, but it should still get pretty close on average. I think there still might be a problem when inflation is relatively high, but I need to think more on that.

Tgb writes:

In a world where insider trading is allowed and everyone believes the EMF, trades will still happen, by insiders at least.

M. writes:

[Comment removed pending confirmation of email address. Email the webmaster@econlib.org to request restoring this comment. A valid email address is required to post comments on EconLog and EconTalk.--Econlib Ed.]

James writes:

Scott,

No one is refuting the EMH. They are recognizing that it would not apply to a market where a central bank engaged in trades for the purpose of pegging a price.

This is an easy objection to overcome, of course. Instead of participating in the NGDP futures market, the Fed could simply observe the contract price and pay me for consulting services with the fee set at whatever amount is needed to bring NGDP up to target.

Jack Davis writes:

Re: claim #1: If mostly true means true in the social sciences, then certainly the EMH is true. Both Richard Thaler and Robert Schiller, neither radical libertarians, have described the EMH as mostly true.

Comments for this entry have been closed
Return to top