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Defending the EMH

Tim Harford has gone in to bat for the Efficient Market Hypothesis (EMH).  As Tim says, somebody has to.

Sort-of-officially, there are three versions of the EMH:

  • The strong version says that the market-determined price is always “correct”, fully reflecting all public and private information available to everybody, everywhere.
  • The semi-strong version says that the price incorporates all public information, past and present, but that inside information or innovative analysis may produce a valuation that differs from that price.
  • The weak version says that the price incorporates, at the least, all public information revealed in the past, so that looking at past information cannot allow you to predict the future price.

I would add a fourth version:

  • A very-weak version, saying that even if the future path of prices is somewhat predictable from past and present public information, you can’t beat the market on average without some sort of private advantage such as inside information or sufficient size as to allow market-moving trades.

    For example, you might be able to see that there’s a bubble and reasonably predict that prices will fall, but that doesn’t create an opportunity for market-beating profits on average, because you cannot know how long it will be before the bubble bursts and, to regurgitate John M. Keynes, the market can remain irrational longer than you can remain solvent.

I think that almost every economist and financial analyst under the sun would agree that the strong version is not true, or very rarely true.  There’s some evidence for the semi-strong or weak versions in some markets, at least most of the time, although behavioural finance has pretty clearly shown how they can fail.  The very-weak version, I contend, is probably close to always true for any sufficiently liquid market.

But looking for concrete evidence one way or another, while crucially important, is not the end of it.  There are, more broadly, the questions of (a) how closely each version of the EMH approximates reality; and (b) how costly a deviation of reality from the EMH would be for somebody using the EMH as their guide.

The answer to (a) is that the deviation of reality from the EMH can be economically significant over short time frames (up to days) for the weak forms of the EMH and over extremely long time frames (up to years) for the strong versions.

The answer to (b), however, depends on who is doing the asking and which version of the EMH is relevant for them.  For retail investors (i.e. you and me, for whom the appropriate form is the very-weak version) and indeed, for most businesses, the answer to (b) is “not really much at all”.  This is why Tim Harford finishes his piece with this:

I remain convinced that the efficient markets hypothesis should be a lodestar for ordinary investors. It suggests the following strategy: choose a range of shares or low-cost index trackers and invest in them gradually without trying to be too clever.

For regulators of the Too-Big-To-Fail financial players, of course, the answer to (b) is “the cost increases exponentially with the deviation”.

The failure of regulators, therefore, was a combination of treating the answer to (a) for the weak versions as applying to the strong versions as well; and of acting as though the answer to (b) was the same for everybody.  Tim quotes Matthew Bishop — co-author with Michael Green of “The Road from Ruin” and New York Bureau Chief of The Economist — as arguing that this failure helped fuel the financial crisis for three reasons:

First, it seduced Alan Greenspan into believing either that bubbles never happened, or that if they did there was no hope that the Federal Reserve could spot them and intervene. Second, the EMH motivated “mark-to-market” accounting rules, which put banks in an impossible situation when prices for their assets evaporated. Third, the EMH encouraged the view that executives could not manipulate the share prices of their companies, so it was perfectly reasonable to use stock options for executive pay.

I agree with all of those, but remain wary about stepping away from mark-to-market.

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Mark Kleiman on Mexico’s drug violence

Mark Kleiman has an interesting idea on how to fight Mexico’s drug violence.  It’s short enough to quote in full:

Drug-related violence has claimed 35,000 Mexican lives since 2006, and the level of bloodshed is still rising. With legalization not in the cards and an all-out crackdown unlikely to succeed, good options seem to be scarce.

Here’s a candidate, based on a strategy of dynamic concentration:

Mexico should, after a public and transparent process, designate one of its dealing  organizations as the most violent of the group, and Mexican and U.S. enforcement efforts should focus on destroying that organization. Once that group has been dismantled – not hard, in a competitive market – the process should be run again, with all the remaining organizations  told that finishing first in the violence race will lead to destruction. If it worked, this process would force a “race to the bottom” in violence; in effect, each organization’s drug-dealing revenues would be held hostage to its self-restraint when it comes to gunfire.

This is parallel to David Kennedy’s “pulling levers” strategy to deal with gang violence.

Would it work?  Hard to guess. But it might.  That’s more than you can say for any of the other proposals currently on the table.

It’s a nice idea, but it would probably suffer somewhat in the politics.  If, in order to ensure the downfall of the most violent gang, the government needs to divert resources from fighting other gangs, it may look to some as though they were going easy on crime in one area in order to fight it properly in another.  It could also be tainted with a brush of tacitly legalising the trade for all non-violent traffickers.  Still … cool idea.

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Ayn Rand, small government and the charitable sector

The Economist’s blog, Democracy in America, has a post from a few days ago — “Tax Day”, for Americans, is the 15th of April — looking at Ayn Rand’s rather odd view of government.  Ms. Rand, apparently, did not oppose the existence of a (limited) government spending public money, but did oppose the raising of that money through coercive taxation.

Here’s the almost-anonymous W.W., writing at The Economist:

This left her in the odd and almost certainly untenable position of advocating a minimal state financed voluntarily. In her essay “Government Financing in a Free Society“, Rand wrote:

“In a fully free society, taxation—or, to be exact, payment for governmental services—would be voluntary. Since the proper services of a government—the police, the armed forces, the law courts—are demonstrably needed by individual citizens and affect their interests directly, the citizens would (and should) be willing to pay for such services, as they pay for insurance.”

This is faintly ridiculous. From one side, the libertarian anarchist will agree that people are willing to pay for these services, but that a government monopoly in their provision will lead only to inefficiency and abuse. From the other side, the liberal statist will defend the government provision of the public goods Rand mentions, but will quite rightly argue that Rand seems not to grasp perhaps the main reason government coercion is needed, especially if one believes, as Rand does, that individuals ought to act in their rational self-interest.

The idea of private goods vs. public goods, I think, is something that Rand would have recognised, if not in the formally defined sense we use today, but I do not think that Rand really knew much about externalities and the ability of carefully-targeted government taxation to improve the allocative efficiency of otherwise free markets.  I think it’s fair to say that she would probably have outright denied the possibility of anything like multiple equilibria and the subsequent possibility of poverty traps.  Furthermore, while she clearly knew about and despised free riders (the moochers  in “Atlas Shrugged“), the idea of their being a problem in her view of voluntarily-financed government apparently never occurred to her.

However, this does give me an excuse to plump for two small ideas of mine:

First, I consider the charitable (i.e. not-for-profit) sector as falling under the same umbrella as the government when I consider how the economy of a country is conceptually divided.  In their expenditure of money, they are essentially the same:  the provision of “public good” services to the country at large, typically under a rubric of helping the most disadvantaged people in society.  It is largely only in they way they raise revenue that they differ.  Rand would simply have preferred that a (far, far) greater fraction of public services be provided through charities.  I suspect, to a fair degree, that the Big Society [official site] push by the Tories in the UK is about a shift in this direction and that, as a corollary, that Mr. Cameron would agree with my characterisation.

Philanthropy UK gives the following figures for the size of the charitable sectors in the UK, USA, Germany and The Netherlands in 2006:

Country Giving (£bn) GDP (£bn) Giving/GDP
UK 14.9 1230 1.1%
USA 145.0 6500 2.2%
Germany 11.3 1533 0.7%
The Netherlands 2.9 340 0.9%

Source: CAF Charity Trends, Giving USA, Then & Spengler (2005 data), Geven in Nederland (2005 data)

Combining this with the total tax revenue as a share of GDP for that same year (2006), we get:

Country Tax Revenue/GDP Giving/GDP Total/GDP
UK 36.5% 1.1% 37.6%
USA 29.9% 2.2% 31.1%
Germany 35.4% 0.7% 36.1%
The Netherlands 39.4% 0.9% 40.3%

Source: OECD for the tax data, Philanthropy UK for the giving data

Which achieves nothing other than to go some small way towards showing that there’s not quite as much variation in “public” spending across countries as we might think.  I’d be interested to see a breakdown of what services are offered by charities across countries (and what share of expenditure they represent).

Second, I occasionally toy with the idea of people being able to allocate some (not all!) of their tax to specific government spending areas.  Think of it being an optional extra page of questions on your tax return.  Sure, money being the fungible thing that it is, the government would be able to shift the remaining funds around and keep spending in the proportions that they wanted to, but it would introduce a great deal more democratic transparency into the process.  I wonder what Ms. Rand (or other modern day libertarians) would make of the idea …

Anyway … let me finish by quoting Will Wilkinson again, in his quoting of Lincoln:

As Abraham Lincoln said so well,

“The legitimate object of government, is to do for a community of people, whatever they need to have done, but can not do, at all, or can not, so well do, for themselves—in their separate, and individual capacities.”

Citizens reasonably resent a government that milks them to feed programmes that fail Lincoln’s test. The inevitable problem in a democracy is that we disagree about which programmes those are. Some economists are fond of saying that “economics is not a morality play”, but like it or not, our attitudes toward taxation are inevitably laden with moral assumptions. It doesn’t help to ignore or casually dismiss them. It seems to me the quality and utility of our public discourse might improve were we to do a better job of making these assumptions explicit.

That last point — of making the moral assumptions of fiscal proposals explicit — would be great, but it is probably (and sadly) a pipe dream.

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Working hours in the OECD

Via Economix, here’s an OECD study of working hours by citizens of it’s member countries.  Here’s the relevant graph:

Much of it is as you’d expect from cultural stereotypes — Western Europe working the least, Japan and Mexico working the most — but I was a little surprised that Australia isn’t above average.  What’s striking — to me, at least — is that hours worked per day doesn’t seem to be a particularly good predictor of income per capita.  In fact, it’s interesting enough that I pulled the GDP per capita data from the OECD to do up a scatter plot:

There’s not much of a relationship at all (R-squared of 0.1) and to the extent that there is one, it’s negative — working more per day is associated with a lower income per capita.  Without Mexico (on the bottom-right), the R-squared drops to 0.04.

Time spent working per day doesn’t correlate significantly with growth rates in (real) GDP per capita, either (I’ve plotted it for 2006 to capture the state of the world before the financial crisis):

At least here the relationship, if you want to pretend there is one, is positive.

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The origins of ideology

With the US Federal Government looking like it might go into a shutdown over budget negotiations (as I type, Intrade puts the chance at 40%), you can expect to see more articles around like this one from the Economist’s Democracy in America.  Here’s the gist of what they’re saying:

As Steve Benen points out, it definitely isn’t (or isn’t just) a function of Democratic legislators’ lack of determination. It’s partly a function of the fact that, as recentNBC/Wall Street Journal, Pew, and Gallup polls show, Democratic voters want their leaders to compromise, while Republican voters don’t. Jonathan Chait argues that what we have here is a structural issue that forces Democratic politicians to be wimpy:

Most people have the default assumption that the two parties are essentially mirror images of each other. But there are a lot of asymmetries between the Democratic and Republican parties that result in non-parallel behavior. The Republicans have a fairly unified economic base consisting of business and high-income individuals, whereas Democrats balance between business, labor, and environmental groups. The Republican Party reflects the ideology of movement conservatism, while the Democratic Party is a balance between progressives and moderates.

The upshot is that the Democratic Party is far more dependent upon the votes of moderates, who think of themselves in non-ideological terms and want their leaders to compromise and act pragmatically. The reason you see greater levels of partisan discipline and simple will to power in the GOP is that it has a coherent voting base willing to supportaggressive, partisan behavior and Democrats don’t. This isn’t to say Democrats are always wimps, but wimpiness is much more of a default setting for Democrats.

The article then goes on to discuss the psychological origins of ideological allegiance.  The upshot is that certain people have certain preferences and the political parties are representations of those groups of people.  There’s an implied assumption that all of this is exogenous to the system at large; that there’s nothing you can do about it, you just need to take it as given in your deliberations.

For anybody interested in this stuff, I strongly encourage you read Steve Waldman’s opposing view:  “Endogenize Ideology“. Here is his basic point, from quotes arranged in a different order to that in which he provides them:

Many [people] treat ideology or “political constraints” as given, and perform the exercise that economists perform reflexively, starting with their first grad school exam: constrained optimization. Constrained optimization is a mechanical procedure. The outcome is fully determined by the objective function and the constraints.

However …

That’s the wrong approach, I think. Rather than treating ideology as fixed and given, we should treat it as dynamic, as a consequence rather than a constraint of policy choices.

Ultimately, he argues, in a world of hard-nosed ideologues versus constraint-respecting policy wonks …

Rather than two optimizers, one of which has strictly less information than the other, in the real world we’ve seen two satisficers, one of which has adopted the strategy of optimizing subject to fixed constraints and the other of which has neglected pursuit of optimal present policy in favor of action intended to reshape the constraint set. A priori, we would not be able state with certainty which of the satisficers would outperform the other. If the constraint set were, in fact, strongly resistant to change Team Obama’s strategy would dominate. But if the constraint set is malleable (and constraints frequently bind), then Team Bush outperforms.

Just to really kick it home, he pulls out this quote from Karl Rove:

[Probably Karl Rove, talking to Ron Suskind] said that guys like me were ”in what we call the reality-based community,” which he defined as people who ”believe that solutions emerge from your judicious study of discernible reality.” I nodded and murmured something about enlightenment principles and empiricism. He cut me off. ”That’s not the way the world really works anymore,” he continued. ”We’re an empire now, and when we act, we create our own reality. And while you’re studying that reality — judiciously, as you will — we’ll act again, creating other new realities, which you can study too, and that’s how things will sort out. We’re history’s actors . . . and you, all of you, will be left to just study what we do.”

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The ECB starts raising interest rates (updated)

[Updated to include labour cost inflation too]

Here are the stories at the FT, the WSJ, the Economist (in their blogs) and for a won’t-somebody-think-of-the-children perspective, the Guardian [1].

There are plenty of arguments against the increase.  You could argue that there’s a sizeable output gap, so any inflation now is unlikely to be persistent.  You could argue that core inflation is low and that it’s only the headline rate that’s high.  You could argue that with the periphery countries facing fiscal crises, they need desperately to grow in order to avoid a default or, worse, a breakup of the Euro area.  You could argue that a period of above-average inflation in Europe’s core economies and below-average inflation in the periphery would allow the latter to (slowly) achieve what a currency devaluation would normally do:  make them more competitive, attract business and allow them to grow in the long run (above and beyond the short-run stimulus of low interest rates).

On that last point, though, it’s worth looking at the data.  It’s a great idea, in principle, but unfortunately and despite all the austerity packages, the data show exactly the opposite picture at present.  Here’s the current year-over-year inflation rate broken down by country, from Eurostat (HICP and Labour Costs):

 

 

Economy HICP Labour Cost Index
Euro area as a whole 2.4% 2.0%
Germany 2.2% 0.1%
France 1.8% 1.5%
Greece 4.2% 11.7%
Ireland 0.9% n/a
Portugal 3.5% 1.0%
Spain 3.4% 4.1%

 

 

For some reason Ireland doesn’t seem to be included in the Labour Cost data.  Look at Greece and Spain.  They’re getting more expensive to do business in relative to Germany and France.  Portugal is in the right area, but with Germany’s growth rate in Labour Costs so low, they’re still coming out worse.  The same story is painted in consumer inflation.  It looks like Ireland is doing what it needs to, but Greece, Portugal and Spain are all getting even less competitive.

Here’s my theory:  The ECB hates the fact that they’re temporarily funding these governments, but can’t avoid that fact.  Furthermore, they reckon that Greece, Ireland and Portugal are eventually going to restructure their debt.  Given that they cannot shove the temporary funding off onto some other European institution, the ECB either doesn’t care whether it’s in 2013 or today (they’ve already got the emergency liquidity out there and it can just stay there until the mess is cleaned up) or quietly wants them to do it now and get it over with.  Either way, the ECB is going to conduct policy conditional on the assumption that it’s as good as done.

 

[1]  Just kidding, Guardian readers.  You know I love you.  Mind you, the writing in that article could have been better — it says that inflation has gone above the ECB’s target of 2% and never mentions what it actually is, but later mentions the current British inflation rate (4.4%) without explaining that it is for Britain and not the Euro area.