Beyond the Efficient Market Hypothesis

I've got to run because I'm volunteering on two political campaigns. The thought of Barbara Boxer losing her Senate seat drives me to despair and I'm also volunteering for a local candidate for the Board of Supervisors.

A quick post on the efficient market hypothesis or EMH. “The Efficient Market Hypothesis is not only dead,” noted the financial blog Minyanville on July 29, 2010. “It’s really, most sincerely dead.” Perhaps, first, a quick definition is in order. From Investopedia:

The Efficient Market Hypothesis (EMH) is an investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

The EMH is at cornerstone of our economic model because it lies at the Greenspanian (and conservative) notion that financial markets can be self-regulated, even though financial markets operate very distinctly from normal supply and demand economic principles. As The Economist has noted that “Financial markets do not operate the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally falls. When the prices of a financial asset rises, demand generally rises.”

Financial markets are too often guided by a herd mentality that leads to financial asset bubbles. This was true in the Tulip Mania of the early 17th century in Holland and it was true in the more recent Dot Com Stock Market Crash and US housing bubbles. Irrational exuberance trumps information. The EMH is built on the assumptions of investor rationality. 

John Maynard Keynes, however, argued that the stock market should be seen as a "casino" guided by an "animal spirit". Keynes held that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements.

Today, Joseph Stiglitz in the Financial Times writes on the need for a new economic paradigm of moving beyond the efficient market hypothesis.

The blame game continues over who is responsible for the worst recession since the Great Depression – the financiers who did such a bad job of managing risk or the regulators who failed to stop them. But the economics profession bears more than a little culpability. It provided the models that gave comfort to regulators that markets could be self-regulated; that they were efficient and self-correcting. The efficient markets hypothesis – the notion that market prices fully revealed all the relevant information – ruled the day. Today, not only is our economy in a shambles but so too is the economic paradigm that predominated in the years before the crisis – or at least it should be.

It is hard for non-economists to understand how peculiar the predominant macroeconomic models were. Many assumed demand had to equal supply – and that meant there could be no unemployment. (Right now a lot of people are just enjoying an extra dose of leisure; why they are unhappy is a matter for psychiatry, not economics.) Many used “representative agent models” – all individuals were assumed to be identical, and this meant there could be no meaningful financial markets (who would be lending money to whom?). Information asymmetries, the cornerstone of modern economics, also had no place: they could arise only if individuals suffered from acute schizophrenia, an assumption incompatible with another of the favoured assumptions, full rationality.

Bad models lead to bad policy: central banks, for instance, focused on the small economic inefficiencies arising from inflation, to the exclusion of the far, far greater inefficiencies arising from dysfunctional financial markets and asset price bubbles. After all, their models said that financial markets were always efficient. Remarkably, standard macroeconomic models did not even incorporate adequate analyses of banks. No wonder former Federal Reserve chairman Alan Greenspan, in his famous mea culpa, could express his surprise that banks did not do a better job at risk management. The real surprise was his surprise: even a cursory look at the perverse incentives confronting banks and their managers would have predicted short-sighted behaviour with excessive risk-taking.

Stiglitz also points to the work at the George Soros funded Institute for New Economic Thinking (INET) that was founded in October 2009. Its mission is to create an environment nourished by open discourse and critical thinking where the next generation of scholars has the support to go beyond our prevailing economic paradigms and advance the culture of change. Two of my favorite economists are associated with the Institute: Simon Johnson of MIT and Richard Koo of Nomura Securities whose book on Japan's lost decade The Balance Sheet Recession has been my guide for looking at our economic situation.

Here's a short video on the INET:

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Weekly Audit: Silencing Conservative Deficit Hawks

by Zach Carter, Media Consortium blogger

The same conservatives who spent the past year senselessly screaming about the U.S. budget deficit are now demanding an extension of the Bush tax cuts for the rich. The extension simply doesn’t make sense, and the policies implied are a recipe for massive job loss in the middle of the worst employment crisis in 75 years.

Deflation nation

As William Greider explains for The Nation, the major problem facing the U.S. economy is not the budget deficit, but the prospect of deflation. Deflation was one of the driving forces behind the Great Depression. Under deflation, the value of money increases, which drives prices down. When millions of Americans are deep in debt, deflation makes those debts much larger. It also creates total economic paralysis, as Greider explains:

Deflation essentially tells everyone to hunker down and wait. Instead of buying big-ticket items, consumers wait for prices to fall further. Instead of investing in new production, companies wait for cheaper opportunities, cheaper labor.

In other words, nothing happens. And when nothing happens, the economy falls apart. Instead of spending money now while it’s still valuable, everybody just waits for it to accumulate value. Businesses lay off workers and workers don’t spend money, creating a vicious cycle in which prices fall further because nobody has any money to buy anything with.

Deflation over deficit

There are time-tested ways to fend off deflation. The Fed can cut interest rates, and the federal government can spend money—lots of money—putting people to work. But instead, conservative politicians are emphasizing the budget deficit, claiming that without immediate action to cut the deficit, the U.S. economy will collapse.

As I note for AlterNet, the deficit is only a problem if it creates very high interest rates (our current rates are at record lows) or if it leads to severe inflation, as governments print loads of money to pay off their debts. But we aren’t seeing inflation—instead, we’re getting dangerously close to deflation.

Spending cuts kill jobs

As David Moberg observes for In These Times, massive spending cuts in the middle of a recession don’t reduce the deficit. Those cuts create layoffs and reduce economic growth, which results in lower tax returns for the federal government. They make the deficit worse. We’ve just watched several nations attempt to counter their budget deficit woes with “austerity”—cutting back on jobs and social services—and the result has been disastrous. Here’s Moberg:

Government austerity and cuts in workers’ wages will simply reduce demand, slowing recovery from the Great Recession or even creating a second downturn. And weak recovery will bring lower tax revenues, continued pressure for austerity and difficulty repaying debts. In short, the medicine the financial markets and their political allies prescribe will make the global economy sicker.

Spending money to make jobs

In a pair of posts for The Washington Monthly, Steve Benen notes that conservative politicians can’t even make sense when they talk about the deficit. They’re demanding action on the deficit, while also demanding an extension of the Bush tax cuts for the rich. Tax cuts make the deficit bigger, something Rep. Eric Cantor (R-VA) acknowledged in a recent interview. Cantor’s justification? We need jobs right now, and it’s okay to inflate the deficit in the pursuit of jobs.

That justification is right—but Cantor’s policies are wrong. Tax cuts for the rich don’t create jobs, because rich people just hold onto the money. The fact is, government spending is a much more effective way of creating jobs than cutting taxes. If jobs are the priority in a deep recession, Benen argues, then, we should be spending to create jobs, not funneling economically useless money to the wealthy.

The corporate agenda after Citizens United

Much of the deficit and tax-cut hysteria is being pushed by corporate executives that are looking to score tax breaks for themselves and their shareholders. So it’s profoundly disconcerting to see corporations begin pouring money into elections in the aftermath of the Supreme Court’s infamous Citizens United ruling.

As Suzy Khimm emphasizes for Mother Jones, corporations have started spending like crazy on advertising in support of conservative causes. Prior to Citizens United, corporations were banned from conducting such direct electoral advocacy, but as Khimm notes, now major retailers like Target and Best Buy are jumping into the fray.

Spending big bucks to derail the economy for profit is not okay. The best way for policymakers to fight this corporate assault is to make a strong push to actually repair the economy. Self-interested executives and corrupted politicians will make all kinds of convoluted economic arguments to enrich themselves and their backers. They’ll use the recession as an excuse. But if lawmakers actually fight the recession successfully, they can’t listen to deep-pocketed corporate miscreants.

President Barack Obama and Congress should ignore the phony deficit hysteria and push for a strong jobs agenda, filled with lots and lots of government spending to put people back to work. Creating jobs is not just an economic priority, it’s a key tool to defanging disingenuous political attacks.

This post features links to the best independent, progressive reporting about the economy by members of The Media Consortium. It is free to reprint. Visit the Audit for a complete list of articles on economic issues, or follow us on Twitter. And for the best progressive reporting on critical economy, environment, health care and immigration issues, check out The Mulch, The Pulse and The Diaspora. This is a project of The Media Consortium, a network of leading independent media outlets.

 

 

Quick Hits

Three U.S. troops died in blasts in Afghanistan, bringing the death toll for July to at least 63 and surpassing the previous month's record as the deadliest for American forces in the nearly 9-year-old war. More coverage in the Los Angeles Times.

Florida Gov. Charlie Crist leads the three-way race for the U.S. Senate seat with 37 percent, followed by 32 percent for Republican Marco Rubio and 17 percent for Jeff Greene, the leading candidate for the Democratic nomination, according to a Quinnipiac University poll released today.

In Nevada Senate Race, the Las Vegas Review Journal reports that Senate Majority Leader Harry Reid and Tea Party candidate Sharron Angle are locked in a dead heat. The new survey by Mason-Dixon Polling & Research shows Reid and Angle neck and neck. The Senate majority leader would win 43 percent and Angle 42 percent of support from likely Nevada voters if the election were held now. The margin of error is plus or minus 4 percentage points . A July 12-14 Mason-Dixon poll showed Reid 7 points ahead of Angle, 44-37 but Angle has countered with ads blaming the Nevada economy on Reid.

Judicial confirmation rates have nosedived in the Obama Presidency as flibusters, anonymous holds, and other obstructionary tactics have become the rule. The Center for American Progress has the story.

The financial blog Credit Writedowns has more on the report by Fed Governor James Bullard on deflation which I covered yesterday. Their post has a great summation of the situation we face:

In our view the case for deflation is a strong one as most of the classic symptoms are present in the U.S. today. Record historic debt is already in the process of deleveraging, and there is still a long way to go. Consumer demand is restrained. There is an excess of labor supply with five people available for every open job. Capacity utilization rates are historically low. Household net worth is far below peak levels. Credit is available only to the most highly qualified borrowers. Money supply has been flat or decreasing despite massive stimulus. All of this is a classic recipe for deflation. We also believe that there is little the Fed can do to avoid the outcome. Japan kept both short and long-term interest rate exceedingly low for many years and ran massive budget deficits with little to show for it, although they did prevent a complete collapse of their economic and financial system. While there is a difference between the U.S. and Japan, two major differences were in favor of Japan rather than the U.S. During most of Japan’s two-decade malaise the global economy was quite strong and Japan was able to support its economy with a substantial amount of exports. Furthermore, Japan started with a 12% household savings rate and was able to run it down, thereby providing some support for consumer spending.

Michael Whitney over at Firedoglake covers the latest madness from Senator Dianne Feinstein of California. Senator Feinstein's “Saving Kids from Dangerous Drugs Act of 2009″ (S. 258) that targets pot brownies and other marijuana edibles preferred by some medical marijuana patients passed the Senate unanimously.

Quick Hits

Three U.S. troops died in blasts in Afghanistan, bringing the death toll for July to at least 63 and surpassing the previous month's record as the deadliest for American forces in the nearly 9-year-old war. More coverage in the Los Angeles Times.

Florida Gov. Charlie Crist leads the three-way race for the U.S. Senate seat with 37 percent, followed by 32 percent for Republican Marco Rubio and 17 percent for Jeff Greene, the leading candidate for the Democratic nomination, according to a Quinnipiac University poll released today.

In Nevada Senate Race, the Las Vegas Review Journal reports that Senate Majority Leader Harry Reid and Tea Party candidate Sharron Angle are locked in a dead heat. The new survey by Mason-Dixon Polling & Research shows Reid and Angle neck and neck. The Senate majority leader would win 43 percent and Angle 42 percent of support from likely Nevada voters if the election were held now. The margin of error is plus or minus 4 percentage points . A July 12-14 Mason-Dixon poll showed Reid 7 points ahead of Angle, 44-37 but Angle has countered with ads blaming the Nevada economy on Reid.

Judicial confirmation rates have nosedived in the Obama Presidency as flibusters, anonymous holds, and other obstructionary tactics have become the rule. The Center for American Progress has the story.

The financial blog Credit Writedowns has more on the report by Fed Governor James Bullard on deflation which I covered yesterday. Their post has a great summation of the situation we face:

In our view the case for deflation is a strong one as most of the classic symptoms are present in the U.S. today. Record historic debt is already in the process of deleveraging, and there is still a long way to go. Consumer demand is restrained. There is an excess of labor supply with five people available for every open job. Capacity utilization rates are historically low. Household net worth is far below peak levels. Credit is available only to the most highly qualified borrowers. Money supply has been flat or decreasing despite massive stimulus. All of this is a classic recipe for deflation. We also believe that there is little the Fed can do to avoid the outcome. Japan kept both short and long-term interest rate exceedingly low for many years and ran massive budget deficits with little to show for it, although they did prevent a complete collapse of their economic and financial system. While there is a difference between the U.S. and Japan, two major differences were in favor of Japan rather than the U.S. During most of Japan’s two-decade malaise the global economy was quite strong and Japan was able to support its economy with a substantial amount of exports. Furthermore, Japan started with a 12% household savings rate and was able to run it down, thereby providing some support for consumer spending.

Michael Whitney over at Firedoglake covers the latest madness from Senator Dianne Feinstein of California. Senator Feinstein's “Saving Kids from Dangerous Drugs Act of 2009″ (S. 258) that targets pot brownies and other marijuana edibles preferred by some medical marijuana patients passed the Senate unanimously.

Quick Hits

Three U.S. troops died in blasts in Afghanistan, bringing the death toll for July to at least 63 and surpassing the previous month's record as the deadliest for American forces in the nearly 9-year-old war. More coverage in the Los Angeles Times.

Florida Gov. Charlie Crist leads the three-way race for the U.S. Senate seat with 37 percent, followed by 32 percent for Republican Marco Rubio and 17 percent for Jeff Greene, the leading candidate for the Democratic nomination, according to a Quinnipiac University poll released today.

In Nevada Senate Race, the Las Vegas Review Journal reports that Senate Majority Leader Harry Reid and Tea Party candidate Sharron Angle are locked in a dead heat. The new survey by Mason-Dixon Polling & Research shows Reid and Angle neck and neck. The Senate majority leader would win 43 percent and Angle 42 percent of support from likely Nevada voters if the election were held now. The margin of error is plus or minus 4 percentage points . A July 12-14 Mason-Dixon poll showed Reid 7 points ahead of Angle, 44-37 but Angle has countered with ads blaming the Nevada economy on Reid.

Judicial confirmation rates have nosedived in the Obama Presidency as flibusters, anonymous holds, and other obstructionary tactics have become the rule. The Center for American Progress has the story.

The financial blog Credit Writedowns has more on the report by Fed Governor James Bullard on deflation which I covered yesterday. Their post has a great summation of the situation we face:

In our view the case for deflation is a strong one as most of the classic symptoms are present in the U.S. today. Record historic debt is already in the process of deleveraging, and there is still a long way to go. Consumer demand is restrained. There is an excess of labor supply with five people available for every open job. Capacity utilization rates are historically low. Household net worth is far below peak levels. Credit is available only to the most highly qualified borrowers. Money supply has been flat or decreasing despite massive stimulus. All of this is a classic recipe for deflation. We also believe that there is little the Fed can do to avoid the outcome. Japan kept both short and long-term interest rate exceedingly low for many years and ran massive budget deficits with little to show for it, although they did prevent a complete collapse of their economic and financial system. While there is a difference between the U.S. and Japan, two major differences were in favor of Japan rather than the U.S. During most of Japan’s two-decade malaise the global economy was quite strong and Japan was able to support its economy with a substantial amount of exports. Furthermore, Japan started with a 12% household savings rate and was able to run it down, thereby providing some support for consumer spending.

Michael Whitney over at Firedoglake covers the latest madness from Senator Dianne Feinstein of California. Senator Feinstein's “Saving Kids from Dangerous Drugs Act of 2009″ (S. 258) that targets pot brownies and other marijuana edibles preferred by some medical marijuana patients passed the Senate unanimously.

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