Shiller: More Expectations Theory, Less Efficient Market Hypothesis
Yale professor Bob Shiller’s column in the Sunday NYT ( The Sickness Beneath the Slump) is filled with interesting tidbits, data and analysis.
You may be tempted to think of his column as the typical Residential Real Estate analysis, looking at historical prices and current trends.
Don’t.
What the good professor does this morning is damn his own profession for their slavish devotion to bad theory. The Efficient Market Hypothesis — at least as practiced by Wall Street economists — is the rough equivalent of a million monkeys with a million typewriters creating Hamlet. That somehow out of a crowd of emotional, irrational, ill-informed and greedy humans, some form of truth will emerge.
Magic!
Professor Shiller mentions the “speculative bubble that generated pervasive optimism and complacency” as a lead in to his discussion. He describes the theoretical failings of economics:
“A half-century ago, there was a lively discussion among economists about the dynamics of price expectations. For example, Alain C. Enthoven, then of the Massachusetts Institute of Technology, and Kenneth J. Arrow of Stanford wrote in 1956 that expectations that extrapolate past price increases can produce economic instability. But that thinking was largely cast aside in the 1960s, when my profession embraced the theory that efficient markets formed by people holding rational expectations could explain virtually all economic activity.
As a result, economists in recent decades have not developed expectations theory much further. That needs to be corrected in coming years. In the meantime, this failing helps explain why the current crisis was generally unpredicted, and why its future course is so poorly understood.”
Bob is far too diplomatic to be blunt, so I will do it for him: Economics failed. The entire profession took a theory that had some value to it, and extrapolated it to the point of magical thinking.
How badly did the economics profession, academics and market pros alike, fail? Classic economic belief systems could not appropriately anticipate in advance or even identify in real time what was happening with the Residential RE/Housing market. They failed to see the Great Recession coming or even the market collapse.
The basis for this failure was the erroneous belief that “efficient markets formed by people holding rational expectations could explain virtually all economic activity.”
That thesis has now been thoroughly discredited. It is still taught in colleges and business schools, which is why I find most MBAs not worth hiring. Frequently, they can be worse than clueless — they are steeped in the bad ideas of long dead economists, and in my profession, that is not a formula for making money.
As history has revealed over and over again, the popular extreme version of EMH is bollocks. Markets can and do generate lots and lots of useful information and price discovery. But their strength derives from the inputs of the crowd. That strength is also their weakness when that crowd turns into a panicky mob.
>
Previously:
Efficient Market Hypothesis
Source:
The Sickness Beneath the Slump
ROBERT J. SHILLER
NYT, June 11, 2011
http://www.nytimes.com/2011/06/12/business/economy/12view.html
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June 12th, 2011 at 7:26 am
Shiller is one of the primary opponents of EMH. See, for example, his book Irrational Exuberance. That he would write a column today against it is hardly surprising.
EMH started as a claim that the market price is right. It quickly changed into the claim that it’s hard to beat the market. The later version is hardly surprising. It’s on par with the Lake Wobegon effect – just as everyone can’t be above average, everyone can’t beat the market.
What we’ve left is that beating the market is a competitive activity. Very talented people compete to do so. The opportunity for excess profit is very low in a competitive market. A random investor’s ability to beat the market is on par with a random investor’s ability to beat Google in search.
The problem for the average investor is that he has no real ability to pick a talented manager and that a talented manager would want to be appropriately compensated for her talents, leaving very little excess return available to our average investor. That’s the real lesson of EMH.
June 12th, 2011 at 7:35 am
This is my favorite quote of yours form the post:
This has been true time and time again used in junk bond pricing studies, EMH and the use of historical pricing of CDS to show future default correlations. A price is simply a price, that which at a moment in time reflects known information and is the summation of the expectations of buyers and sellers. Price does not necessarily show risk or value or deal with future or generally not known information. Like you said a profession took something useful and extrapolated it to the point of magical thinking.
June 12th, 2011 at 8:12 am
Efficient markets require knowledge based in facts, with equal and rational players.
I vote for sociology over mythology of efficient markets.
June 12th, 2011 at 8:13 am
“Those who cannot remember the past are condemned to repeat it” – George Santayana is the simple quote, the longer one is Marvin Minsky’s, “Stabilizing an Unstable Economy.” All the rest is merely commentary that is either worthless or totally worthless.
June 12th, 2011 at 8:20 am
EMH is a model that was cross-contaminated by the intellectual poison pervading the UofC campus at the time. Too much radioactive neo-Thomism floating around (among others things). Ideological systems are instruments to be wielded. Their irrationality reveals the wielders’ intent.
“which is why I find most MBAs not worth hiring. Frequently, they can be worse than clueless “…
In 2007 a younger sibling completing an MBA in Finance in the Boston area asked me for recommendations regarding a target country for a group project – develop a concept for a business to be operated abroad. My reply was: country-Brazil; business- B2B database expertise. The rest of her group rejected the notion- their choice- car rental business in Ireland. Hahahaha! They would have had more success selling Carrie Nation statuettes to pubs.
WRT Brasil-one example- IBM and COSAN. That’s just one.
June 12th, 2011 at 8:21 am
When I first heard the phrase, “until you change the way money works, you can nothing,” I had no idea how profoundly my life would change. Six years later and I’m studying Henry George and reading books by Byron Dale and Stephen Zarlenga. Coupled with my long term study of the True nature of our existence and nearly everything has changed about the way I see the world.
Our formerly free and independent country, like England before us, has been captured by debt money. Since 1913 all so-called money has been issued by a bank as a debt instrument. Once you’ve grasped the consequence of our monetary system you’ll understand why the profession of economics is hopelessly mired in falsehoods. There is no hope for us until we’re free of debt money… and by “us” I mean the whole world. If the bankers are allowed to suck Asia (Japan’s already been captured) into their cartel, if they’re permitted their war on debt free Islam, who’s going to challenge their power?
“The” human rights issue of the 21st century is debt servitude. Spiritual consciousness is awakening all over the world so change is coming… either by evolution or revolution
June 12th, 2011 at 9:38 am
The fairy tale of efficient markets persists because it is useful — and very teachable. Those unfamiliar with its flaws put up their money with confidence, only to be taken by those who know better. The whole thing then gets excused as an anomaly. The whole irrationality/expectations thing is fraught with…uh…uncertainty. Who wants to deal with that?
Revisiting past ideas runs contrary to the notion and arrogance of scientific progress. Sure Kenneth Arrow is Nobel-prize-winning bright but that whole expectation stuff was considered and dismissed for much more elegant models. Never mind that they only work well in academic papers.
June 12th, 2011 at 9:43 am
Steve Keen – one of the few economists to predict the crisis – also points out the failed treatment of debt by Economist:-
http://www.debtdeflation.com/blogs/2011/06/11/dude-where%E2%80%99s-my-recovery/
“Neoclassical economists ignore the level of private debt, on the basis of the a priori argument that “one man’s liability is another man’s asset”, so that the aggregate level of debt has no macroeconomic impact. They reason that the increase in the debtor’s spending power is offset by the fall in the lender’s spending power, and there is therefore no change to aggregate demand.
Lest it be said that I’m parodying neoclassical economics, or relying on what lesser lights believe when the leaders of the profession know better, here are two apposite quotes from Ben Bernanke and Paul Krugman ……
….. They are profoundly wrong on this point because neoclassical economists do not understand how money is created by the private banking system—despite decades of empirical research to the contrary, they continue to cling to the textbook vision of banks as mere intermediaries between savers and borrowers.”
June 12th, 2011 at 9:53 am
I read this and the related articles referenced.
Might it be that extrapolating prices explains the generation of bubbles (as described in the referenced article) while efficient markets explains the eventual correction?
If so, then the failure of efficient markets, from the standpoint of public policy, is that it does not react quickly enough to protect against and minimize disruption but that it permits disruption to occur, greater than what society can bear. To minimize the resulting disruption when the “efficient” market swings to the negative, society (government) intervenes to blunt the effects of the efficient market (such as bankruptcy, liquidation, etc.) on the downside. This then becomes TARP, HAMP, Auto industry bailouts,QE1 & 2, et al.
I submit that it is the role of regulation and oversight (government and non-governmental such as accounting standards) to act as a governer to diminish the amplitude of these swings characteristic of the “efficient” market.
June 12th, 2011 at 9:56 am
Everyone wants to trash EMH and the “Chicago School”. Fine.
Booth, with Fama’s help accumulated several billions, enough to buy the U of C Business School, without government intervention or playing commodities, or buying politicians off. Actually he did not play the all important (to Wall Street) game.
So stick that up your nose and smoke it. I know exactly how he did it. The antithesis of BR’s Wall Street.
Any billionaires commenting here?
June 12th, 2011 at 11:00 am
Whats a real pitty is a slight variation, the “Efficiently inefficient market hypothesis” has great value.
“The market efficiently discovers the price as perceived by the knowledge and beliefs of the active market participants“.
Namely, the market participants are NOT always rational, and only ACTIVE participants matter, those who either stay out of the market entirely or use passive strategies (eg, indexing) are not contributing to price discovery. But this slight variation leads to wildly different conclusions.
June 12th, 2011 at 12:13 pm
I did a post on EMH a while back that I think is pretty decent:
http://efficientish.blogspot.com/2011/04/efficient-market.html
I went at the question from a slightly different angle than what is presented here. Rather than questioning whether or not the participants were rational, I questioned the very notion that the markets could possibly price-in all known information.
June 12th, 2011 at 1:27 pm
Although Shiller doesn’t mention Fannie/Freddie, their existence did contribute to the rise in home prices during a multi-year period leading up to the bubble peak. One could say that it follows from Shiller’s analysis that Fannie/Freddie did contribute to the housing bubble, a notion which is contrary to that of certain financial blog hosts.
~~~
BR: Multi-year period? Don’t you mean multi-decade period?
Let’s see, Fannie around since 1938, Freddie since 1968 — how much did they contribute over those 70 and 40 year periods? Now explain their impact on Housing prices in the UK, Spain, Ireland, France, Greece, Europe, Korea, Australia? How much did FNM/FRE contribute there?
FAIL
June 12th, 2011 at 1:27 pm
The phrase “magical thinking” is quite apt. A further example is the belief that mathematical formulas can do more than describe. It is amazing that anyone would believe that the accounting convention termed “velocity” has any real world correlation other than to describe what happened. Sure, when velocity slows we can make the equation “MV = PT” balance by increasing “M”, but that is a tautology, and the balance only applies within the equation – it does not transfer its balance to the real world.
In the real world, increasing “M” has no bearing on the economic activitities of a population intent on not spending.
June 12th, 2011 at 1:35 pm
“. . . is the rough equivalent of a million monkeys with a million typewriters creating Hamlet.”
Are you talking about the evolution hypothesis?
June 12th, 2011 at 6:29 pm
@rip
I guess if you count your wealth in billions you can buy a business school and get it to sell you personal interest as a valid scientifically based ideology. Currently there is a couple of brother from Texas trying to do a similar thing luring people to a tea-party to serve their Koch.
June 12th, 2011 at 7:46 pm
@rip
what’s your point?
Gates has made billions, Buffett has made billions, blah blah blah. What is the relevance to EMH? Did Booth make billions because he stuck to EMH? If he did why haven’t others? i.e. more probably something specific with Booth’s skill set rather than EMH? Soros has made billions trading and he is firmly against EMH. You do not have to believe in EMH to become a billionaire trader.
June 12th, 2011 at 8:04 pm
@lunartop
the continuation is also illuminating:
‘This is bizarre, since as long as 4 decades ago, the actual situation was put very simply by the then Senior Vice President, Federal Reserve Bank of New York, Alan Holmes. Holmes explained why the then faddish Monetarist policy of controlling inflation by controlling the growth of Base Money had failed, saying that it suffered from “a naive assumption” that:
“the banking system only expands loans after the [Federal Reserve] System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt.” ‘
While on one hand it is alarming, on the other hand it is pretty funny that economists don’t actually know how the banking system works. For some reasons these guys won’t adjust their religious beliefs despite information showing them to be wrong. They also seem to rely on gold standard models quite a bit. Unless I’m mistaken the gold standard ended 40 years ago.
June 12th, 2011 at 8:08 pm
“BR: Multi-year period? Don’t you mean multi-decade period? … …explain [the impact of Fannie/Freddie] on Housing prices in the UK, Spain, Ireland, [etc.]”
As far as the “multi-decade period” is concerned, I’m going to refrain from commenting, because I just don’t know how much Fan/Fred money went into housing during the period of, say 1997-2007 as compared with other periods, such as the 1980’s.
And to the other point, of course Fannie/Freddie did not cause real estate prices to rise in Spain and Ireland (or other foreign countries). But by the same token, one cannot say that the Wall Street bankers who created “subprime slime” (in this country) caused prices to rise in foreign countries such as Spain and Ireland.
~~~
BR: You need to brush up on exactly what the word CAUSATION means
June 12th, 2011 at 8:16 pm
@wild: Thought my point was pretty explicit. Booth made billions following Fama’s EMH advice.
Can’t answer the other questions. You’ll have to ask them. There’s more than one way to make a billion.
June 12th, 2011 at 9:15 pm
How often has it happened (fill in the blank):
__________ was a useful tool when applied to specific situations and problems. Then someone tried to make a religion out of it.
June 13th, 2011 at 12:08 am
I never could understand how markets which involve crowd psychology could be rational or efficient.
EMH however does make for a nice tool to fool the semi-sophisticated investor into buying your overpriced investment.
June 13th, 2011 at 2:46 am
I think a statement that “Economics Failed” is *way* too broad a brush, and you know it, Barry. I consider it perhaps justifiable as an expression of poetic license, but you know as well as I that economics is a far more diverse discipline than just “markets are efficient and therefore right and need little if any regulation.”
What needs to be layered here is a political analysis, which looks at the fact that academic disciplines always have a certain diversity of ideas, and those outside of the academy with money and power then pick and choose to certain ideas (that serve their purposes) to elevate to orthodoxy and self-interested theoretical justification.
Wall Street keeps bashing academics, saying “academics got it all wrong,” as if academics were united in their view in the first place. But the only thing that united the “academics who got it wrong” is that they were the ones chosen by banks to justify their (arguably) irrational risk taking as rational. Ones that said “hey, we’re basing MBS pricing on a type of borrower for which we have no history, and therefore you shouldn’t be buying this AAA rated stuff for only 20 bps over treasuries,” somehow never made it through the interview process, because it sounded to managers like advice to take a sear while the music is still playing.
I also want to point out that the bulk of the people that made malinvestments using the efficient markets hypothesis were not academics; they had simply taken a course from academics at some point, and when they found that they had made some bad decisions and “who could have known?” wasn’t sufficient excuse, they then went and blamed “the academics” even though academics know (or do a better job of remembering) what the assumptions are in the models they use than those who are just trying to get a passing grade before they can rake in the big bucks.
The efficient market hypothesis is useful as just that – a hypothesis. Asking yourself “what would this price imply about market conditions if markets were efficient” is still an excellent baseline for asking yourself if prices or yields seem reasonable, and is essential for trying to figure out the degree to which you agree or disagree with the consensus.
June 13th, 2011 at 2:55 am
I forgot to say: that doesn’t mean that I believe that EMH is literally true, merely that it can be a useful heuristic tool when used alongside of others.
June 13th, 2011 at 7:05 am
[...] A better theory in practice than Efficient Markets Hypothesis. (TBP) [...]
June 13th, 2011 at 9:37 am
When it comes to orthodoxy in economics, I have a Sticky Theory Theory.
June 13th, 2011 at 10:52 am
The authors begin by re-examining utility theory in order to establish a stable foundation to their work in risk quantification and a markets hypothesis.
This fresh perspective offers a truly heterodox methodology, abandoning the assumptions economic and financial theory have depended on for decades. Introducing the updated utility theory into post modern portfolio theory has enabled the authors to demonstrate ex ante efficiency, rather than ex post optimization.
The current financial crisis, as well as historical ones, could have been avoided if market participants had a better theoretical framework from which to operate. This work offers such a framework with the guiding principle that the inherent uncertainty of markets cannot be modeled away with convenient assumptions.
Physics Envy: A Collection of White Papers Identifying Positive Economics, Optimization, Their Role in the Financial Crisis and Solutions
June 14th, 2011 at 4:43 am
I do not have any business degree or formal education in business/ economics but I have always felt that the EMH has some validity over a complete business cycle / secular time frame. But in the short to medium-long term that the many market participants individual future expectations which are often extrapolated from recent events and each individuals various reasons for buying selling securities and general lack of all possible knowledge about those securities creates quite a bit of inefficiences which can be exploited for profit; not to mention the psycology of individuals and crowd behaviors. Thus prices do not reflect the correct value all the time. I i right on this BR . Further would be appreciated. Sorry I am a day late on this discussion.
June 14th, 2011 at 10:31 am
[...] I hope you did not miss our weekend post of Yale Professor Bob Shiller’s Efficient Market Hypothesis discussion. It is very worthwhile: Shiller: More Expectations Theory, Less Efficient Market Hypothesis [...]
June 14th, 2011 at 12:02 pm
nice
there was also dallas fed Pres Fisher last night
Fed’s Fisher: Efficient Market Theory Is ‘Nonsense’ 06/13 07:59 PM
but i cant find a speech text yet
looks like another barn burner like Hoenigs outstanding. and Fisher is not leaving that i know
maybe the fed system is not hopeless, even if Bernanke and the board are.
June 14th, 2011 at 12:11 pm
The problem is that the “if’s” are iffy.
If all market participants were: smart, all knowing, and rational – then they would create an efficient market.
June 14th, 2011 at 12:12 pm
one quible BR,
Why do you of all people call it “The Great Recession”?
You should be calling it “The Great Restructuring”.
Referring to 2007-2011 (which continues) as a cyclical bump in the road is to parrot the n0 knothings.
We made big decisions in the 90′s, add a decade of water and sunlight and 9.1 % une mployment is the economic makeover, that like Joan River’s 14th cosmetic procedure, we are now living with indefinitely.
People in the media really need to get this idea out of their heads that we are going back to the old days.
This is linear change not a cyclical one.
June 14th, 2011 at 12:46 pm
Dear rip
and other chicago school losers here
fama/french have already recanted some of his more extreme BS
As for your proof of Booth
reading it his big bucks come from dimentional fund advisors who basically sell buy and hold to the ignorant. check their record its up 2 -4% total last five years according to them before their most of a % pt fees PER YEAR someones making money all right where are the customers yachts
they only wholsale to little bullhitters who sell only their stuff
who stroke “ith how could we have known”and take another more than % pt per year
by astounding coincidence i am going to debate efficient markets with one of them and their CEO
5 on one hardly a contest
according to you you can only make 5-6percent per year
very long term
let me know what that buy and hold but pay
2% peryear for nonadvice
works out after 20 year
June 14th, 2011 at 4:04 pm
i am thinking its nothing more than economists came up with a theory, then never validated it. they were trying to be scientific, but skipped the part where every one is trying to prove or disprove the theory. all the time. scientists always ad new information to their theories, seeing if new technology or data changes it.
June 14th, 2011 at 4:48 pm
Yves Smith should read this article. Might make her a little less sure of herself.
June 14th, 2011 at 5:10 pm
ha. From Krugman’s profile of Milton Friedman’s career in the NY Review: although Friedman made great strides in macroeconomics by applying the concept of individual rationality, he also knew where to stop. In the 1970s, some economists pushed Friedman’s analysis of inflation even further, arguing that there is no usable trade-off between inflation and unemployment even in the short run, because people will anticipate government actions and build that anticipation, as well as past experience, into their price-setting and wage-bargaining. This doctrine, known as “rational expectations,” swept through much of academic economics. But Friedman never went there. His reality sense warned that this was taking the idea of Homo economicus too far. And so it proved: Friedman’s 1967 address has stood the test of time, while the more extreme views propounded by rational expectations theorists in the Seventies and Eighties have not.
June 14th, 2011 at 10:19 pm
Mr. Shiller seems to read articles from Mr.Prechter :)
June 17th, 2011 at 7:28 pm
“they are steeped in the bad ideas of long dead economists” And bad ideas of living economists.