Effecient Market Hypothesis: 40 Years of Confusion

I just finished reading a commentary by Bernard Guerrien and Ozgur Gun entitled Efficient Market Hypothesis: What are we talking about? . Inter alia the authors do an efficient job (as in 12 pages) not at demolishing the efficient markets hypothesis but rather the central confusion created by Fama’s inclusion of the term of efficiency into what had prior to the 70s been a discussion not about whether or not financial markets could be fairly described as efficient but rather about whether they could be fairly described as a “fair game.”

The distinction is incredibly important because something can be fair but not efficient and vice-a-versa. If we define “efficiency” to mean the quickest possible method to arrive at a decision between two strategies to achieve the same goal then the strategy chosen and the attainment of the goal has nothing to do with the efficiency or fairness of the process used to arrive at the decision. A coin toss would be both a fair and efficient process. A mother saying to her child “we will do X” is equally efficient but not fair.

Economics of course has a peculiar and convoluted definition of efficiency which is directly related to the the confusion introduced by Fama by maintaining that financial markets were not only a fair game but an efficient process. As the authors show, Fama conflated the fairness of the market (price formation displaying a random walk, i.e., unpredictable), with the proposition that a spot market price reflects the “true” valuation of say a publicly traded equity on an exchange on any given day, minute or second.

It is easy to imagine that an equity’s price reflects its “real” value and imagine that that price was arrived at through a contrived and unfair process (insider information). Fama conflated all these issues and that is why when queried in 2010 he responded that EMH was right because everyone got burned; that is, it is a fair game because nobody can beat the market. But as Bernard Guerrien and Ozgur Gun remark:

Now, it is not harmless to replace “beat the market” by “market efficiency”. For economists “efficiency” has a precise meaning: Pareto optimality. That is, a propriety of resources’ allocation which has little to do with stock markets and speculation. On the contrary, there is a close relation between Pareto optimality and general competitive equilibrium (through the two Welfare Theorems); it seems then natural to put forward this particular “model of equilibrium” – as it is suggested by Fama himself at the beginning of his 1970’s paper. With, as a result, even more confusion.

I will leave readers to go and read the paper to fill in the gaps. What however I found really interesting is the account the authors gave as to why such a central confusion could become the dominant account of financial markets. The conclusion they come to is:

Only ideology – strong a priori beliefs – and circumstances can explain Fama’s decision to term the “old” Bachelier-Samuelson no-free-lunch theory “efficient market hypothesis”. In 1970, Fama was professor at the University of Chicago, where the “new classical macroeconomy” was elaborated on the postulate that an economy is always – thanks to “rational expectations” – in competitive equilibrium. Efficient resource allocations (that is, Pareto optimality) results from this postulate – at least if “market failures” are excluded. Contrary to the old “monetarist” (Friedman) tradition, external shocks – even those provoked by government’ discretionary actions – are not supposed to generate inefficiencies. Agents can be (temporary) fooled, but they always realize their optimal plan. Markets became a sort of deus ex machina which instantaneously (re)allocates resources in an efficient way12. In a nutshell, they are “efficient”. That is a postulate, an a priori belief, not a (testable) result.

This is a very interesting and concise commentary and is worth readers’ time. So go read the paper.

Just ask the English minimum wage laws are job killers

Rarely do we get a chance for something close to a natural experiment in the social sciences and the introduction of the national minimum wage legislation in the UK in 1999 is not one such example (no control group).  But is nonetheless an interesting case.

As everyone knows most economists (less so than before but I would guess still a majority) think that minimum wages reduce employment.  Indeed in the canonical model increasing the minimum wage decreases the demand for labour with the result being unemployment.  For anyone who has not of yet had that model force fed to them in an econ 101 class here it is in all its graphic detail.

I am not going to do the walk through.  Clearly the increase from the equilibrium wage (Ew) to the minimum wage (Mw) causes unemployment.

So much for theory lets take a look at what happened in the UK after the introduction of their first ever national minimum wage in 1999.

NMW  in the graph above is the national minimum wage laws.  Each of three plotted lines tracks a different age cohort of the labour market.  Anyway what is the take away.  For all groups unemployment decreased after the introduction of the minimum wage law.  So what do the other two vertical dashed lines represent.  S-11 is the terrorist attacks and the GFC is the attack of finance aka the great financial crisis.

Moral of the story: terrorists and bankers kill jobs  minimum wages do not.  At least not in the UK anyway.

Understanding Corporate Tax Cuts: embracing conventional wisdom and coming to radical conclusions

Warning this post contains scenes of graphic illustration, it is not intended for short attention spans or people who can not locate coordinates in two dimensional space.  Viewer patience is therefore highly advised.

The debate on corporate income taxes brings out a really nice teachable moment in that it provides an occasion to clarify the terrain of past present and likely future debates on macroeconomic policy.  In what follows I will hew closely to the standard story, but what I intend to show is that even within the terms of the conventional collective memory there is an important contradiction that helps clarify what the real debate over corporate cuts ought to be about.  Let me see if I can deliver.

The conventional account of history runs something like this.  By the 1970s and early 80s unions had become too strong, unemployment insurance and welfare programs too generous and together they produced highly distorting macroeconomic outcomes: high unemployment, high inflation and low output (referred to at the time as stagflation).  Let me just accept this account for argument sake because I think it represents the story in the back of the head of most policy makers and economists over forty.  Let us represent this conventional story by line A in the diagram below.  Notice the oscillating line around A.  That represents the economic cycle.  From the vantage point of policy makers and economists over forty  the problem with the Keynesians is that they were preoccupied with stabilizing those oscillations when they should have been preoccupied with moving the economy towards line B.  Line B represents an equilibrium in which both employment creation and output proceed in a balanced manner.

Point Y represents the bad equilibrium that Keynesians were unwittingly fixated.  In their drive to stabilize the macro economy via employment they gave short thrift to output and thus created an inflationary environment which produced increasing high levels of unemployment, low levels of output and high levels of inflation. In time policy makers and economists shifted their attention away from cyclical stabilisation to structural change .  That is, from attempting to smooth the oscillations around line A to moving the macroeconomic trajectory from line A to B.

Notice that point Y does not entail a lower level of employment but rather a higher level of output.  And this was what was so seductive about the supply side arguments of that time.  What they in fact said was that it was possible to maintain employment and increase output provided the appropriate structural reforms were undertaken.  Everybody and I mean everybody wanted lower inflation and higher employment.  And in the face of stagflation the punters got onside and away we went.

My argument is simply this.  After the largely successful attack on trade unions was accomplished, after the reform of both welfare and unemployment insurance programs were completed and within the context of free trade and capital mobility the real impact of he structural changes was to move the economy to line C point Z.  That is to say, even granting neoliberalism was not some radical attempt to reconfigure income and wealth distribution between economic classes the structural reforms were more successful than its antagonists imagined and thus instead of landing on trajectory B point Y we landed on trajectory C, point Z.

When therefore there is the call to cut corporate income taxes it explicitly assumes that the Canadian economy is still stuck on trajectory A point X.  But if in fact we are on trajectory C, point Z; we are thus in fact stuck at a bad equilibrium.  The move to further juice up output without a commitment to juice up employment is like the Keynesians of yore trying to smooth the oscillations around a bad equilibrium. But this time around it is employment which is lacking not output capacity.

What does this have to do with corporate tax cuts?  Corporate income tax cuts are suppose to be a stimulus to increase the output capacity of the Canadian economy over the medium to long term.  But if as is widely recognized output is not the problem but employment why are we even talking about supply side measures (i,e. corporate tax cuts)?

I think economists are still fighting the last war and not the war we are in.  And as any historian of war will tell you an army that does so will loose.

Update: this is not as radical an idea as it may appear: see this article in the business section of the Globe online.  The difference with Canada is that I think are debt growth is papering over the underlying bad equilibrium.

No. 6: Low interest rates anywhere and everywhere cause inflation

Ok this is a bit of pinball intro as I bounced first to the PEF to be greeted by a blog post by Erin Weir recommending we all read Nick Rowe poking at the President of the Minneapolis Federal Reserve with a sharp stick (more on that below).

Erin writes:

The President of the Minneapolis Federal Reserve had warned that unduly low interest rates would cause deflation. Of course, anyone with a handle on basic macroeconomics knows that the risk of leaving interest rates too low is inflation.

Ehhem, as everybody ought to know…ceteris paribus “anyone with a handle on basic macroeconomics knows that the risk of leaving interest rates too low is inflation.”

And what is often left out in inventory (introductory) macro is that ceteris paribus is crucial.

If you were to take Japan as your only data set and regress interest rates on the general price level you might be tempted to agree with the Pres. of the Min Fed. If you took Zimbabwe (interest rates and inflation rates only) as your case you would be tempted to argue the same: high interest rates cause high inflation! Neither of course is right. Back from the extremes; what is the relation between low interest rates in NA and the price level right now? There is a group of economists that have been promising, predicting, and now praying for an acceleration in the general price level since 2001. Ceteris paribus so is Erin if he believes that low interest rates ————> inflation. I do not think he does but it sure sounds like it.

Perhaps if intro to macro started with these real world examples they would be better courses. As everyone knows (don’t they?) both inflation and deflation are anywhere and everywhere decidedly more complex phenomena than simple causal arrows running from interest rates to general price levels. NB. Even the case where interest rates cause inflation or deflation they are going to be particular cases. The causal case (general law level) can only be sustained if and only if the economy being investigated conforms to the model. The theoretical model rarely will (and only loosely) so that too would be a particular case from which no general (———>) covering law can be given. Again the Fed Pres is wrong but not simply because he got the standard Macro 101 ass to front. As Nick Rowe notices and then notes.

I notice he has an undergraduate in maths, then went straight into a PhD in economics. My conjecture: I bet he never took Intro Economics, or anything vaguely similar. I bet he waded straight into the mathematical deep end. And so he never really learned economics. So he took the Fisher identity (nominal interest rates = real interest rates + expected inflation), added monetary super-neutrality (equilibrium real rates are independent of monetary policy in the long run), and ran with it. He never distinguished between the equilibrium thought-experiment and the stability thought-experiment. If you explain this in words, as you have to in Intro Economics, you have to get it right.

We should never, ever, let students do this. Yet we do it all the time.

And this is also why we should never frame monetary policy in terms of interest rates. If this guy can’t understand it, maybe some average people will get it wrong sometimes too, and have things going in the wrong direction

Sometimes I despair of my discipline. And for my economy.

None of which seems to have aught much to do with math save for in one sense; like alcohol, the math does a kind of confidence trick .

And guess what: heterodoxy is working a whole lot better than orthodoxy.

Who said that? Karl Marx? No. Joan Robinson? No. Kalecki? No. Implied by all three but actually said by no less than Paul Krugman the new fringe of of the economics profession.

Welcome aboard chappy!

Potash, Economic Nationalism, and National Champions

Harper did the unthinkable. It is only in the rarest of circumstances that the federal government actually uses its powers of review to quash foreign takeovers. Yet this is not really where the action is–that is, what caused the cons to deny BHP bid to take over Potash.

The action is just beginning. In less than 12 hours from now the major Canadian print media outlets–from the globe and mail through to the National post and Macleans, are going to be blitzed by a uniform message: the conservative government was wrong to kill BHP’s bid. The chief purveyors of this line are going to be, of course, Andrew Coyne and Stephan Gordon. And both are likely to riff off the same logic.

The argument will most likely be something like the following. Investment decisions that are made in the context of competitive private markets produce the most efficient outcomes. Public attempts to interfere with that outcome are most likely to be sub-optimal. Of course we could point to Canadian banking legislation which effectively guarantees an oligopolistic market structure and then point out that these same talking heads prattled on about our regulatory environment being responsible for avoiding the excesses of the GFC. But having a general comprehension problem in moving from point A to B they will of course celebrate the beauty of free markets.

But wait there is more. There is always, of course, more with talking head economists. Even if they grant that potash and the potash industry is far from a competitive industry–indeed BHP’s bid is largely about consolidating the market to guarantee price making capacity–they will pull out plan B.

Plan B is rather devious. Plan B says that even when the norms of perfect competition are violated government intervention is not necessarily warranted. The inspiration here is some pissy little paper written by Hayek. I won’t tangent. The cut and thrust; the pith and substance here is that even under imperfect competition private market structured are subject to outside scrutiny and competitive pressures such that we can proceed as though the results of perfect competition nearly apply. The government on the other hand when picking a national Champion will have no such information and might as well be flipping a nickel to make its choice.

This is a stupid argument. The very fact that BHP is making an offer gives the state an indication that Potash is a viable national Champion. But wait here is more. Potash is strategic: there is every good reason to believe that in a world of increasing consumption fertilizer, like oil, is going up.

So between the market structure and future path of potash prices it should be incredibly hard to paint a picture of government interference causing a net loss.

But both the abstract science and the empirical reality be damned because the real action here is about precedent. The last thing the Coyne’s and Gordon’s of this world want is a positive example of the public interest trumping private profits with the math on the side of the public.

More evidence that orthdox economic ideas and politics do not mix

Case in point: Gordon Campbell. Yep that is what Gordon following the Gordon gets.

Mankiw was right, incentives do matter

It turns out that Greg Mankiw perhaps was *mostly* right: incentives do matter. To understand to what extent and how far my dear readers you will have to do three things.

First you will have to read Mankiws original article here. Then you will have to watch this 10 minute long animated lecture here (h/t Marc Lee) and then you will have to read Iglika’s post over at the Progressive economics blog. I know that is about 30 minutes of your time dear reader but I promise you will be rewarded for doing your homework and be equipped to make a difference.

My take away from the three homework assignments is this. If we combine Iglika’s post with Marc’s video link and reflect back on Mankiw’s now infamous article in the NYT we are left with one of three conclusions.

A) Mankiw is wrong.

B) The type of intellectual work he does is akin to basic mechanical manipulation of say moving a mountain of manure from spot X to spot Y.

C) A & B are correct if, and only if, Mankiw does not generalize from what he does for work to what real professionals do for work.

Take away is that both incentives and the type of work being done matter.

The rich get substitution effects and the poor get income effects

It is pretty much understood that the basic orthodox labour market model is agnostic insofar as income and substitution effects are concerned. If for example real wages increase workers may choose to work less because they can consume more leisure with less hours of work or workers may work more hours because the opportunity cost of leisure has gone up. Which effects dominate workers’ incentives are not predetermined by the standard labour market model.

Implicitly, however, we can glean what mainstream economics tends to think are the incentives facing different classes (economic classes that is) of workers. In Mankiw’s recently ridiculed here, here, here and here article in the NYT, he argued the impact of a tax increase on the economic class of ‘workers’ at the top of remuneration scale was a decrease in the real wage which would be met by a substitution of more leisure for less work as the opportunity cost of leisure had been cheapened by the tax increase. Simply stated this class of workers would respond to a decline in their real wage with a union strike like reaction.

So far so good. I do not imagine it inconceivable that those workers with compensation packages that put them in the top 1% of income earners could choose to work less hours if they were faced with a wage cut with one important caveat. They would have to have the type of job which allowed them to control their hours of work and or have sufficient means to withdrawl from the labour market altogether aka independently wealthy. For example, an NHL hockey player cannot say to his coach I am playing one less game a year because of the increase in marginal tax rates; although he might try to make the team offset the tax increase with a higher salary. Thank god for salary caps.

However, when we turn to lower classes of workers we find that Mankiw argues that income effects dominate their incentives. In his introductory texbook he has the following to say about unemployment insurance:

So here Mankiw argues that workers respond according to income effects. Lowering unemployment insurance replacement rates would decrease unemployment because workers would have a greater income incentive to take a job.

What, therefore, accounts for the different reactions between these two classes of workers? Why that is will increased taxes on the rich (a decrease in the real wage) lead to a withdrawal from the labour market but a decrease in unemployment benefits (again a decrease in the real wage) increase the supply of labour. The answer of course is that most classes of workers are not independently wealthy and do not meaningfully control their hours of work. Workers have to work and outside of access to unemployment benefits they do not have the option of defecting from paid labour markets. Therefore whether income or substitution effects predominate is largely a function of class. Most classes of workers save for those at the very top respond to a decreased real wage either by seeking more hours of work through one of three ways: overtime, a second job or telling their teenager to go get a job and pay their own cell phone bill.

It is interesting that Karl Marx (well Smith too in some respects) were the first to recognize the differences between classes of workers what we once called proletarians and the bourgeoisie. But that is for another post.

The fringe responds to Krugman and wins Jack-ass Economist of the year 2010 prize

I do not know nor have I read, nor do I have any friends who know or who have read Stephen Williamson. Apparently he graduated from Rochester. Who cares? What is sad about his post is that he gets almost everything wrong–to get everything wrong would be a triumph of sorts. No heterodox economists do not hate math. The most significant elements of the heterodox community have been both well versed in both math and linux (sadly). The Sraffians for example are a very math oriented bunch so much so that given the weight of their critique and mathematical proofs the lauded Samuelsonian school had to beat a hasty retreat into of all things hermeneutics to defend orthodox capital theory. Marxist economists have long been enamoured with math. You just do not get a calculation debate without math. Moreover all the new solutions to the so-called transformation problem have been fought out using math. Further the most recent high profile heterodox economist Steve Keen has been championing hard math for analysis of capitalist economies. Some might even say his reliance on hard math is the Achilles heal of his hard predictions.

There is no shortage of math on the so-called heterodox side of the economics profession there is, however, a shortage of insecurity masquerading as self-assured arrogance which truth be told is the real dividing line between the orthodox and the fringe.

PS. What a shameless display of disrespect to Douglas North who by the fringes’ account is one of the chief protagonists of neoclassical imperialism. Williamson does not even know who his own ideological generals are. But I guess that is what you get when you purge historical memory from orthodoxy.