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Can The Efficient Markets Hypothesis Survive?

George Manson University economist Tyler Cowen has written an interesting new paper entitled "A Simple Theory of the Financial Crisis." That's a good title, because I'm very much on the lookout for simple theories of the financial crisis. The paper's main mission, it seems to me, is to protect the efficient markets hypothesis from the fallout of the financial crisis. The key bit of the paper comes on page three:

In a strict rational expectations model, we might expect some people to overtrust others and one view of rational expectations is that investors’ errors will cancel one another out in each market period. Another view of rational expectations is that investors’ errors will cancel one another out over longer stretches of time but that the aggregate weight of the forecasts in any particular period can be quite biased owing to common entrepreneurial misunderstandings of observed recent history. In the latter case, entrepreneurial errors magnify one another rather than cancel one another out. That is one simple way to account for a widespread financial crisis without doing violence to the rational expectations assumption or denying the mathematical elegance of the law of large numbers.

I'd like to see what Justin Fox -- author of the excellent new book The Myth of the Rational Market -- would say in response. Luckily, he has a blog where he could write such a response, and hopefully this link combined with that book plug will act as a bat signal of sorts.

By Ezra Klein  |  June 8, 2009; 3:30 PM ET
Categories:  Financial Crisis , Solutions  
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Shouldn't that be Charles Manson University?

Posted by: epreisin | June 8, 2009 3:53 PM | Report abuse

Are you sure you aren't conflating rational expectations with efficient markets?

Posted by: JulianSanchez | June 8, 2009 4:37 PM | Report abuse

Having just finished reading the paper, it seems very much of a piece with Professor Cowen's other post-crash writings, and yes, it does seem to be designed as a defense of the rational markets hypothesis.

The most curious thing about the paper is how beside the point it is. Professor Cowen moves a rhetorical heaven and earth to take the term 'endemic bias' (otherwise known as 'blowing bubbles') out of the file called 'irrational' and added it to the file 'rational' --- but I can tell you with a somewhat-inside view of a finance industry company that absolutely no one was buying derivatives and thinking 'this will look really rational in the long-term' -- they were worried about beating benchmark and not suffering redemptions -- both short-term concerns.

The real problem is that, whether one is speaking of rational markets, or even just the law of large numbers, both include a chance of catastrophic failure in them with no alteration at all. And that was ignored. Moody's initial models showed results on the housing market that indicated it was going to go down --- the humans didn't believe it and reprogrammed their models. And the law of large numbers is routinely used to predict how many multi-car pile-up fatalities a state will have in a given year. Taleb has been going on about this for literally years. In short, the math was fine, and the market did exactly what a market periodically does when it's left alone: it blew itself up.

Whether it is secretly rational or not, most of us embrace markets for their results, not their purity of philosophical expression. The market, operating exactly as a rational market is supposed to, destroyed $10T of value in less than a year, and all the armor thrown up over either market rationality and large numbers doesn't hide that.

Posted by: rsuleiman | June 8, 2009 4:54 PM | Report abuse

GMU economics department is a wholly owned subsidiary of Charles Koch (of Koch Industries) who gave over $22 million to set it up as a bastion of libertarian thought.

Their mission is to defend the "free" market so that the Koch brothers and his colleagues that also fund Cato, Heritage and the rest of the bunch can continue to rake in huge profits with a minimum amount of government "interference".

What makes Cowen so amusing is that he has been bought by Koch while stoutly denying it. Who does he think pays his salary and that of his appointment at the sister Mercatus Center?

Posted by: robertfeinman | June 8, 2009 6:16 PM | Report abuse

1) in the long run we're all dead. Prices will be efficient when the universe gets to heat death.

2) EMH hasn't failed, it just hasn't been tried yet.

3) Nothing is more pointless than debating EMH. Either it's defined so narrowly as to be pointless, or it's obviously false. The rest is word games.

Posted by: chrismealy | June 9, 2009 4:10 AM | Report abuse

Cowan has chosen to redefine the rational expectations hypothesis. He has also defined it so that it is meaningless, unfalsifiable, and not a hypothesis.

His intellectual accomplishment can be reproduced in other fields. If I redefine "The Ptolomaic model" to mean "The hypothesis that the earth orbits the sun" then I can save it from its recent difficulties.

I think he could have made his point more clearly if he decided to redefine "the rational expectations hypothesis" to be the hypothesis that 2+2=4. Oh and while he's at it he could define "the law of large numbers" to mean large numbers are larger than small numbers."

His use of the phrase "law of large numbers" shows that he is absolutely unwilling to consider the actual statement of any actual theorem. Oh and that he doesn't know the difference between mathematics and science.

I think a refutation of Cowan's argument which is just as valid as his argument is "I am Tyler Cowan and I retract abjure and reject my argument". Technically, I am not Tyeler Cowan, but if he can redefine the rational expectations hypothesis as he pleases then why can't I redefine "Tyler Cowan" to mean "Robert Waldmann."

Posted by: rjw88 | June 9, 2009 5:31 AM | Report abuse

The conversation stops when one is asked what other system besides free markets and capitalism has produced the same wealth.

The best example I can give is Hong Kong....essentially a rock with few resources. However with few taxes and unbridled capitalism, it now has more wealth per capita than any other Asian nation and more millionaires per capita.

Posted by: ElViajero | June 9, 2009 8:12 AM | Report abuse

As a recently laid off 63 year old, all the talk of long term rationality, the law of large numbers, and making more millionaires like Hong Kong seems to be coming from the wrong perspective. I'd like to see an economy designed to provide basic economic security, healthcare, housing, and food to all people on a stable basis. That such an economy might produce lower growth statistics is of less concern and might even have a positive impact on environmental destruction.
The rest seems academic gamesmanship -- bought and paid for by those who would sacrifice a good portion of our human capital to enrich the short term.

Posted by: ljfamily | June 9, 2009 10:46 AM | Report abuse

The problem is really the lack of a decent alternative. We're simply not smart enough to dictate prices. The real problem is people that are willing to take huge risks. If you want a stable company, you need to design incentives in such a way that the risk taker is exposed to the risk. Hopefully recent events, more people reading Taleb, etc. will help us to appropriately price risk.

Of course, the government is as guilty of this as anyone else- the FHA is still allowing 3% down loans, which combined with the $8000 first time buyer tax credit and $170,000 average home price means that people can still buy homes with no money down. How do they do it? You and I, the taxpayers, are the backstop for the downside risk. Now the banks know we are going to bail them out if they go down too- moral hazard, anyone?

Posted by: staticvars | June 9, 2009 11:18 AM | Report abuse

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