Monday, January 11, 2010

Efficient Market Hypothesis and criticism

IN a recent blogpost the odd and quirky Robin Hanson discusses How To Dis EMH (Efficient Market Hypothesis) and (more importantly) - how not to. He shows some quotes of the debates going on and argues that you cannot judge EMH unless you can at the time do better than it and prove that you can do this consistenly over time.

So the clearest way for EMH skeptics to show they are right is to collect a track record showing that they can predict, ahead of time, when prices are too high, vs. too low. There’s little point in picking out some year old event, and saying, “see that price drop was too big.” Monday morning quarterbacking is way too easy.


But all this continual harping year after year on how EMH is obviously wrong, based on selective stories of past prices you say were obviously wrong, sounds awful suspicious when you don’t bother to publicly flag price errors at the time, much less to collect and publicize a track record of such error flags. (E.g., care to declare which prices are wrong today?) What’s up with that?

It's an interesting point that I agree with to a point, but there's something odd about it as well. I think it may have something to do with what we mean by "criticism of EMH". Hanson's point is valid if a critic says that the EMH is often obviously wrong and can easily be improved. But what if a critic says that the quality of forward looking predictions (including his/her own) is generally poor, and that this translates into an extreme volatility in stock markets and markets in futures and derivatives? If this is so, and if there are significant and real costs to sharply and vigorously yanking the economy towards whatever-our-best-guesstimate-of-the-future-is-right-now, then we might not want our economy to be as dependent on the estimates of the future. We may be able to choose or influence at a social or policy level how "forward looking" our economy is in its adjustments - and we may not want the ADHD economy that wants to pull up all roots and set sails towards whatever the future seems to hold at any given instant.

Friday, January 8, 2010

From Economics to Ideology to Real World Disaster?

Two interesting articles I recently read tied nicely together as a story about how the search for intellectual sophistication and grand theory in economics generated a doctrinaire belief in the free markets marvels and ability to police itself, which became an intellectual alibi and ideological fuel for a "hands-off-the-economy" Conservative movement, that in turn removed all road-blocks to a Financial Crisis and completely bungled the reconstruction of Iraq.
Phew... that was a long sentence...
Anyway - this piece by Kenneth Davidson in the American Interest argues that George Stigler and Milton Friedman turned the Chicago School of Economics into the hotbed of laissez faire economics that it is still regarded as today. And how this in turn helped along a new policy of deregulation that created the recent Financial Crisis.
Once it abandoned its political concerns with economic power, Chicago theory, with its axioms of profit maximization, perfect information and self-correcting markets, had no advice to limit the downside risks of economic and financial disaster. The fruitful blending of social and economic concerns pioneered by Simons may not be suitable to a modern economy, but his concern about the dangers of centralizing economic power remains an issue that is ignored by the Chicago School. Doctrine supplanted healthy intellectual doubt, theoretical purity trumped common sense and historical memory, acolytes took over from masters, and a different kind of irrational exuberance was the result. We’re all now paying the price.
The other piece, by Naomi Klein, in the Atlantic from 2004, describes the reasoning behind the Iraq reconstruction effort - basically, the attempt to set up a totally free and rigorous free market paradise that would have every capitalist in the Milky Way clamoring to invest and generate jobs, wealth and prosperity for all. While clearly biased against this ideology, there are numerous interesting quotes and witty observations - though it seems weird to both argue that their attempt was foiled because it was illegal against international law and to argue that the chaos of Iraq that followed should be proof that a full and perfect implementation of free market laws and regulations does not work.
And - as always - both authors can be attacked by any economist worth his salt. Because academic economics, of course, has nuances and spends much of its time discussing and analyzing flaws and caveats to the simplified picture that these authors attack. Its just that no conclusion ever lives on except as it does in broad stroke form. Friedman's essay on positive economics becomes "unrealistic assumptions are fine and lead to true welfare conclusions because it is all as if theory". A "perfect competition" reference model and "rationality assumption" with selfish preferences becomes "the broad truth" and what policy makers with bachelors in Economics and even the intuitions of many sophisticated researchers reach for.

Or something like that - what's the point? - if you recall this in the future it may all be reduced to "he blames economics for Iraq and everything that goes wrong" anyway... ;-)

Monday, January 4, 2010

Distorting the truth to make the case that economists distort the truth?

Hans made me aware of this: In a recent blogpost entitled "What Should Economists Study?" Brad DeLong writes the following:
As one of the students interviewed for the original The Making of an Economist, let me say that there was a distressingly wide gap between what we told Colander and Klamer and what they heard: we were not nearly as stupid and as narrow as they wanted us to be.
Bit of a let-down, since several of their claims seemed to ring true to me, but worth noting. Seems a bit silly to ignore empirical data when it contradicts your hypothesis that economists too frequently ignore empirical data.

BTW - don't recall this book as arguing that economist students were stupid or narrow. It's argument was more that the education they were offered seemed - to them - to be narrow and stupid. As far as I recall from skimming it several years ago.