Tuesday, June 09, 2009

Efficient Financial Market Hypothesis

Over at ThinkMarkets, Mario Rizzo has a great exposition of what the efficient market hypothesis means in financial markets. As he puts it, the financial crisis is not a result of mortgage backed securities, credit-default swaps, or new financial instruments, per se -- but rather a result of a poor institutional context.

The argument relies on first making the point that markets work because of arbitragers (at the very least) -- implying that entrepreneurial action is necessary to discover what types of information are relevant and to whom. Without a grasp on how new information becomes injected into a competitive market, it becomes harder to understand the causes of the financial crisis. First, arbitragers and entrepreneurs must perceive profitable opportunities. Second, the ability to then act on those perceptions of profit is dependent on the incentives they face in assuming risk or acting under conditions of uncertainty.

Fed low interest rate policy set up counter-corrective incentives, encouraging investment in assets which did not reflect the true relative prices of those mortgages. It should also be noted that this was compounded by the regulatory and legislative environment, not assuaged by it (ie - Neighborhood Reinvestment Act etc). In terms of the market complications associated with the lattice work of the credit-default swaps and other novel instruments -- there are reasons to believe that it wasn't that market players failed to perceive such problems. Instead, the incentives to act on those perceptions were exceptionally weak. As Rizzo puts it:

"Most financial players realized that there was, as they thought, some extremely small probability that the highly leveraged complex of securities could blow up. But why worry about that? Under those circumstances bailouts would be highly likely, perhaps certain. That certainly was a good bet given recent events. And from this point on, it will be an even better bet."

In other words, the necessary incentives for a "well working" error correction mechanism are institutionally dependent and in this case were eroded by Federal Reserve actions and regulatory environment that encourages people to write checks they can't cash.

Rizzo began the post by mentioning that the NYT column that calls the EMH into question. I think its worth talking the relationship between the discussion of economics in the popular press and the discussion of ideas that take place in journals. For the popular press to suggest that the EMH is empirically no longer relevant opens up the discussion to various different avenues. Does the popular press get the theory right? Does the popular press ask the empirically relevant questions? Does the popular press understand the relationship between models and empirics? These questions spark debate among economists, much less between economists and non-economists.

Rizzo's post highlights an Austrian interpretation of the EMH, suggesting that a strict interpretation leaves the ideas of Keynes and Thaler much more attractive. Is the route to better everyday economics found in revising the common understanding of what efficiency in the market looks like?

On a related note, TPS blogger Will Luther has a paper coming out with Peter Boettke on the importance of ordinary economics in extraordinary financial times. A working paper version will hopefully be posted soon!

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