Part 1: A Legacy outside the institution
Part 2: Currents in Austrian School; fundamentalism, scholarship, media, etc..
part 3: Financial economics: The Efficient Market Hypothesis
Part 4: Classsical economics and Market Socialism; Updating classical
Part 5: Hayek vs. Central Planning; Hayek Vs. Rational Expectations
Part 6: The Cycle and Rational Expectations; island Parables
Part 7: The Cycle as a Prisoner's Dilemma -- in "Anarcho Capitalism"?
Part 8: 2008 Crisis and Market Efficiency; Keynes vs. Chicago vs. Hayek vs. Warren Buffett
I'm going to press the pause button on the Austrian story and talk about one of the most important theories in mainstream Chicago thinking and how this theory radically argues for a free-market paradigm. With this theory in hindsight, developing the Austrian perspective should prove quite interesting.
To tell this like an origin story where a lot of context and background developments will go unattributed, an economics student by the name of Eugene Fama was busy at work with a professor developing a trading scheme to "beat" the stock market back in the 60's. Looking for patterns in stock movements, if extrapolations about future movements could be made from past movements, a large fortune might be made. Professor and student didn't have much success, and Fama came to the conclusion that these kinds of strategies couldn't work. The problem? They weren't the only ones looking at the data. How many other Phds and analysts out there were looking to make an easy buck this way? Where incentives are astronomically high, access to information equal, transaction costs low, and barriers to entry nil -- anyone can have a brokerage account -- a financial market, like a stock market or foreign currency market, should approach the conditions of a true, perfect economy. Fama called his discovery the Efficient Market Hypothesis.
Arbitrage incentives keep prices honest. If one can buy bread on the east side of town for a dollar and sell it on the west side of town for twenty, and a two-way cab ride costs a buck, then one is going to buy a lot of bread and make some cab runs. If the west side of town ignores the situation, they will be undersold and driven out of business. As a further result, we can expect the price on the east side to rise with every bread run. In this scenario, the arbitrager makes an easy buck, but his activities effect prices and eventually bring the market into equilibrium where arbitrage opportunities disappear. In markets, arbitrage is hoped to be self-defeating.
If a stock could be bought on the NYSE for 20$ and sold on AMEX for 100$, this would leave open a straightforward opportunity for arbitrage that parallels the bread example above. It's unthinkable a condition like this could prevail. Similarly, it's unthinkable that a clear price trend could last for very long. If a stock price followed a patter like this: /\/\/\/\/\/\/\/\ then as in the bread example, any trader will buy at the troughs and sell at the peaks - "buy low, sell high!". What idiot wouldn't? But as in the bread example, buying the stock ticks the price up, and selling ticks the price down, if enough analysts were to uncover the trend at the same time, within just a few minutes of spotting the trend, the trend would disappear. The trend disappearing parallels the bread example where the prices of east and west come to match each other. Well, as in the bread example, it's unthinkable that the trend would exist in the first place. We can summarize this intuition that such price trends shouldn't exist by saying that past prices and future prices of stocks should be uncorrelated. And with this simple insight, it's all statistics from there to determine if this is indeed the case.
This theory was not well-received by financial analysts, of course. I can't say I was very happy to learn about it either because, prior to my first financial econ class, I became friends with some guys who had ties to the industry and I grew interested in the prospect of doing something Wall-Street related in an analyst capacity. Recall from my last post, I, like many students, suffered through micro theory as my adviser recommended, having hope something better was around the corner. So I walked into my financial economics class ready to apply all that theory to financial reality and, imagine showing up to your first day of medical school and being told that the human body is fascinating but our knowledge about it can't be used to save lives. The reasons why economics was dubbed the dismal science were stacking up fast.
Anyway, Market Efficiency does not just cover "trend-watching" kinds of analysis, but every kind of analysis possible -- studying firm fundamentals, macro data, crowd psychology, you name it. No matter how much you study, you will never beat the market in terms of returns to risk exposure -- so the theory goes. The test hypothesis? The main tests here are statistical models demonstrating that active mutual fund managers underperform a random selection of stocks on average. Active fund managers, by the way, are trained to "actively" buy and sell stocks, "manage" their portfolio based on what they have determined to be the merit of the securities they hold by whatever means. If on average, a medicine led to healing your body more slowly than doing nothing, you'd think twice about taking the medicine.
As controversial as the theory was, it had a huge impact on Wall Street. Passive funds "buy and hold" strategies became popular and if there was ever any question that a stock broker was something other than a used car salesman, the matter was settled now. EFH in bare bones:
- agents are "rational"
- agents have access to all available information (relevant to the financial market)
If the above is true, then the price of a stock will correctly reflect all available information.
- test hypothesis: if the above are true, then there should be no opportunities for arbitrage. Thus, uncovering a trading strategy that "beats the market" in terms of return to risk, calls the hypothesis into question (though doesn't necessarily overturn it).
So how does this tie into free-market discussions? From a longtime favorite article of mine (no, this guy wasn't my professor):
http://marriottschool.net/emp/SRT/passive.html
Thorley wrote:Stock market players do not generally appreciate why economist are so enamored with efficient market theory. The reason is that informational efficiency in security prices is a key assumption behind the argument for capitalism. Fair prices in unfettered financial markets promote social welfare by ensuring that capital is allocated to its best and highest use. Scarce funding is automatically dispersed to those industries and companies most likely to produce the goods and services we all want. If stock mis-pricing due to overreaction, crowd psychology, or neglect, are as common as some market observers claim, then we would all be better off with a central planning committee making society's capital allocation decisions. This concept lies behind the humorous observation by Rex Sinquefield of Dimensional Fund Advisers: "I've polled everyone I know, and the only people who think that markets are not efficient are the Cubans, the North Koreans, and the active fund managers."
And how is this relevant to Austrian Economics?
The Singuefield quote needs another comma and to add "The Austrians." Next to the Paul Krugmann, the vocal Keynesian economist and pundit, nobody damns the Efficient Market Hypothesis to hell like the Austrians do.
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Here's a great paper on EFH, written by one of fama's colleagues.
http://www.princeton.edu/~ceps/workingp ... alkiel.pdf