Tot Sententiae

I’m reading Gordon Tullock’s On Voting. It’s an odd little book, but very entertaining. Tullock comes across as the kind of old curmudgeon you see on TV sitcoms, albeit one who practically invented an important sub-field of economics. I discovered today that someone interviewed him before the 2008 election and put together an amusing little piece on why he doesn’t vote.

I don’t feel like providing a wealth of citations, but the press is awash lately in talk of how economists were wrong to believe in market efficiency and rationality, and how they remain unwilling to change their opinions in light of recent events. Unfortunately, most of the commentators don’t know what they’re talking about.

Many people seem to think that the efficient market hypothesis (EMH) means ‘the market never makes mistakes.’ This is, of course, absurd. The market functions precisely because it makes mistakes, mistakes which are punished by losses in a feedback and learning cycle. What economists actually mean by the EMH is that is is essentially impossible to systematically beat the market. Any information that is known today should more or less be priced into the stock before individual investors have a chance to react. This is not an ‘everywhere and always perfectly true’ proposition, but seems to be a pretty robust approximation.

But what about the recent housing bubble? We can all see that that wasn’t efficient. The EMH must be wrong! This is another misunderstanding. The EMH doesn’t say that the market will get things right ex post, merely that it prices in relevant information ex ante. If you think it’s going to rain today, it is ex ante efficient to bring an umbrella. Of course, if it turns out to be a sunny day, you’re lugging around dead weight all afternoon–an ex post inefficiency.

But aren’t bubbles founded on irrationality in any case? Tulipmania, the South Sea Bubble? In a sense, yes. These episodes aren’t based on the long-term ‘fundamental’ value of the underlying assets. But participating in a bubble can be perfectly rational. If you see that everyone around you is foolishly bidding up the price of Ben Affleck memorabilia, provided you think they’ll keep doing this long enough for you to make a profit, it makes sense to buy a few hundred copies of ‘Gigli.’ Indeed, anyone who got in and out of the housing market before it tanked made a hefty profit. The episode may be founded on irrationality, but the individually rational response could still be to add fuel to the fire.

This is not to say that such situations are good, of course. And perhaps we think the government ought to do something about it. But it’s not as simple as ‘market bad, government good.’ If you want government regulators to ‘burst’ asset bubbles, they need to be able to reliably detect them. But how exactly are they going to do this? Anyone who detected the housing bubble could have a made a fortune selling certain assets short. Of course, when enough people short a stock, the price falls. In other words, there are massive market rewards to private ‘bubble bursting,’ yet millions of intelligent investors, with a deep financial interest in the situation failed to burst the bubble soon enough. Are we really supposed to believe that a small panel of government experts without a financial stake in the outcome can do better?

Perhaps not, you might say, but the government will err on the side of caution, keeping interest rates high when in doubt. This might well work, but it doesn’t come for free. If what is actually a period of growth is misidentified as a bubble, high interest rates will hamper the expansion. Will the cure be worse than the disease? At this point, it’s hard to say, but there is one thing you should bear in mind: whenever you wonder if market participants are irrational, be sure to ask the same about the regulators.