Keynes and the efficient market hypothesis

Over at The Money Illusion, Scott Sumner has posted a number of blog entries about John Maynard Keynes as an investor and how it informs the debate about efficient markets:

Far from refuting the efficient markets hypothesis (EMH), the story of Keynes’ investments actually supports the buy and hold recommendations of those who adhere to the efficient markets view, “stocks for the long run.” He did best when he didn’t try to time the market, and did poorly when he engaged in fancy speculative gambles during 1928-29.

It seems to me that one of the errors that many people (including some academics) make when discussing market efficiency is to assume that the hypothesis requires that all participants in the market are rational. Since this postulate so obviously contradicts empirical reality, it is argued that economic approaches associated with market efficiency (such as New Classical Macroeconomics and Real Business Cycles) must be flawed as well. But does the efficient market hypothesis really require such a strong postulate? Is it not enough to propose that rational individuals take advantage of the profit opportunities created by those who make mistakes?

Another flaw in discussions about rationality and efficient markets is that little attention is being paid to the question whether it can be rational to be irrational. As Bryan Caplan has argued in his book The Myth of the Rational Voter: Why Democracies Choose Bad Policies, the average  voter in a mass democracy does not have a strong incentive to be rational because irrationality is basically costless. Thus Caplan writes “irrationality, like ignorance, is sensitive to price, and false beliefs about politics and religion are cheap.” Linking rationality to incentives in this fashion offers the prospect for a reformulation of classical economics that can lead to improved insights into the observation that we see so much variability in the applicability of the strong rationality postulate.

Of course, the case against efficient markets is of little practical interest unless it can be argued that something meaningful can be done about it. Government intervention seems to be of little use if the incentives that shape and maintain irrational behavior apply to collective choice as well; instead, we should expect them to be worse for reasons that are unique  to government (monopoly, the absence of price mechanisms, the prospects of redistribution etc.)

Animal spirits in public policy

In the Summer 2009 issue of the Independent Review, Arnold Kling reviews George A. Akerlof and Robert J. Shiller’s new book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Reading his review, one wonders how it is still possible for a serious scholar to make a case for more government intervention by simply documenting all the ways in which actual human behavior differs from the (strong) rationality postulates of classical economics. As Arnold Kling points out, and this must be getting quite tiresome, why assume that these same “animal spirits” do not inform and shape public policy as well? It is not hard to imagine a book that uses politics and government policies as illustrations of irrationality, conformity, and unfair decision making. As a matter of fact, current government responses to the financial crisis should provide a wealth of examples for numerous volumes about “politicians in panic.”

What might be more illuminating from a scholarly perspective is to investigate how different incentives and institutional environments produce lesser and greater diversions from the postulates of rational choice. A focused contribution to investigating these topics has been made by the economist Bryan Caplan, culminating in his excellent, and courageous, book, The Myth of the Rational Voter: Why Democracies Choose Bad Policies.

Of course, purists will rightly argue that the case of Akerlof and Shiller is dead on arrival because no prescriptive statements can be derived from their detailed descriptions of irrational behavior without accepting the authors’ own outlook, in their case expressed in the metaphor of society as a family in which the government behaves as the parents. The use of this metaphor sheds an interesting light on how some modern liberals view society as an extended family.

Macroeconomics in politics

Steve Chapman writes:

If the economy improves and unemployment drops, Obama can take credit. If it fails to improve and unemployment rises, though, he can say he averted an even worse showing. Republicans will take the opposite tack — attributing any improvement to the natural resilience of the economy and blaming the administration if things get worse. And neither side will really know who’s right.

A scientifically trained politician (or journalist) often has good reasons to simply say, “I do not know.” But in politics, or especially in politics, such statements are considered a sign of weakness, and therefore, political suicide. To be a successful politician you need to signal strength, not epistemological sophistication. To a lesser extent this applies to (partisan) journalists who write about macroeconomic matters as well. If Paul Krugman would just confine himself to sketching a number of different scenarios without taking sides, many people would find his columns boring and would look for ammunition to engage in political debate elsewhere. The addiction to politics is so strong that we are prepared to throw everything we have been taught about valid reasoning and how science operates out of the window.

Related reading: Looking at the world through politically-colored glasses

On economic forecasting: A positive-sum game against nature

Undercover at Wal-Mart

The New York Post recently posted an interesting personal account of writer and cryonics activist Charles Platt about working conditions and company policies at Wal-Mart. In Platt’s own words:

Some people, usually community activists, loath Wal-Mart. Others, like the family of four struggling to make ends meet, are in love with the chain. I, meanwhile, am in awe of it.

Platt does not found much ground for the negative treatment of Wal-Mart by progressives and singles out labor unions as one of the major sources of misinformation about Wal-Mart:

You have to wonder, then, why the store has such a terrible reputation, and I have to tell you that so far as I can determine, trade unions have done most of the mudslinging. Web sites that serve as a source for negative stories are often affiliated with unions.

But as he points out in his intelligent discussion of labor unions, the reason that people are paid low wages at Wal-Mart and other large retailers simply reflects supply and demand and not any deliberate attempt to keep wages low:

In our free-enterprise system, employees are valued largely in terms of what they can do. This is why teenagers fresh out of high school often go to vocational training institutes to become auto mechanics or electricians. They understand a basic principle that seems to elude social commentators, politicians and union organizers. If you want better pay, you need to learn skills that are in demand.

The blunt tools of legislation or union power can force a corporation to pay higher wages, but if employees don’t create an equal amount of additional value, there’s no net gain. All other factors remaining equal, the store will have to charge higher prices for its merchandise, and its competitive position will suffer.

This is Economics 101, but no one wants to believe it, because it tells us that a legislative or unionized quick-fix is not going to work in the long term. If you want people to be wealthier, they have to create additional wealth.

Although there is less support for labor unions in the United States than in other modern Western countries, the mystery remains why these organizations are taken seriously at all. Labor unions are labor cartels that do not create wealth but can only redistribute existing wealth at the expense of others. In reality, labor unions are often detrimental to increased productivity and creation of wealth because their policies produce unemployment, social unrest, and contribute to an entitlement culture in which people are discouraged from seeking individual solutions to better their economic conditions. As such, labor unions represent a harmful combination of tribalism and economic ignorance.

The writer also draws attention to the issue that small “mom and pop” stores are not necessarily better than large corporations. Many of them simply go bankrupt because they are unimaginative, wasteful, and rude to their customers. There is one caveat to this perspective, however, and that is that government regulation and labor union policies often favor bigger companies over smaller companies. Economies in countries like the Netherlands are heavily regulated by the government and the result has not been more diversity in retail but the depressing development of (designated) urban “shopping streets” that feature the same stores wherever one goes.

Despite their rhetoric about representing the little guy against corporate interests, in reality labor unions feel a lot more comfortable with large scale negation between the government, big corporations, and union representatives than the prospect of a healthy competition between unruly, impenetrable small companies. This (unintended) bias of government and unions for large corporations has recently been made official policy as a result of the “Too Big to Fail” doctrine which shelters failed companies from bankruptcy and socializes losses (corporate welfare).

Perhaps the most telling sign of the times is the influence of government employee labor unions. As an opinion piece in the Wall Street Journal notes:

When the movement among public-sector workers to unionize began gathering momentum in the 1950s, some critics, including private-sector labor leaders such as George Meany, observed that government is a monopoly not subject to the discipline of the marketplace. Allowing these workers — many already protected by civil-service law — to organize and bargain collectively might ultimately give them the power to hold politicians and taxpayers hostage.

There is a great taboo on individuals selling their votes but what to think of a President that rewards labor union voters in the public sector (the new privileged class) with more projects, higher wages, and increased job security while people  who work in the private sector cannot escape the consequences of the current financial crisis?

Further reading: Public Sector Unions Are Killing United States

Understanding business cycles

In his book Recessions and Depressions: Understanding Business Cycles, Todd A. Knoop points out that a Rational Expectations perspective does not necessarily require that all segments of society are rational or use all available information:

Those who are rational will take advantage of the profit opportunities created by those who are consistently making mistakes.

In other words, the failure of some individuals to act on the future effects of policies  will create profit opportunities for people who do anticipate such effects.  This is an important observation because it highlights how public policies can be rendered ineffective without having to assume that all people are forward-looking, rational individuals.

The book also contains a useful observation about the effect of random shocks on business cycles:

It might seem strange that random shocks to productivity can create business cycle swings. Shouldn’t every negative shock be quickly offset by some positive shock? The answer is, no. Economists and statisticians have long known that if you flip a coin 20 times, cyclical patterns will emerge. There will be series of heads that follow each other just as there will be series of tails. If productivity is a random variable, then it is not surprising that economies exhibit cyclical patterns. Persistent business cycles can come about as a result of the luck that is inherent in any random process.

The existence of business cycles as such in unregulated economies does not necessarily constitute “market failure.”  In its most simplistic form, such a view of market failure would be akin to saying that free markets fail because they are not immune to meteorite attacks.

But at the end of his chapter on Rational Expectations Knoop states that

rational expectations in an imperfectly competitive model of the economy can have much different implications….It is not necessarily rational expectations but the Rational Expectations model of perfectly flexible markets that generates what many economists consider to be implausible results.

Any model that assumes competitive markets will lead to implausible results if it is used to predict how individuals behave in an economy where government policies adversely affect the operation of markets. This does not invalidate models of perfect competition but highlights the need for models that reconcile the postulate of rationality with imperfect markets, provided such models do not claim to be actual descriptions of laissez-faire economics.

One troubling implication of Rational Expectations is that government can only influence real variables in the economy if its policies are secret and unpredictable.  Even if one does not agree with the strong postulates of Rational Expectations, public stabilization policies that assume that people will repeatedly ignore their future tax burden or neglect profit opportunities that are generated by these policies, do not even pass the test of common sense. Government can, of course, respond in turn by preventing markets to refect these new realities, but this can only produce  a perpetual cycle to disturb the operation of the price mechanism.

Knoop’s book on understanding business cycles is a useful introduction to the subject although his chapter on Real Business Cycles Models could benefit from a more balanced perspective. The conjecture that business cycles could be the most efficient response to  exogenous changes given the structure of the economy is an important insight and reconciles microeconomics and macroeconomics.  Although the New Keynesian economists also provide microfoundations for their views, it is sometimes hard to tell whether these views are refinements of classical economics or departures from it. If New Keynesian Economics is just a “hodge podge of reasons for this or that market failure” it runs the risk of being able to explain any kind of empirical observations.

New Keynesian Economics seems to be less confident about public policy recommendations. It will be interesting to observe what the fate of this school of economics will be if recent work on the microfoundations of political failure will be given more attention in macroeconomics.