[ExI] Psychology of markets explanations

Stathis Papaioannou stathisp at gmail.com
Sat Jun 20 10:59:42 UTC 2009

2009/6/20 <dan_ust at yahoo.com>

> > I believe the EMH is right. It simply says that, in
> > general, you can't
> > beat the market unless you have special information. This
> > is true even
> > in an economic bubble: in general it is never possible to
> > pick the top
> > or the bottom or say when the market will turn, no matter
> > how smart
> > you are, no matter how much information you accumulate, no
> > matter how
> > obvious it seems in retrospect. However, this is not the
> > same as
> > saying that a bubble is "efficient" or "rational". Also,
> > there is no
> > incompatibility between the EMH and government
> > intervention. The
> > government intervention is just another factor that impacts
> > on the
> > market, as an increase in the popularity of hoola hoops
> > might impact
> > on the share price of a toy maker. The government action
> > may make the
> > economy better or worse, but it won't make it easier or
> > harder to beat the market.
> I'm aware, but I still believe it's wrong.  Why?  The EMH assumes that market prices are in equilibrium and factor in all relevant data.  However, real world market prices are never in equilibrium and all relevant data is not factored in.  Prices are formed based on market interactions; they don't form because some divine intelligence knows all and tells all -- simply telling it in the language of prices.  (It might be better to see prices not as information, but as information surrogates.  A price rise, as information, tell us nothing about why the price rose.  The entrepreneur and economic historian might try to figure out that a rise in the price of tin is caused by reduced supply (current or expected), increased demand (current or expected), or inflation (current or expected), but the actual price doesn't reveal that.)

The market factors in all the information as best it can. Obviously,
not all the information is known, understood, or known and understood
in a timely manner. I'm not sure what you mean by "equilibrium" but
sometimes the price of a security will fluctuate wildly within a
period of minutes, without there being any obvious new information.
Perhaps the day-traders have noticed an interesting pattern on the
chart, or perhaps a big buyer who was accumulating stock got bad
indigestion after lunch and went home early; this is all "information"
which affects the price. The point is, you won't be able to
consistently predict what the market will do before the market does it
unless you have access to relevant information before everyone else
gets it.

> Also, EMH assumes instantaneous or at least very rapid changes in prices and the economy.  Actual information is not only imperfect, but takes time to flow through an economy.  This is so for government interventions, whose immediate impact might be indiscernible.  Were this not so, there would no such thing as unintended consequences and no government intervention would backfire: markets would instantly and perfectly adjust.  (The same goes for inflation.  Inflation doesn't instantly impact an economy causing all prices to rise.  If it did, as I mentioned in earlier posts, there would be little or no problem with inflaton -- and NO incentive to inflate in the first place because all possible benefits would be neutralized.  And yet it moves!  Yet there is inflation and specific groups not only lobby for it, they benefit from it.  So, the theory (EMH, New Classical Economics, and the like) must be wrong, no?)

House prices move sluggishly, partly because it takes a long time to
buy or sell a house. But that doesn't mean you can exploit this
"inefficiency" to make a profit. You still don't know what the market
is going to do until it does it.

> On, and I don't think there's a clash between interventionism and EMH.  (Though perhaps certain types of interventions would clash directly with EMH, such as those aimed at fixing prices or slowing down price change.  E.g.., the recent prohibitions (in America, Britain, and much more extensively in Australia) on short selling of financial companies' stock tends to slow down price changes of those assets.  This creates a price rigidity in the downward direction.  The asset price can still fall, but not as quickly as when short selling is allowed.  This also removes one incentive for investors to weed out overpriced stocks by removing the profit from betting against the asset.  Finally, from a sociological perspective, it tends to keep established parties in place -- meaning that anyone with a current long position is more protected, therefore, has her or his position privileged over all others.  Thus, governments that prohibit short selling are
>  protecting
>  monied elites.)  My point was, rather, that some use imperfect markets as a justification for government intervention -- arguing as if government interventions worked and there were no problems with government.  (And, though it's usually unheard of, there's a vast literature on "government failure."  In fact, one could say the science of economics started out by pointing out the limits of government intervention.  Discoverers of economic laws, in a sense, were relating how this or that policy couldn't work -- that there were unintended consequences and that people couldn't just set aside economic laws on a whim.)

"Imperfect" markets still follow the EMH. The market may do something
totally stupid, but you can't be any more certain that it is stupid at
a particular time than the market itself is. If you could, then you
could exploit this to make a profit. Arguments for and against
government intervention have nothing to do with the EMH.

> Often, too, the problem is that people proposing interventions suffer under the Nirvana fallacy.  They compare a real world situation (imperfect markets or markets that don't work under idealizations like perfect competition, instataneous changes, homo economicus actors, and the like) with an idealized alternative (e.g., perfect markets, government regulations that aren't counterproductive, government actors who are  true public servants and who also know exactly what to do (no doubt, many government actors are well meaning people, but that alone doesn't make them better at solving problems)) -- when the actual choice is between one real world situation and another.  For instance, the choice is between imperfect real world markets with people who don't have total information, take time to act, often make mistakes, have to work with disequilibrium prices and so forth AND layering more regulation on these imperfect markets where the regulation is to be
>  enforced by people who are, just like the people in the market, imperfectly informed and some of which might have vested interests that don't allign with the best market performance.

The government is just another player in the market, albeit usually a
big player. The government may make things worse but there is no a
priori reason why it has to make things worse. Would the Japanese
post-war economic miracle have been even more miraculous without the
actions of the Ministry of International Trade and Industry?

> > I have been trying to make the point that you have finally
> > acknowledged as trivially obvious. I hope it's also
> > trivially obvious
> > that if everyone suddenly became depressed and stopped
> > spending money
> > while all else was the same, the economy would also go
> > into
> > depression, even though such a thing is unlikely to
> > happen.
> But how does that wild speculation explain any real world crisis?  In fact, it explains no particular crisis and is mainly used as a rationalization for central banks to inflate or for governments to spend during panics or recessions.  What typically happens is people save so that they can spend in the future -- not because they are mindless hoarders of money but because they have plans for the use of that money at some point in the future.
> Now, such savings can impact current businesses, but this need not cause a recession, especially if markets are allowed to freely adjust.  If people save, that's merely postponing consumption and entrepreneurs will try to forecast, more or less successfully, where this postponed consumption will go.  (This doesn't mean they'll always be right or that this is predictable with high precision when some of them get it right.  However, one would not expect -- and history as well as theory should be a guide here -- that this is completely unworkable.  If it is completely unworkable -- if, say, we're living in a Keynesian/Lachmannian market-world, then there's no explanation of how things ever go right much less what to do about them.  On the last point, where market entrepreneurs simply unable to work at all, there's no reason to expect regulators or economic planners to somehow get it right where market entrepreneurs always got it wrong.)
> But let's say there's some change in the overall savings rate.  Let's leave alone how this happened.  (In the real world, lots of things can influence people to change their rate of savings, though, typically, few things cause broad segments of the population to change in a like direction by a similar amount.)  Further, let's posit this change is completely unforeseen -- that not one single entrepreneur bet on it, not even the ones playing Black Swan strategies.  The immediate impact would be less money chasing after the same amount of goods and services.
> Chances are, in the real world, this would not be uniform.  People would likely cut off spending on some goods and services and not others.  This would depend on each person's particular preferences, specifically the marginal utility of each good or service experienced against the marginal preference to save.  (In the abstract, we need not treat savings here as something categorically different from all other goods and services.  For instance, looking at a person who has to choose between, say, apples and oranges, we might find that she prefers one more apple over one more orange.  We could just add that she now prefers saving a certain specific amount of money over one more orange.  Of course, "de-abstracted," it's probably more likely that she prefers saving for future goods and services -- say putting more money into her "2010 trip to New Zealand" fund over one more apple.)  This lower demand would translate into less goods and services
>  clearing the
>  market than before -- until prices adjust.
> Notably, price adjustment is not instantaneous, so one might expect some surpluses for certain goods and services.  But the faster people recognize the demand has fallen for these -- e.g., the grocer notices apples and oranges start piling up or the nail salon owner notices that only 10 people come in daily instead of 15 -- the quicker they can adjust.  And the adjustment could be a fall in prices (to clear inventories; e.g., the grocer might prefer to sell even with a little loss rather than have rotting fruit on his shelves) or reducing supply (e.g., the nail salon owner might decide to lay off some of her staff since she now has one third less customers coming in).  And expectations, of course, play a role here.  People might not, e.g., close a restaurant down because of one bad weekend.
> Anyhow, if the adjustments do take place, there's little reason to expect a lengthy process of reallignment.  However, let's postulate there is one.  It's long, hard, and there seems no end in sight.  We might inquire what would cause this in the first place, but let's leave that alone.  How would anyone improve on this situation?  The typical mainstream solution is to stimulate demand -- usually via inflation but also sometimes via fiscal and tax policy, such as by increasing public spending (and often public debt) or by lowering taxes.  However, if one is going to posit people just want to save more period, it's hard to see how any of these policies would stop that without some serious bad side effects.  For instance, high inflation might eat away at savings, but it causes business cycles and is hard to predict, so, even were it okay to beat up on people who simply want to save more (and it's not okay to beat up on them), there's no way to
>  target
>  them via inflation as inflationary effects are systemic NOT localized.
> Increasing public spending, too, is likely to have systemic side effects and is likely to lead to certain groups benefiting from public largesse regardless of whether they saved or not.  And suppose relative non-savers benefit more.  What would this do?  These people were already spending at high levels.  Giving them more -- and all public spending gives someone more than she or he would otherwise have -- might not do the trick and would be heavily depend on what the spending is on.  E.g., if you give an extra $10,000 a year, I'm likely to save it.  If you give another guy that much, he might spend it on a new car.  Still another might blow it on drugs.
> The same pretty much goes for reducing taxes, though the solution is preferred.  (All tax cuts are not, of course, equal, but the goal should be cut until taxes are at zero.:)  However, again, the solution presumes not unintended consequences.  If the goal is to neutralize the savings, then tax cuts will only do that if people spend [enough of] the tax cut.  (One should ask throughout this exercise, especially if one is ready to apply this to the real world, why on earth neutralize savings?  Who are we to say what the correct spending level is for all of society?  How would anyone even be able to determine the correct level outside of observing what people -- the ones who make up society -- prefer when they're not being forced to save or to spend?)

The chosen fiscal policy may not have the intended effect, simply
because economies are very complicated and difficult to predict.
However, it will have an effect, and the effect will not necessarily
be a negative one.

Stathis Papaioannou

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