Efficient Market Hypothesis & the rise of Behavioral Economics

I put some thoughts on this topic few months back EFFICIENT MARKET HYPOTHESIS .

One of the major philosophical takeaways from the past 15 years has been the failures of the Efficient Market Hypothesis and the rise of Behavioral Economics. Consider, as a corollary, the argument assumption that many pro Free Market folks make: Markets are much more effective, efficient and productive than government mandates or regulations.

I do not disagree with that view. However, every now and again, we see examples that challenge, and (even disprove) this thesis. At the very least, we find circumstances that provide context for why market solutions can and do fail with stunning regularity.

Specifically, the Deregulatory era of Banks and Wall Street — we know how that ended (disastrously); BVut also consider the more strongly regulated Asian and European Internet services — they are 10X faster than that in the US; Cell service on those continents are much, much better than in the US. Both of these are offered for the same or lesser prices than here. Speaking of price: Health Care in the US costs twice the price as anywhere else in the world. Then there are the Financial “innovators” who abdicated lending standards — “hey, we’re just selling junk to securitizers who want it!” — they helped to inflate a bubble that popped, crushing housing; Bankers plowed into subprime securitization because it appeared profitable and “everyone else was doing it.” Bond buyers desperate for yield bought up all of this junk.

The Even rationing work suspect,is for the same reason that EMH has failed: Human Behavior. There is a very human tendency for excess emotions to take control — and at the worst possible times — especially when disruptive events occurs. We see panic set in.

Consider the Bank Runs we saw as the collapse began in 2007. There was no need to wait on a line for 3 hours for your money — your checking account is FDIC insured. Go to another bank, write a check, no worries. Even as WaMu and others were on the verge of failing, your ATM card never stopped working.
There is a contra argument that Markets were not allowed to work — that prices were not allowed to rise in response to supply shortages.

This is a fair argument, but it ignores a key concept that many free market absolutists seemingly miss. The contra argument is that we have decided, as a Democracy, that we do not want to see people priced out of the most basic necessities of life due to emergencies. Certainly, we can allow free markets to raise the price of food and fuel to rise in response to severe shortages; perhaps prices rise so much that only the well off can afford them. But the results of this would very likely be civil unrest, riots and even violence. This is not a very desirable outcome in an ostensibly civilized society.

Before the FDIC, people did not trust banks much. There were regular bank runs, and occasional panics. This created a system that was not stable, discouraged savings, and led to spasms of social unrest. It was a never ending issue for the economic system to deal with. We had regular panics, dislocations and crashes. It was not a conducive system in which to conduct business or grow an economy.

Rules and regulations exist because when left to their own devices, people will occasionally make spectacularly bad decisions. The impact of some of these decisions are so negative and far reaching that we as a society seek to prevent them.

Consider the Royal Bank of Scotland (RBS), at one time the biggest bank in the world. In 2008, it had assets of $3.5 trillion dollars. The Economist reported that RBS “was sunk by a loss of £8 billion, or 0.3% of its assets. RBS and its regulators had let the simplest measure of balance-sheet strength, how much equity it had compared with its total assets, fall below 1%. Other lenders were in similar positions.”

0.3% !! How can a bank fail with such a tiny loss relative to their total assets? The answer is leverage. When you are jacked up 40X or 50X, it only takes a tiny miscalculation to make you insolvent.

Why don’t banks hold more capital? Because it reduces profit. Publicly traded companies have utterly misaligned incentives — its in the interest of management (but not shareholders) to use maximum leverage to generate the highest profits and therefor the most salary and bonuses for themselves. If the company fails, its the shareholders loss. (As we saw with the collapse of Lehman and Bear, insiders may have lost some paper wealth but they had already cashed out billions for themselves).

Hence, in many circumstances, markets may not work ideally. You could even say that their outcomes are sub-optimum.

For the vast majority of economic transactions, markets are vastly superior ways to allocate resources. They are far more productive and efficient than government mandates, regulations and edicts.


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