Barry Ritholtz: Shiller: More Expectations Theory, Less Efficient Market Hypothesis
The Bear on Jun 22 2011 at 7:20 am | Filed under: Economy
Economic Theory
Bob is far too diplomatic to be blunt, so I will do it for him: Economics failed. The entire profession took a theory that had some value to it, and extrapolated it to the point of magical thinking. How badly did the economics profession, academics and market pros alike, fail? Classic economic belief systems could not appropriately anticipate in advance or even identify in real time what was happening with the Residential RE/Housing market. They failed to see the Great Recession coming or even the market collapse. The basis for this failure was the erroneous belief that “efficient markets formed by people holding rational expectations could explain virtually all economic activity.” That thesis has now been thoroughly discredited. It is still taught in colleges and business schools, which is why I find most MBAs not worth hiring. Frequently, they can be worse than clueless — they are steeped in the bad ideas of long dead economists, and in my profession, that is not a formula for making money. As history has revealed over and over again, the popular extreme version of EMH is bollocks.
Markets can and do generate lots and lots of useful information and price discovery. But their strength derives from the inputs of the crowd. That strength is also their weakness when that crowd turns into a panicky mob.
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” The basis for this failure was the erroneous belief that “efficient markets formed by people holding rational expectations could explain virtually all economic activity.” That thesis has now been thoroughly discredited.”
Actually, that statement, in and of itself, as limited as it is by it’s own limitations, is or should be mostly if not completely true, given a small margin of error for effieciency correction and the hysterisis involved. However, there are a couple of glaring errors, assumptions, really, that make it completely false from the beginning, and they really should have seen this.
Efficient markets – there’s no such thing. Markets are model of inefficiency, at times, but rarely, and usually only accidentally, models of efficiency. The larger they are, the more compromises they must make in order to enslave themselves to the overall production, the measure of efficiency. Why? If you measure a man’s progress by the yard, he buys a yardstick. If you use a ten foot rope, he buys a ten foot rope. All we have to do is change our definition of efficient, and the efficiency ratings will change.
formed by people – human factor introduced, nuff said.
holding rational expectations – a person is rational, a mob is not. Rationality is inversely proportional to crowd size. To speak of the market, a mob if ever there was one, as being rational is ludicrous, unless you give wide room for rational. Not to mention the fact that information is inefficient, not all of it known nor all of it known by all.
could explain virtually all economic activity – virtually all economic activity can’t be measured, only a percentage of it, and the part we can measure hardly mirrors the parts we can’t, so anything is a best guess scenario to begin with, and the pipe dream of explaining is bad enough, since you can never actually attribute any one happening to any one thing, it’s always a group effecting a group. Never mind the guaranteed loss when you put the word ‘all’ in there, virtual or not.
Just one or two things I’d have noticed the day they coined the phrase.