This is Naked Capitalism fundraising week. 788 donors have already invested in our efforts to shed light on the dark and seamy corners of finance. Join us and participate via our Tip Jar or another credit card portal, WePay in the right column, or read about why we’re doing this fundraiser and other ways to donate, such as by check, as well as our current goal, on our kickoff post. And read about our current target here.
Yves here. I was going to say a few words about newly-announced recipients of the award known as the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, but Yanis Varoufakis beat me to the punch. I’ve taken the liberty of combining his two short posts on this topic. Rest assured that as Varoufakis indicates, that Eugene Fama (one of the three recipients of this year’s prize) was one of the leading proponents of the Efficient Market Hypothesis, which as we discussed in ECONNED, provided critical intellectual support for the idea that markets, particularly financial markets, did an excellent job of price determination and thus should be left to their own devices as much as possible.
By Yanis Varoufakis, professor of economics at the University of Athens. Cross posted from his blog
The moment I heard that Fama and Shiller (together with Hansen) were awarded the latest pseudo-Nobel in Economics, my initial thought was: What next? A Darwin Prize to some Arch Creationist? The Award for Top Seamanship to the Titanic’s captain?
But then I quickly changed my mind. Awarding this ‘Nobel’ to both Fama and Shiller was a brilliant hedge. One that can only be bested by awarding the Physics Nobel to Galileo and to the Inquisitor who condemned him.
Readers have requested a summary of the Efficient Market Hypothesis, which is in the news again as a result of the ‘Nobel’ Prize award to Professor Eugene Fama . In what follows the reader can peruse very brief presentations of the triad of toxic theories that undermined macroeconomic logic and helped legitimise the practices that contributed no end to the Crash of 2008. They are: the Rational Expectations Hypothesis, Eugene Fama’s Efficient Market Hypothesis and the so-called Real Business Cycle Theory…
[The desciription below is an extract from Chapter 1 of my Global Minoatur]
The type of economics which dominated the thinking of influential people (in the banking sector, the hedge funds, the Fed, the ECB, everywhere) was no more than a thinly veiled form of intellectual fraud which provided the ‘scientific’ fig leaf behind which Wall Street tried to hide the truth about its ‘financial innovations’. They came with impressive names such as the Efficient Market Hypothesis (EMH), the Rational Expectations Hypothesis (REH), Real Business Cycle Theory (RBCT). In truth, they were no more than impressively marketed theories whose mathematical complexity succeeded for too long in hiding their feebleness.
Three Toxic Theories Underpinning pre-2008 Establishment Thinking
EMH: No one can systematically make money by second-guessing the market. Why? Because financial markets contrive to ensure that current prices reveal all the privately known information that there is. Some market players overreact to new information, others under-react. Thus, even when everyone errs, the market gets it ‘right’. A pure Panglossian theory!
REH: No one should expect a theory of human action to predict well in the long run if it presupposes that humans systematically misunderstand that very theory. No doubt, this sounds radically anti-patronising. It assumes that not much light can be shed on society by theorists who believe they understand its ways better than Joe Blog. But note the sting in the tail: For REH to hold, it must be true that people’s errors (when they predict some economic variable, e.g. inflation, wheat prices, the price of some derivative or share) must always be random; i.e. un-patterned, uncorrelated, untheorisable. It only takes a moment’s reflection to see that the espousal of REH, especially when taken together with EMH, is tantamount to never expecting recessions, let alone crises. Why? Because recessions are, by definition, systematic, patterned events. However surprising when they hit, they unfold in a patterned manner, each of its phases being highly correlated with what preceded it. So, how does a believer in EMH-REH respond when her eyes and ears scream to her brain: Recession, Crash, Meltdown? The answer is: By turning to RBCT for a comforting explanation.
RBCT: Taking EMH and REH as its starting point, the theory portrays capitalism like a well-functioning Gaia. Left alone, it will remain harmonious and never go into a spasm (like that of 2008). However, it may well be ‘attacked’ by some ‘exogenous’ shock (coming from a meddling government, a wayward Fed, heinous trades unions, Arab oil producers, aliens, etc.) to which it must respond and adapt. Like a benevolent Gaia reacting to a large meteor crashing into it, capitalism reacts efficiently to exogenous shocks. It may take a while for the shockwaves to be absorbed, and there may be many victims in the process but, nonetheless, the best way of handling the crisis is by letting capitalism get on with it, without being subjected to new shocks administered by self-interested government officials and their fellow travellers (who pretend to be standing up for the common good in order to further their own agendas).
To sum up, toxic derivatives were underpinned by toxic economics which, in turn, were no more than motivated delusions in search of theoretical justification; fundamentalist tracts that acknowledged facts only when they could be accommodated to the demands of the lucrative faith. Despite their highly impressive labels and technical appearance, economic models were merely mathematised versions of the touching superstition that markets know best, both at times of tranquillity and in periods of tumult.
31 comments
Comments are closed.
Thanks Yanis. This was very lucid and easily understandable.
However, methinks you changed your mind too quickly in accepting this prize decision. Fama is the Water Carrier of Water Carriers for the 0.1%. He has set a mark at which future generations of water carriers will shoot in vain. There are for sure, special places in Hell reserved for people like Fama and the entire sorry boot licker brigade of Fresh Water economists. As a fan of Krugman I must call shame on him as well for his blog post yesterday complimenting Fama even if it was merely a slight nod. The need of the hour is independence from the Capitalist Slave Machine. Some way should be found for every man and his family to grow their own food and return to the soil, however impractical that may sound. We need to find a way. Our generation carries this responsibility to give the bird to the Capitalist Fat Cats and make them wail and weep when there is no one left to buy their useless products and depend on their measly wages. That is the only thing they will understand. Taking their money away, that has always been the ONLY answer.
Well, if I go by all the money I’ve lost trying to outguess the market I’m thinking EMH might be correct — that is unless the govermint is manipulating GLD. Some people think it is.
I don’t know. How could anybody like me know? There’s no way
That’s the problem, lack of information. When you don’t know anything, how can anything you do be efficient? it impossible.
You just live day to day hoping to get lucky. When you guess right everybody says you have talent. When you don’t, everybody says you need to get competitive. OK, that sounds like the efficient market hypothesis, I admit, but instead of everybody having all available information all they have is wild guesses.
Maybe that’ what these prizes are. Just a wild guess. It’s probably wrong, of course. It usually is for most people. Why should this be any different? I can’t think of any reasons.
Info is out there, my man. Just go to Shiller’s website, and download his Excel file, which he’s maintained ever since nailing the Internet Bubble top when Irrational Exuberance was published in January 2000 (the exact month the Dow peaked):
http://www.econ.yale.edu/~shiller/data.htm
Currently, Shiller’s data shows a CAPE (Cyclically Adjusted Price Earnings ratio) of 23.50 on the S&P 500 index. Invert it, and that’s an earnings yield (E/P) of 4.26%.
Whereas, the 10-year T-note currently yields only 2.69%. Thus, although stocks ain’t cheap, their earnings yield beats gov’t bonds because of ZIRP and all that.
By contrast, in Jan. 2000 when Shiller unleashed Irrational Exuberance on the clueless likes of Greenspan (who doubtless deserves a Pelosi medal for competence in government), the T-note yield of 6.78% simply trounced stocks’ E/P of 2.28%, indicating that investors ought to be way overweighted in bonds vs. stocks.
Tested back to 1926, this simple timing method kicks the ass of buy and hold and (by extension) Fama’s efficient market theory, which effectively mandates blindly buying and holding ‘the market’ regardless of valuation.
Robert Shiller, you rock!
that all sounds very logical, I admit.
but like most boneheads, I want a 100% gain in one year and if I can’t get it, I feel deprived!
I don’t want to wait 20 years to get rich slowly. I want it now, so I can quit my job and lay around.
Honestly, I would settle for just knowing that I’m going to be able to provide for myself in six months or a year. I don’t need 100% gain (or any gain, really), just a little basic security would be nice.
Sadly, all you boneheads who are chasing 100% gain (or even 5%) are f#@king it up for the rest of us. Thanks a lot.
Why oh why have we consented to be governed by gamblers? Anybody?
Though I’m not a Catholic, I think we may have gone wrong as a society when we enshrined one of the seven deadly sins as our raison d’être…just sayin’…
I assume this situation is held aloft by QE. So if QE is continued forever, what would be the target P/E? For example, say that the added risk (above that of QE being discontinued) made the traditional acceptable earnings return be 2% higher than Treasury yields. So the target earning would be 2.7+2= 4.7, which is a P/E of 21. So the market is overpriced if you judge solely by P/E. Or is it 1% so the target P/E is 27. But would investors really accept the added risk to make just 1%? Or maybe 10yr Treasury isn’t the right measure. Blah.
Personally, I think Fama should make screen savers for your computer. Web based, of course, so a central robot can efficiently set axioms like ZIRP and QE, then generate efficient, high frequency market data to display on everyone’s computer….oh wait…scratch that idea.
Maybe Schiller does have the right idea with smoothing corporate earnings data over the long term so we can put price discovery in perspective and also glean some important insights into how the economy is presently chugging along.
So bear with me as I wing this thought.
We know that right now..
Schiller’s CAPE (Cyclically Adjusted Price Earnings ratio) of 23.50 on the S&P 500 index. Invert it, and that’s an earnings yield (E/P) of 4.26%.
Whereas, the 10-year T-note currently yields only 2.69%.
No one has disproved supply-demand yet (there is a prize to be had, if you do), then we can assume that treasury yields are low due to lack of loan demand from both consumers and business. This is consistent with a weak economy.
Concurrently, corporate profits are at record highs and PE ratios are near the high end.
No one has eliminated the biz cycle yet (tho you can get a prize for making them worse), so from this we can conclude that…this is a great time to get into stocks…or bonds… oh, never mind.
Agreed with PaulArt, a very helpful post.
But I think you can carry the perniciousness of this alphabet soup even farther. By defining all breakdowns of market funciton as “shocks”, econmics in essence claims itself to be infallible, since its failures can’t be distinguished from—in fact, they’re defined to be—truly unforeseeable events.
Of course, from a Popperian standpoint, this removes economics from the sciences since its theories can’t—by definition—be tested.
How we got to this point is really amazing, and from research I’ve been doing on my alma mater, the University of Chicago, it reflects the intense belief of key faculty of the University, and it’s wealthy industrialist backers, in proving the rational and moral superiority of capitalism in the face of the Great Depression. During the ’30s both the economics department and law school were run by leaders with an intense hatred of the New Deal and government regulation, and sought to “prove” their case at every turn, history be damned.
From this environment, Fama’s rise based on his self-serving pseudo-scientific nonsense was inevitable.
Terrific point about Popper and disconfirmation. Hadn’t thought of it that way, but once you say it, it’s exactly right.
I recommend Joan Robinson’s Economic Philosophy for an excellent discussion on why economics really is metaphysical and not scientific. That’s not necessarily a bad thing: for once we admit we can’t think of economic activity in scientific terms, we can then jettison the burden of listening to people who claim to be economic “engineers” building collapsing bridges to nowhere; this will allow us to think of how to satisfy human needs instead of the appetites of false gods.
econmics in essence claims itself to be infallible, since its failures can’t be distinguished from—in fact, they’re defined to be—truly unforeseeable events.
No. Failures are merely claimed to be unforeseeable. The claim itself is a calculated lie and part of the scam. Failures are in fact quite foreseeable, and many people do see them, precisely because economics is a science. A lot of people saw the 2008 crash coming. And it should be obvious that the present condition of the global economy will inevitably lead to another massive failure.
Of course, from a Popperian standpoint, this removes economics from the sciences since its theories can’t—by definition—be tested.
Ah, but they can. It is easy to predict, for example, that a stock that is positively misrepresented will go up, that suckers will lose money when the scam is exposed, and the cheaters will make money if they’re not prosecuted. It’s well-established that a ponzi scheme will predictably collapse when the scam are exposed or the scheme becomes financially unsustainable. The main difficulty is in predicting the timing, but predicting that it will fail isn’t a problem at all.
The principles of economics are twisted to make money, and that is only possible because those principles have predictive value.
In the absence of corruption these theories could be expected to be quite valid. EMH, REH, and RBCT all fail in practice for the very simple reason that one essential assumption happens to be invalid, that the participants will act honestly. In practice people will lie, cheat, steal, maim, kill, and plunder unless prevented from doing so, and markets behave accordingly and predictably. Markets do work, more or less, when they are regulated in such a way as to compel participants to operate honestly, more or less, and fail when dishonesty exceeds the systems’ tolerance for corruption. It is preposterous to assume that markets can be self-regulating. That also is part of the scam.
I suggested years ago that the timing of market failures is not predictable because the type and degree of market corruption is not known. The exact nature of corrupt practices is information which is not normally available and is not priced by markets. Naturally predictions based on information which is incomplete in this way are likely to be wrong.
On the other hand, the perpetrators of economic corruption are in possession of this information, which is why they’re able to make money at it. The penalties for corruption are so light that they constitute merely a cost of doing business.
It is easy to suspect that a majority, if not most, if not actually all, of the global economy is supported by corruption at some point in the chain of financial transactions, if only because there are so many transactions in a chain and because people have so much motivation to cheat.
One could conceivably construct an entire theory of economics based on the inevitable and widespread practice of cheating. It’s also conceivable that one or more financial institutions have already developed such constructions and use them to form the basis of their business models. There is a great deal of evidence to support this theory, much of which appears to be described in detail on NC.
Even without the science, plenty of people knew the 2008 Crash was coming, inevitably, because they utilized simple, rational common sense.
It doesn’t take a Ph.D to figure out that that a family bringing in $50k a year cannot possibly afford a $300k house. Not in the long-term. And not if they turn around and use its equity as a cash cow.
I watched this go on around me, back then. I can put 2 and 2 together. So can others. That danged cognitive dissonance-thingy can really be a b#tch, for the rest.
It turns out that common sense is not all that common. On the other hand, it appears to be common enough to be useful for con-artists.
The media was a wash with how-to books that go into detail on how to buy and sell real estate. They always come with calculator of formulas to help you figure out how much house you can afford. And what is more, the banks used the same formulas.
Most people buying homes don’t normally buy a lot of homes and are dependent on the advice of their handlers which they assume are operating in good faith. And they probably are as they are using calculators and other tools standardized throughout the industry.
And let’s not forget people were making a ton of money this way for a while. Even when people did get into trouble, you could always well the house – at a substantial profit.
It may not take a PhD to figure this out, but what do you do when the con-men are the ones with PhD’s, work in a fancy office, and make their living by profiting off the market or real-estate.
The information was out there. Heck I was warning of the housing bubble as far back as 2004. And I was only repeating what I was reading on the blogs. The problem was that this information was not circulating – where it needed to be, where the average person could actually see it.
Problematic… which Common Scene are *utilizing to its maximum potential* SEE:
en.wikipedia.org/wiki/Common_sense
skippy… No wonder Babylon went all the ways of the compass thingy… to many bloody philosophers… every body got the point in Life of Brian at the same time~
Great post!!! Those “scientists” remind me of medieval monks who took the bible to calculate how many angles might fit on the pin of a needle. Same thought process and surely great mathematics for the times. Seemingly mankind hasn´t learned much since the middle ages.
I do not think medieval monks did speculate about the angels on the head of a pin. I believe that may have been an eighteenth or (?) nineteenth century slur
From Benjamin Disraeli’s father, no less.
Congratulations to Prof. Varoufakis on an excellent post. As a practicing scientist (professor/researcher) let me just reinforce both him and Tom: Economics is not a science, and the Bank of Sweden Prize is not a Nobel Prize. (Thanks to Prof. Varoufakis for putting inverted commas around `Nobel’)
I am receptive to the idea of a “Gaia” of the marketplace in the sense that it is a complex emergent system with a lot of feedback loops. The trouble comes when we think of Gaia (in the market sense at least) as being benevolent. :-)
When Philip Mirowski’s new book Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown was promoted on this site I bought it and read it. He does an excellent job of thoroughly exposing the many roles played by the orthodox economics profession in creating and then justifying the financial debacle. It is not just a matter of corruption and deception, though there is no shortage of that. Neoclassical economics is arguing about how many angles can dance on the head of a pin while the real spins more and more out of control.
“No one can systematically make money by second-guessing the market. Why? Because financial markets contrive to ensure that current prices reveal all the privately known information that there is.”
Well the financial markets contrived to hid the fact that their flimsy gambles ( private bank lending backed only by 3% equity ) were in reality under-written by the ability of sovereign governments to create the debt-free money to bail-out the financial markets!
So much for EMH predicting that value in financial markets can be ascertained by market discovery processes!
http://www.bubblews.com/news/259600-book-review-039the-bankers039-new-clothes039
https://gsbapps.stanford.edu/researchpapers/library/RP2065R1&86.pdf
If the claims made by EMH, REH, and RBCT were true, large financial institutions would not exist. Therefore the claims cannot be true.
Certain financial institutions can and do “systematically make money by second-guessing the market” for the simple reason that they have manipulated and corrupted the market.
“Because financial markets contrive to ensure that current prices do not reveal all the privately known information that there is, in particular information about their corrupt practices.”
FIFY
Let us recall that the Economics “nobel” has only been around since, iirc, 1968.
http://ineteconomics.org/video/30-ways-be-economist/philip-mirowski-why-there-nobel-memorial-prize-economics
Where’s the prize for studies leading to the understanding of the root of all evil?
Heaven
I would say hell.
The Bank of Sweden backs the Nobel Prize in economics. It legitimizes economics as a science and has a hand in nominating the stars of the profession. A soft sort of corruption.
But the corruption of the economics profession is more straightforward. In “Inside Job,” the documentary about the crash, Charles Ferguson interviews, among others, Frederic Mishkin and Martin Feldstein. These guys sell their expertise. They are too busy counting their winnings to be concerned about the falsifiability of economic theory.
In his book “Predator Nation” Ferguson goes into a lot more detail about the buying of the economics profession. I thought it was only the ex-Presidents, like Clinton, who got truly huge amounts of money for a speech. No, it is the whole of the economics profession that is getting the dough.
These guys are crooks. They aid and abet stealing with ideas and theories.
Great post.
I am very sad having read Krugman. He looks to me as a frivolous person who sides economists just because they are “his own”, “one of us”, etc…
Economy cannot progress if ridicul and anti-empiric theories are not ruled out and their authors not only are not expelled from the mainstream with tar and feathers, but are given prizes.
It is a sad day for the economy as science
Fama finds markets are efficient, thus supporting index funds for the masses.
Shiller finds markets are predictable, thus supporting hedge fund managers’ jobs, making them superrich.
The financial elite always want it both ways, and they get it in the 2013 Nobel Prize in Economics.
This is Cognitive Dissonance, writ large. The truly insane are in charge!