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The Fallacy of the “EMH Twist”

I really liked this piece at Pieria by Unlearning Economics.  They emphasize a point that I think is very important with regards to the Efficient Market Hypothesis and how we go about framing an understanding of the financial world and how we perceive future potential outcomes:

“Hereafter referred to as the ‘EMH-twist’, this argument was first used by John Cochrane, and it has reappeared since then: it was more recently referenced by Andrew Lilco, who was sadly echoed by the generally infallible Chris Dillow. The idea is that financial markets process new information faster than any one individual, government or institution could, and so for most people they may seem to behave unpredictably. However, economists can not be expected to understand these sudden movements better than anyone else, so expecting them to foresee market crashes is absurd. As Cochrane puts it, “it makes no sense whatsoever to try to discredit efficient market theory in finance because its followers didn’t see the crash coming”.

However, this logic is completely circular. The mere fact that a theory exists which claims crises are unpredictable does not mean that, if a crisis is not predicted – particularly by the proponents of said theory – this shows the theory is correct. If the EMH had, to the best of our knowledge, been shown to be correct, then the EMH-twist might hold some water, but we must establish this truth separately from the the fact its proponents didn’t predict the crisis (David Glasner recently made a similar point about the ubiquitous use of rational expectations in macroeconomics). While Cochrane does claim that the central tenet of the EMH “is probably the best-tested proposition in all the social sciences”, he fails to reference supporting evidence, and in fact goes on to add substantial qualifications to the empirical record of the EMH, admitting that market volatility might happen “because people are prey to bursts of irrational optimism and pessimism”.

In fairness, there is an element of truth to the EMH-twist. Financial markets are incredibly difficult to understand, and the argument that economists don’t yet understand them, along with a mea culpa, might be acceptable – there are many things natural scientists still don’t understand, such as dark matter, or what happened ‘before’ the big bang. However, the EMH-twist as used by Cochrane et al is phrased more strongly: it is the assertion that economists can’t and shouldn’t understand the movements of financial markets, simply because the EMH allows them to wash their hands of the task. We wouldn’t accept this kind of attitude from any other field, so I can’t help but feel Cochrane’s claim that “the economist’s job is not to ‘explain’ market fluctuations after the fact” can only be met with: “then what is the economists’ job, exactly?”

That’s perfect.  More succinctly, what the EMH really boils down to is an excuse not to have the government intervene in the economy because the markets do things just fine on their own.  We should really cut the academic and “empirical” nonsense and just start calling the EMH what it really is – it’s a myth based on some free market ideology and it has almost no realistic application to the way we implement policy, the way we construct portfolios or the way we do anything in the financial world.

The reason why is simple – the markets are dynamic and its participants are naturally forward looking.  Sure, we might not be able to perfectly predict what future outcomes are.  But that doesn’t mean we should sit back like fools and assume that the markets will just take care of everything on their own.  After all, the markets are merely comprised of the decisions of its imperfect participants.   The assumption that markets are always perfectly allocated for future outcomes is not just grounded in faulty logic, but empirically false.

The assumption that markets do everything better than everyone else is no different than the fallacious argument that markets are self regulating or self correcting.  I find it hard to believe that anyone could understand the underlying principles of capitalism and still honestly believe that to be true.  Markets aren’t perfect.  Corporations and individuals make highly irrational decisions at times.  They do not self regulate and they do not self correct.  I don’t think this should be controversial unless you live in some Rothbardian fairy tale.  Yet some variation of these concepts persist to this day.

The conclusion should be rather simple.  There are times, when a forward looking approach is not only smart, but very necessary.  We are forward looking animals who constantly try to gauge the potential risks in our future.  Just pick up a newspaper and read how many implicit forecasts are being made.  Whether it’s about future policy in Iraq, the weather, or this weekend’s sports scores.  We are all actively looking into the future trying to gauge what might occur.  And yes, there are times when it makes sense for policy to be proactive as well as times for us all to be proactive in how we position our financial lives.

This doesn’t mean looking into the future is easy.  This doesn’t mean it’s going to be an efficient process.  This doesn’t mean that understanding the drivers of future outcomes is simple.  But it’s a necessary process.  The idea that markets do everything better than everyone else is a myth.  It’s a myth grounded in the idea that we shouldn’t try to glance into our futures or intervene in what is supposedly a perfect free market.  This idea is destructive not only at the personal financial level, but also at the political level.  In fact, one could argue that this sort of politicized thinking has caused more harm than just about anything else in the world.  And it’s time for this idea to get crushed so soundly that its negative consequences get crushed with it.

 

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