by Mario Rizzo
The New York Times had a very interesting article recently on the demise of the efficient markets hypothesis. The proximate cause of this demise is the failure of the hypothesis to explain the recent financial meltdown. It has been standard for Austrians to say – not just recently but over many years – that the hypothesis could not be strictly correct. At the very least, Austrians would supplement it with a theory of arbitrageurs who take advantage of asset-pricing inefficiencies and move markets toward greater efficiency.
Furthermore, there are issues about just what an efficient asset market is. What does it mean for all “available” information to be taken into account in asset prices? Available to whom? Information interpreted by whom? The matter of interpretation gives rise to the question of whether there is only one correct model of efficient information use. Today’s information must be used to predict future returns. They may be more than one scenario consistent with the efficient use of today’s information.
How close markets would get to the efficiency ideal, assuming away problems of meaning and definition, would depend mostly on the nature of the error correction system. Theoretically, the asset markets could be quite close to an efficient equilibrium but never quite there. Or they could be far from efficiency, although closer than they would be without the error-correction process. In this latter case, the world would be far from the “Chicago” ideal but possibly the best we can ever get.
Yet even this modification may not go far enough. Entrepreneurs make mistakes, even systematic ones. I recall Jerry O’Driscoll’s and my Austrian-style discussion in The Economics of Time and Ignorance of the Keynesian Beauty Contest and the possibility that markets could be subject to speculative bubbles. When “direct” access to fundamentals is difficult, perhaps because of novel assets, agents might mainly look to others to determine the future course of their prices. This could go on for some time under the right cooperating conditions.
What were the cooperating conditions in this recent meltdown? Here I agree with the economist John Taylor and Angela Merkel, the German Chancellor, that the conditions for the speculative bubble were laid by the low interest-rate policy of the Federal Reserve System. Without this groundwork any bubble would not have gotten very far. As Tyler Cowen shows so well in his book Risk and Business Cycles low interest rates encourage greater risk-taking.
In addition, there is reason to believe that the error correction mechanism was compromised from the start. Most financial players realized that there was, as they thought, some extremely small probability that the highly leveraged complex of securities could blow up. But why worry about that? Under those circumstances bailouts would be highly likely, perhaps certain. That certainly was a good bet given recent events. And from this point on, it will be an even better bet.
Thus with accommodating monetary policy and a compromised error-correction mechanism, the conditions for a crisis were in place.
The next step, of course, will be regulatory innovation. Will this improve the efficiency of markets? I am not adverse to “regulations” that ensure transparency in buying and selling activities — to the extent that they approximate the workings of rules against fraud.
Nevertheless, it is likely that we shall to deal with more than that. (We still don’t know what Team Obama has in mind.) In the first place, any regulations specifically designed to prevent a recurrence of recent events are superfluous. I do not think that financial markets are going to repeat past mistakes anytime soon.
So the question then is what kind of “reforms” will improve the workings of these markets? Anything that gives regulatory bodies significant discretion will run afoul of big-player problems. Markets will spend time and resources trying to predict the behavior of regulators rather than financial fundamentals. And, of course, the regulators will try to predict the likely behavior of market participants who are anticipating their behavior.
I believe that the creativity of the market is greater than that of regulators so the regulators will be, as they were recently, several steps behind. Then there is also the danger that regulators will take blunt regulatory actions that prevent the emergence of new financial products. That would be the safe place to be. But such a policy will cause the “unseen” loss of wealth as a remedy for seen losses of wealth that crises bring. This is not smart.
The problem has not been the existence of credit default swaps, mortgage-backed securities and other forms of securitized lending per se. It has been in the crisis-enabling context.
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The efficient market hypothesis is simply the law of large number writ large. The coin has no memory, but if you flip it enough you’ll get a stable mean. The same is true with the efficient market hypothesis : some market participants might be overly stupid (or optimistic), some might be overly smart (or pessimistic) but at the end of the day the price settles around the equilibrium price. There may well be some outliers, but the net effect is no excess return or loss with regard to the mean – equilibrium – price. The error correction mechanism here is simply the Gaussian distribution, the wisdom of the crowds as it were. There’s no room here for a distinction between separate positive feedbacks and negative feed backs that spring from exogenous sources, such as regulatory or monetary policy. Hence the strenght as well as the weakness of the efficient markets hypothesis.
All markets are involved in regulatory arbitrage, on the other hand : this simply follows from the function of price. I think I’ve read Milton Friedman somewhere as saying that all innovations in financial markets proceeded in order to overcome certain governmental constraints. The problem, however, is that this process is not a one way street : given certain institutional conditions at one point or another, you can either use the market to hedge against a certain government policy or you can use the government to hedge against a market process. The billion – or, as is now more appropriate, the trillion – dollar question is what exactly should be the ideal institutional framework that will enhance the positive aspect of risk taking and reduce the negative aspect of risk taking? This involves determining an optimum of al kinds of details, everything from what should the capital requirements of financial institutions be to what should the the interest be. But, since it’s precisely because of the lack of such an Archimedian optimal point we have markets, the solution to this problem seems to be simply even more markets and less government.
I have heard from multiple pundits, bloggers, and posters that the Fed created the housing Bubble with how short-term rates.
I’m going to come down and say that this cannot be correct. Firstly, residential real estate is purchased with LONG-TERM debt, not short term. The Fed (at least until recently) operates solely at the short end of the yield curve.
So, strictly speaking the Fed didn’t fund the bubble through low long rates.
Now, one can argue that low short rates made it more likely that exotic financial instruments could or would be created. That may be so, but to blame the Fed is to imply that the Fed artificially pushed rates down on the short end. Meaning that rates SHOULD HAVE BEEN HIGHER. How does one determine that? Was the Dollar terribly weak? No? Did we have run-away inflation? No?
What the Fed did was not pay attention to the lack of transparency that was being built up around the mortgage and mortgage derivative markets. This lack of transparency combined with the PERCEPTION of low risk created by real and implied governmental guarantees as well as a long term Bull market in real estate, seem more likely to be the culprits.
Whenever lots of people with lots of money buy billions and billions worth of instruments that they do not fully understand, thinking that they are “safe”, well, it’s not a matter of “if” there will be a financial debacle but “WHEN”.
Mark,
There are at least two mechanisms by which the Fed’s suppression of short term rates distorted the mortgage debt market: 1. Adjustable Rate Mortgages depend directly on short rates, and 2. securitization is financed by the securitizing entity’s sale of commercial paper, which is done at a spread to short term LIBOR.
The latter is an inevitable kind of yield curve arbitrage that will proceed to the extent a major disparity is sustained between short and long rates. The short vs. long nature of this play is why it is referred to as the shadow *banking* system. And note that this kind of securitization was a universally acknowledged conduit for the housing boom.
The consequences of the Fed’s distortions in the short end of the yield curve are simply not containable. They will leak through the entire structure of production.
Also, the question isn’t so much why people were buying these mortgages. People tend to buy things when they’re cheap. The question is why they were being sold (and securitized and resold) so cheap.
Culprit: the Fed.
Bogdan, the equating of efficient markets with a simple Gaussian distribution just won’t do. People’s heights have a Gaussian distribution around their mean, but in no sense could we say that mean is the ‘correct’ height. To the contrary, the efficient markets hypothesis says the market price is the correct one, i.e., it takes in all relevant information. To account for this ‘correctness’ of the price, we need something more than the law of large numbers.
Another great post, Mario. I think we may be approaching the point at which it is generally agreed bubbles exist. I think we are even near agreement that non-rational bubbles exist. That leaves open the question of what tends to aggravate bubbles and what tamps the problem down. Mario is saying that the key is the institutional regime. He is doing comparative institutional macroeconomics. The Big Players argument focuses on the discretionary actions of powerful agents such as central banks. Mario points to the importance of too-big-to-fail in creating one-way bets, which is a huge issue. He also alludes to Kane’s “regulatory dialectics,” which is another important issue. I might also point to computability problems for market agents and regulators alike.
I think we are seeing an interesting research area open up here, which seems to the opinion of Brock, Durlauf, Nason, & Rodina as well. See their important article “Simple versus optimal rules as guides to policy,” JME, 2007, 54: 1372-1396. (It bears some similarity to Frydman and Goldberg’s Theory Consistent Expectations Hypothesis, TCEH, I think.) They explicitly say we’ve been underestimating the importance of Milton Friedman’s 1948 AER article, “A monetary and fiscal framework for economic stability.” They close by saying “we see this paper as only a first step in a long research program.” I think Austrians have a lot to bring to such a research program, a thought well illustrated by Mario’s post.
I wager that most people, since the beginning of the finance industry, do not fully understand the instruments they are working with. In fact, most people do not fully understand any of the instruments they uses day to day, financial or otherwise. For most of history, there has been nobody alive who fully understands any instrument which people commonly put to use.
Markets don’t depend upon anybody having a subjective understanding of anything they do, no more than the evolution of flight required that birds fully understand aero-dynamics.
Note: My comment above was direct at Mark Young.
Mark Young,
First, some subprime “teaser” rates were based on short-term interest rates. Second, and more importantly, Fed open market operations influence interest rates across the entire term structure. There is no question that Comrade Greenspan’s central monetary planning drove interest rates across the board lower than they would have been under a free banking system, under which rates are determined in the (unhampered) market for loanable funds.
Gene Callahan’s point about the insufficiency of the law of large numbers in understanding the distribution of prices is on target. As Nassim Taleb et al. have shown, prices are not normally distributed. They exhibit fat tails, which are not characteristic of Gaussian bell-shaped curves. For example, stock crashes (and melt ups) happen more in the real world than a seer basing his predictions on a normally distributed set of prices would predict.
Isn’t it silliness to keep calling this a “hypothesis”?
Anyone economist who insists on talking like this should quite economics and hire on as a high school science teacher.
Gee. Hayek was “admitting” these existed in 1929 …
“I think we may be approaching the point at which it is generally agreed bubbles exist. I think we are even near agreement that non-rational bubbles exist.”
Note well that the simple Cantillon/Hume/Hayek point about the time it takes relative prices changes to communicate information across space and time makes the whole idea of a perfectly efficient “market” an absurd idea.
If you add in the point that production processes take time, and the discovery of the impossibility of the completion of some plans takes time, then the whole picture of the “Chicago” economists blows up.
One more instance were the absence of production in the “Chicago” mental universe leads to bankrupt economics.
Time lags in the exposure of “information” and “bad risks” allows for profit taking in the interim — e.g. Madoff and AIG and WaMU and all of the now bankrupt mortgage originators based out of Orange County California.
David Friedman penned one of the best critiques of the efficient market hypothesis I’ve seen, comparing security markets to grocery-store checkout lines. If a shopper assumes that grocery-store checkout lines are always efficient, he will just queue up in the nearest line. If all shoppers do that, the lines will become very inefficient — we see a random distribution in their length. It is only because they aren’t perfectly efficient, and it pays to look and choose what seems to be the shortest line, that the lines approach efficiency as much as they do. And just so with security markets — it is on;y the fact that people can profit by seeking out more information about securities that makes those markets approximate an ‘efficient market’.
We should not be too quick to give the back of the hand to ideas we disagree with, as Stuart Mill might wish us to recall. I think we need to distinguish EMH as a description of asset prices in financial markets from other notions involving production. It’s not silly to say that forecasting errors will be white noise in modern financial markets. It took smart guys like Frydman, Durlauf, and Brock trump that sort of reasoning. David Friedman’s point as Gene represents it has been in the standard literature since at least the widely-cited 1980 AER article by Grossman & Stiglitz, “On the impossibility of informationally efficient markets.”
EMH has had a significant following for some time. It is interesting to see that opinion might be shifting to the point at which the general consensus holds that non-rational bubbles are normal. (Or am I just being optimistic?) I wonder if we are also seeing a shift in how we do macroeconomics, which has been rather retrograde lately compared to micro IMHO. I hope some full-on macro theorists will share their opinion on the current state of macro and whether the sort of thing Brock and Durlauf are doing is idiosyncratic or (as I believe) frontline and progressive stuff showing us what the future will be like for a while.
I don’t know David Friedman’s exmaple but the resumé above doesn’t seem correct : a random process entails that some shopers choose the nearest lines (reasoning that it’s more efficient) while other choose the more distant lines (reasoning that this choice is more efficient), to which an array of choices in between can be added. The market efficiency is the outcome, the (normal) probability distribution that results from this overall random process. The market efficiency concept is a statistical probabilistic concept which doesn’t indicate trends, as in technical or fundamental analysis, but simply denotes index-volatility. To undermine the concept, one must state either that the market is not a random walk, or that the probability distribution is not of the normal, Gaussian type. This is Taleb’s argument.
But Bogdan, ‘choosing’ implies non-randomity!
Eric Dennis Said:
“There are at least two mechanisms by which the Fed’s suppression of short term rates distorted the mortgage debt market: 1. Adjustable Rate Mortgages depend directly on short rates, and 2. securitization is financed by the securitizing entity’s sale of commercial paper, which is done at a spread to short term LIBOR.”
Well, lets look at this. ARMS teaser rates are just that, teaser rates. They can be set ANYWHERE. To my knowledge there are no rules on those. Can’t blame that on the Fed. The reset rates are generally based upon FF’s or LIBOR, but I guarantee you most borrowers have no clue about either. If the Fed “forced down” LIBOR, or FF’s, it wouldn’t matter to borrowers. All they cared about are the teaser rates. Trust me on that. To the degree that they were informed at all, they didn’t understand.
“And note that this kind of securitization was a universally acknowledged conduit for the housing boom.”
Absolutely. I posit that it was not PARTICULARLY due to the Fed, however. So far, I’ve yet to see any evidence that the Fed cut rates too far and as far as I can tell, the main culprit was robust capital markets reaching for yield that the PERCEIVED as safe when it wasn’t.
“The consequences of the Fed’s distortions in the short end of the yield curve are simply not containable. They will leak through the entire structure of production.”
Neither you, nor others have shown that the Fed distorted the short end below what it would or “should” have been. If they were too low, why didn’t we see inflation sooner? Why wasn’t it sustainable?
Furthermore, let’s look even closer, let’s say that the Fed didn’t cut and pump after things started falling apart. The mechanism for the bubble would remain untouched, the only difference is that we would have gone into a deflationary recession in 2001. The Bubble would have just developed at some other time.
“Also, the question isn’t so much why people were buying these mortgages. People tend to buy things when they’re cheap. The question is why they were being sold (and securitized and resold) so cheap.”
No. People buy things when they are PERCEIVED as cheap. In point of fact, stocks were cheap as the dickens in March. Did you Buy them or did you perceive them as not cheap enough given the risks? Regardless of your answer, you’ll agree that the vast majority did not perceive stocks as cheap in March, even though they were evidently 40% underpriced.
So, if one PERCEIVES risk to be near zero (implied government guarantee), then one is much more likely to tolerate esoteric derivatives designed to “enhance the yield” of this “near risk free” asset.
Thus, garbage loans were easily packaged and sold to folks who didn’t really understand the nature of the risks that they were taking and who were otherwise fooled by the “guarantees” and swaps and “insurance”. BTW, similar stuff happened with Residual REITs in the early 90’s on a much smaller scale.
In any case, the Fed didn’t help the situation by lowering rates, but lowered rates aren’t the primary driver. The primary drivers were implied guarantees and misperceptions of risk in tandem with an utter lack of transparency. Add in a little bit of greed among everyone from real estate “investors” to Investment Bankers to Lenders to loan brokers.
Now, should the Fed have seen the extent of the problem? Frankly, I think so. AG might not have, but his staff should have seen the horrifying self-referential risks that were in place and should have put the word out that the spigot was going to be turned off if some controls weren’t put in place. But I don’t think that this is really the Fed’s primary mission statement. I think that the SEC, the Congress and Treasury had MORE responsibility in this mess.
Mark Young
Mark Young wrote:
“The reset rates are generally based upon FF’s or LIBOR, but I guarantee you most borrowers have no clue about either. If the Fed “forced down” LIBOR, or FF’s, it wouldn’t matter to borrowers. All they cared about are the teaser rates. Trust me on that.”
So I guess it was just a smoky coincidence that ARM loan volumes exploded just when the Fed started depressing the rates that were *in fact* the major factor in the affordability of these loans.
“Absolutely. I posit that it [securitization]was not PARTICULARLY due to the Fed, however. So far, I’ve yet to see any evidence that the Fed cut rates too far and as far as I can tell, the main culprit was robust capital markets reaching for yield that the PERCEIVED as safe when it wasn’t.”
To repeat, the SPVs, SIVS, conduits, etc. that securitized these loans were financed by selling commercial paper, which was priced at a spread over short term rates, which the Fed controls. The suppression of these rates is precisely what made such securitizations economically viable.
And the evidence of the Fed’s inflation is precisely in the blow-up of asset prices in those sectors central to the boom. This is a critical part of Mises’ theory: prices don’t all just rise and fall uniformly over the economy. Fed-induced inflation, which can be tracked approximatley by say MZM, spills into certain sectors preferentially. Bubbles nucleate, and grow through positive feedback.
That we cannot, with any kind of precision, specify what the right rates should have been is the whole point of the Austrian theory. When you remove determination of a price (here interest rates) from the market and transfer it to a little clique of bureaucrats, there is no doubt they will pick the wrong one. When every political incentive exists for them to set rates too low, you can bet in which direction they will be wrong, and when the plain evidence of their errors (MZM, tech bubble, housing bubble) is brought up, you can bet they will deny it.
Another great post by Mario.
The mortgage market has not run on long-term money for a long time. With securitization, funding was often very short-term, even overnight. One investment bank turned over 25% of its funding every night. That is why Lehman and others were so exposed when the Fed began tightening.
John Taylor has provided evidence that the Fed’s policy post- 2001 was easier than predicted by its past behavior (the Taylor Rule). Leijonhufvud has explained, in very Austrian fashion, why current measured inflation provides no information about how easy or tight monetary policy is.
Mario is right to raise the issue of expected bailouts. That expectation was embodied in the “Greenspan Put,” a term coined after the the 1998 LTCM rescue. The markets had nearly a decade to incorporate that expectation into their pricing.
Mark Young wrote:
“Now, one can argue that low short rates made it more likely that exotic financial instruments could or would be created. That may be so, but to blame the Fed is to imply that the Fed artificially pushed rates down on the short end. Meaning that rates SHOULD HAVE BEEN HIGHER. How does one determine that? Was the Dollar terribly weak? No? Did we have run-away inflation? No?”
It is fairly clear to me that the Fed artificially pushed rates down (the Fed said as much at the time). If the Fed was not pushing rates down, then banks would have been lending to each other at the lower rates before the Fed announcement of lower rates.
“I’m going to come down and say that this cannot be correct. Firstly, residential real estate is purchased with LONG-TERM debt, not short term. The Fed (at least until recently) operates solely at the short end of the yield curve.”
“So, strictly speaking the Fed didn’t fund the bubble through low long rates. ”
I believe this analysis disregards the enormous amount of financial instruments with uneven time structures. That’s the basis of fractional reserve banking as it is today. A banks deposits can be withdrawn instantly, or near instantly when they issue short term CDs, but a bank makes 30 year loans. That’s why central banks exist, to be the lender of last resort in case deposits are withdrawn. But inevitably “last resort” becomes “all the time” in order to keep interest rates low.
Mark, I agree that there were *transparency* problems and *idiocy* problems with many of the complex financial instruments, but you seem to be making the common mistake of not asking where the idiots got the money to put into these instruments. When all sorts of players are leveraged 30 or 40 to 1, they have to get the money for that leverage from somewhere. Under normal circumstances, borrowing that much money would have caused a rise in interest rates (probably to the point that those investments would be unprofitable). THAT is how artificially low interest rates cause increased speculation and bubble blowing.
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