Understanding Efficient Markets

June 2, 2010

By Chidem Kurdas

Headline topics like derivatives are part of the larger issue of how markets function.  About this big question there’s been profound confusion in the past two years.  Peter Boettke’s article in the Winter 2010 issue of the Independent Review clarifies the muddle.

A particular mathematical interpretation of what an efficient market is has hogged the limelight.  In order to achieve a high degree of mathematically useful abstraction, this neoclassical model ignores market adjustment processes; changes are instantaneous or nearly so. Under a set of assumptions chosen for mathematical convenience rather than any real-life correspondence, the model shows that prices fully reflect available information and there are no unexploited opportunities for mutual gain.

This neoclassical model of efficiency was not how Adam Smith, other classical economists and 20th century thinkers in the classical tradition – like Friedrich  Hayek – analyzed markets. On the contrary, they focused on adjustments and changes. Moreover, even before the 2008-2009 crash, many people in the financial industry would tell you that they did not think prices fully reflect information. Ironically, then, neither free market advocates like Hayek nor market players like hedge funds had use for the mathematically-driven academic construct.

If anything, it was central planning advocates who proposed to use an early version of  neoclassical theory for comprehensive government ordering of the economy. In the early 20th century central planning debate, Hayek confronted neoclassical planning proponents, in particular Oscar Lange.  Hayek argued out that planners can not get the right prices by solving a simultaneous equation system, because the information necessary for such a solution is dispersed across the population and not available to any centralized entity.

Markets, where each participant indicates his or her preferences, are spontaneous orders that collect dispersed information. Market prices emerge from the  aggregation of participants’ knowledge. Markets are efficient in the Hayekian or classical sense because they are better than the real life alternative, namely government action, in making use of information. Many decades later, the collapse of centrally planned systems corroborated Hayek in the most spectacular way.

What’s happening now?  American economic policymaking is dominated by the widely taught and cited neo-Keynesian synthesis, which argues for government intervention on the ground that markets are not efficient—by the criteria of neoclassical theory. Professor Boettke of George Mason University points out that policy debates do not compare markets to real government.

Instead, an abstract market model and an artificial government are the main references. Just as the neoclassical model ignores market adjustment processes, advocates of government activism discount the reality of interest group influences or ballooning deficits and debt. In other words, markets that are failing according to a fairyland theory are compared to a fairyland government that never grows gigantic subsidized appendages like Fannie Mae.

In real markets people make mistakes and take time to adjust to changes, but their efforts create prosperity as long as government  policies are not excessively obstructive and distorting. Mr. Boettke writes that markets are alive and kicking to survive, trying to correct previous resource mis-allocations caused by Federal Reserve policy and government subsidies for housing. Market adjustments remain obstructed by policies and political maneuvers—which for instance delay the resolution of non-viable mortgages by encouraging people to wait longer.

In this predicament, classical insights are very much germane, as Mario Rizzo and Jerry O’Driscoll have argued here on ThinkMarkets.

Neoclassical models and efficiency criteria have certainly been misleading, as many recognize. The theory has no useful explanation for the boom-and-bust cycles we’ve lived through. Paul Krugman, for instance, says,  “the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”

The problem is that the mathematical confection is confused with real markets. The theory is kaput; markets would work if perverse interventions could be kept down. Maybe one day people will look back and see much of today’s policies in the same light as we regard medieval medicine—at best useless, at worst deadly. Whatever problems markets have on their own, their ability to survive endless wrong-headed interference shows the power of spontaneous orders where free action by millions of people brings about – not fairyland – but the best that can be achieved.

Peter has great quotes. Here is one from Adam Smith: “The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security, is so powerful a principle, that it is … not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often incumbers its operations…”

To the folly of bad laws must be added the folly of bad theory. Our only recourse is to be clear about both.

10 Responses to “Understanding Efficient Markets”

  1. Troy Camplin Says:

    As usual Krugman is wrong. This time, it’s about beauty. A mathematical model is beautiful like a perfect circle is beautiful. But that’s not true beauty.

    In “On Beauty” Elaine Scarry argues that beauty brings us to justice because of beauty’s attention to symmetry, leading us to an understanding of “a symmetry of everyone’s relation to one another” (97, quoting John Rawls from “A Theory of Justice”). While symmetry is certainly part of beauty, it is in fact only one half of beauty, the other half being asymmetry. A perfectly symmetrical tree would be a ball on a column – hardly beautiful (equating symmetry with beauty also denies the fact that Japanese works, which focus on asymmetry, are also beautiful). Rather, a beautiful tree is one that has symmetry, yes, but also is ragged around the edges, uneven in its evenness, even in its unevenness. If this is the case, justice may in fact be distributive, as Scarry argues, but it cannot be purely symmetrical, as Scarry implies. Rather, it would exhibit qualities of symmetry and asymmetry simultaneously – as network theory in fact says happens in complex network systems. It seems likely that spontaneous orders are the only systems capable of exhibiting such qualities – and of doing so without prejudice. This claim would be strengthened if it turned out that spontaneous orders were, themselves, beautiful.

    One aspect of spontaneous orders is that they allow for equal access to all (which is far different from equal outcome, as outcomes depend on many different things). In a truly spontaneous legal order, for example, there is equality under the law. In a truly spontaneous economic order, there is an equal ability to enter into economic transactions, broadly defined. Scarry observes that “the equality of beauty” in part resides “in its generously being present, widely present, to almost all people at almost all times” (108-9). Beauty is accessible to all, though the more engaged one is with the beautiful object, the more benefits one derives from it, the more beautiful it becomes. The same is also true of participation in spontaneous orders.

    We see, using two different ways of defining both beauty and the nature of spontaneous order, a commonality: paradox. A beautiful object must be both symmetrical and asymmetrical. To have a just legal order, one must have equal treatment under the law (laws applying to all people equally), resulting in unequal outcomes. Contrariwise, to get equal outcomes, you must treat people unequally and, as a consequence, unjustly – as Vonnegut brilliantly demonstrated in “Harrison Bergeron.” The affirmation of paradox seems to lie at the heart of both the nature of beauty and of spontaneous orders. Beauty must contain both complexity and simplicity. Simple rules and feedback generate complex spontaneous orders (see diZerega, Hayek, and also Stephen Wolfram’s The Making of a New Science). Indeed, feedback, or reflexivity, is another feature of beauty. Both beautiful objects and spontaneous orders are ordered, evolutionary (changing over time), rule-based, simultaneously digital and analog, generative and creative (as Scarry also argues of beauty), scale-free hierarchies (what Turner calls heterarchies in The Culture of Hope) in structure, patterned/rhythmic, unified in their multiplicity, synergistic, novel, irreducible, unpredictable, and coherent (see Turner’s The Culture of Hope on these qualities of beauty and Christian Fuchs on these qualities of self-organizing systems). It seems, as I note in Diaphysics, that “there is a correlation between self-organizing complex systems and beauty. Each have the same attributes.” More, “all beautiful objects are information-generating systems. And to the extent that something is a self-organizing system, it is beautiful” (84).

    If one of the problems with understanding spontaneous orders is that they are more complex than we are, we being nodes within the network, and a less complex entity cannot fully understand a system more complex than itself (Hayek, The Sensory Order, 185), then understanding the relationship between spontaneous orders and the nature of beauty (especially in regards to the internal structures of beautiful things, and how they interact to create the beautiful whole) could help us to understand the nature of spontaneous orders. More, learning to better appreciate and understand beauty – whether in nature or in works of art, music, literature, etc. – should help each of us to learn how to better live within the extended order and positively contribute to its health and growth. This then brings us back to the importance of the liberal arts. Plato saw beauty as a sort of master concept informing all the other concepts (or, ideas, to come closer to the Greek word) (Phaedrus). As we see here, there is much truth to that – and, as Keats reminds us, “Beauty is truth, truth beauty” (“Ode on a Grecian Urn”). The truth-seeking orders, such as the scientific order, are more truth-seeking the more they are truly spontaneous orders – which is to say, the more beautiful they are. “Virtue aims at the beautiful” according to Aristotle (Nicomachian Ethics), and more goodness emerges out of the moral order the more it is a truly spontaneous order. And if beauty is fair, and the fair is just (Scarry), the closer the legal and the democratic orders are to being truly spontaneous orders, the more just they and the extended order will be. In fact, if beauty, truth, virtue, and justice are indeed so deeply related, it logically follows that spontaneous social orders, being beautiful, are going to generate people who are truthful, virtuous, and just – and if these are elements not typically associated with the market order, this is a failure as much of the critics of the market order as it is of the economy having yet become a full spontaneous order – or, more, the almost complete failure of money to have become a spontaneous order (which only serves to undermine the catallaxy).

    If we come to embrace beauty, which is, as Frederick Turner observes, the “value of values” (Beauty), we can come to feel at home in the extended order. We evolved in the midst of an evolutionary drama – and this is precisely what a spontaneous order is (Turner, 131). We can find beauty in the social spontaneous orders precisely because they have all the qualities of the evolved, evolving natural ecosystem. Ironically, precisely as our social world has become more and more a set of spontaneous orders within the extended order, we have abandoned beauty as a value – thus cutting ourselves off from the very thing that would have helped us know how we fit in. As Roger Scruton says in Beauty, “When we are attracted by the harmony, order, and serenity of nature, so as to feel at home in it and confirmed by it, then we speak of its beauty” (72). While I would argue against the inclusion of “serenity,” certainly the other two, and the list I gave above, equate beauty and spontaneous orders. Educated in beauty, we could learn to feel at home in the universe, including our spontaneous orders.

  2. Andreas Hoffmann Says:

    I enjoyed reading this post!

  3. chidemkurdas Says:

    Troy–
    “If one of the problems with understanding spontaneous orders is that they are more complex than we are, we being nodes within the network, and a less complex entity cannot fully understand a system more complex than itself (Hayek, The Sensory Order, 185)…” This complexity means that spontaneous orders are at a political disadvantage. Come to think about it, art is also at a political disadvantage–it’s typically what they cut in school budgets!I’m not sure what the solution is.

  4. chidemkurdas Says:

    Andreas, thanks.
    Hope all is well in the old world.

  5. chidemkurdas Says:

    Troy, “In a truly spontaneous legal order, for example, there is equality under the law.” Perhaps common law comes close this idea. It would be interesting to see a comparison of common law vs legislation in terms of equality.

  6. Troy Camplin Says:

    I agree that common law comes close to this idea — Hayek of course made exactly that argument. I also agree that it would be interesting to see the comparison you suggest. Sounds like it could be a significant paper for someone interesting in pursuing it.

    As for the solution . . . consider Nicolai Wenzel’s article in the latest issue of the Review of Austrian Economics on constitutional culture. You might consider something I wrote about spontaneous order here:

    http://zatavu.blogspot.com/2009/08/laws-of-spontaneous-orders.html

    And my observation that socialists are economic creationists:

    http://zatavu.blogspot.com/2009/11/socialism-is-intelligent-design-theory.html

  7. Mario Rizzo Says:

    Excellent post, Chidem.

    I do have problems with the Kirzner-Austrian approach to the efficient markets issue. As Jerry and I pointed out in The Econ of Time and Ignorance — and as I pointed out in later articles — the arbitrage-process theory is too simple. It evades the problems or possibility of systematic error by reducing the claim that “prices convey knowledge” to a tendency claim. This is not an answer to Keynes and others. As Lachmann said, tendencies can be overwhelmed by other forces. Hayek called this the empirical element in economic theory.

    We need to pay attention to real empirical processes.

  8. chidemkurdas Says:

    Mario, my take on Israel Kirzner’s approach is that it looks at one type of market adjustment–a very important one, no doubt, and typically ignored in neoclassical models, but not the only one. Recent experience highlighted the questions you raise, which are outside the focus of the Kirzner approach.

  9. Peter Boettke Says:

    There is a very good article by Axel Leijonhufvud on the crisis and his concept of the corridor that was published in the Cambridge Journal. In my reply to Dan Klein (co-authored with Dan D’Amico) we discuss this in relation to what Mario is talking about … though very briefly and underdeveloped, more like suggest that this is the way to tackle Mario’s issue.

  10. Tobyk Says:

    Troy,

    You’re a pretentious idiot. Krugman’s use of beauty does not require a full-on critique of the use of the word beauty. He simply meant that the economics profession got caught up with elegant solutions, as opposed to grappling with the reality of the problem.

    Krugman has done some great things for economics, and has won a nobel prize for them. What have you got to show for your pretentious garbage?


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