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.