Invulnerable zombies: the Efficient Markets Hypothesis

Discussion on my last post on reanimated zombie ideas in economics touched on a lot of the themes I want to talk about in this one, about the efficient markets hypothesis and why this undead monster can never be laid to rest. (Warning: favorable references to Popper ahead!).





ZombiesWalkEMH





The ultimate zombie is one that is completely invulnerable. Neither special bullets nor hammer blows nor even decapitation can finally lay this undead being to rest. But dramatic logic requires that a zombie invulnerable to external threats must be subject to a subtle, but ultimately terminal, flaw that ends in its own destruction.

Ultimate zombies arise quite commonly in science and economics in the form of ideas that are immune from refutation. The classic examples arise from the popularised versions of Freudian psychology, centred on the Oedipus complex, named for the Greek tragic hero who unknowingly killed his father and married his mother. If a son hates his father, this is, obviously, evidence of the Oedipus complex. But, if he loves his father, this is explained as a repressed Oedipus complex. With rules like this, Freudian psychology can never be refuted.

But as a string of philosophers of science, being with the late Karl Popper, have shown, a theory that can’t be refuted by any conceivable evidence isn’t really a theory at all. All it says, in the end, is ‘anything can happen, and probably will’.

The global financial crisis, along with the earlier dotcom crisis has shown that, on any ordinary understanding of its terms, the efficient markets hypothesis can’t be right. Despite reaching a scale and sophistication unparalleled in history, global financial markets have shown themselves subject to the same manias, bubbles and busts that were seen in the Dutch tulip craze of the 17th century.

So supporters of the efficient markets hypothesis have sought a redefinition that would make it invulnerable to refutation. Their central argument is one that has already been discussed – if it is possible to diagnose the existence of a bubble, then it is possible to make arbitrarily large profits betting against it. And if someone like Warren Buffett has in fact done this, that can be put down to luck. Only if everybody can make money betting against the market can the EMH be wrong. But of course, it’s impossible for everyone to bet against the market – the market is just the aggregate of bets.

This argument in one form or another has been put forward by all the leading defenders of the EMH, notably including Eugene Fama and John Cochrane of Chicago and Scott Sumner of Bentley University

This set of observations from Scott Sumner in a blog post aptly titled ‘Defending the indefensible’ at least recognises the difficulties of the position

But why is Fama’s theory now in such disrepute? Because in the past ten years the world economy has seen two very important bubble-like patterns, indeed arguably the only two such market cycles in the US during my lifetime with macro significance. And they were both predicted by lots of experts because they violated popular theories of fundamentals. So start with the cognitive illusion that people have that makes them see bubbles even where there don’t exist. People think they have made accurate predictions because an upswing is always EVENTUALLY followed by a downturn. Then add in the fact that The Economist really did make accurate predictions in two of the most important events in modern history. Do you think it will be possible to convince them that they just got lucky? About as likely as a husband convincing an already suspicious wife that he is innocent after twice being caught in bed with two separate women. So I feel sorry for Fama. He’s probably right, but I don’t see how he could ever convince anyone in this environment. It would be like trying to convince someone that neoliberalism was the right policy in 1933.

As a well known blogger would say, ‘Indeed’. Looking at the evidence of the two gigantic bubbles of the last decade, it’s hard to see how Sumner maintains his own faith, and he never really gives an explanation, except to say that it’s easy to misperceive bubbles. As far as macroeconomics is concerned, the experience of the Great Depression and of the current Global Financial Crisis (which as Sumner implies, really began with the 2001 recessions) is pretty strong evidence that neoliberalism is not the right policy, at least not for all occasions and not in the forms that prevailed in the 1920s or the 1990s.

But the ultimate response to this invulnerable zombie must be the same as Popper on Freudian psychology. If the Great Depression, the dotcom boom and bust and the current Global Financial Crisis are all consistent with the efficient markets hypothesis, the hypothesis can’t tell us much of interest about anything. At most, it says that even when markets are way out of line with economic reality, it is hard to exploit this fact to make a profit. Most of us (me and Krugman at any rate) already knew that, and confined ourselves to getting out of stocks when they seemed absurdly overvalued.