Excess Volatility Strikes Again

Both David Henderson and Scott Sumner had some fun with this declaration of victory on behalf of Austrian Business Cycle Theory by Robert Murphy after the recent mini-stock-market crash.

As shocking as these developments [drops in stock prices and increased volatility] may be to some analysts, those versed in the writings of economist Ludwig von Mises have been warning for years that the Federal Reserve was setting us up for another crash.

While it’s always tempting to join in the fun of mocking ABCT, I am going to try to be virtuous and resist temptation, and instead comment on a different lesson that I would draw from the recent stock market fluctuations.

To do so, let me quote from Scott’s post:

Austrians aren’t the only ones who think they have something useful to say about future trends in asset prices. Keynesians and others also like to talk about “bubbles”, which I take as an implied prediction that the asset will do poorly over an extended period of time. If not, what exactly does “bubble” mean? I think this is all foolish; assume the Efficient Markets Hypothesis is roughly accurate, and look for what markets are telling us about policy.

I agree with Scott that it is nearly impossible to define “bubble” in an operational ex ante way. And I also agree that there is much truth in the Efficient Market Hypothesis and that it can be a useful tool in making inferences about the effects of policies as I tried to show a few years back in this paper. But I also think that there are some conceptual problems with EMH that Scott and others don’t take as seriously as they should. Scott believes that there is powerful empirical evidence that supports EMH. Responding to Murphy’s charge that EMH is no more falsifiable than ABCT, Scott replied:

The EMH is most certainly “falsifiable.” It’s been tested in many ways. Some people even claim that it has been falsified, although I’m not convinced. In the tests that I think are the most relevant the EMH comes out ahead. (Stocks respond immediately to news, stocks follow roughly a random walk, indexed funds outperformed managed funds, excess returns are not serially correlated, or not enough to profit from, etc., etc.)

A few comments come to mind.

First, Nobel laureate Robert Shiller was awarded the prize largely for work showing that stock prices exhibit excess volatility. The recent sharp fall in stock prices followed by a sharp rebound raise the possibility that stock prices have been fluctuating for reasons other than the flow of new publicly available information, which, according to EMH, is what determines stock prices. Shiller’s work is not necessarily definitive, so it’s possible to reconcile EMH with observed volatility, but I think that there are good reasons for skepticism.

Second, there are theories other than EMH that predict or are at least consistent with stock prices following a random walk. A good example is Keynes’s discussion of the stock exchange in chapter 12 of the General Theory in which Keynes actually formulated a version of EMH, but rejected it based on his intuition that investors focused on “fundamentals” would not have the capital resources to finance their positions when, for whatever reason, market sentiment turns against them. According to Keynes, picking stocks is like guessing who will win a beauty contest. You can guess either by forming an opinion about the most beautiful contestant or by guessing who the judges will think is the most beautiful. Forming an opinion about who is the most beautiful is like picking stocks based on fundamentals or EMH, guessing who the judges will think is most beautiful is like picking stocks based on predicting market sentiment (Keynesian theory). EMH and the Keynesian theory are totally contrary to each other, but it’s not clear to me that any of the tests mentioned by Scott (random fluctuations in stock prices, index funds outperforming managed funds, excess returns not serially correlated) is inconsistent with the Keynesian theory.

Third, EMH presumes that there is a direct line of causation running from “fundamentals” to “expectations,” and that expectations are rationally inferred from “fundamentals.” That neat conceptual dichotomy between objective fundamentals and rational expectations based on fundamentals presumes that fundamentals are independent of expectations. But that is clearly false. The state of expectations is itself fundamental. Expectations can be and often are self-fulfilling. That is a commonplace observation about social interactions. The nature and character of many social interactions depends on the expectations with which people enter into those interactions.

I may hold a very optimistic view about the state of the economy today. But suppose that I wake up tomorrow and hear that the Shanghai stock market crashes, going down by 30% in one day. Will my expectations be completely independent of my observation of falling asset prices in China? Maybe, but what if I hear that S&P futures are down by 10%? If other people start revising their expectations, will it not become rational for me to change my own expectations at some point? How can it not be rational for me to change my expectations if I see that everyone else is changing theirs? If people are becoming more pessimistic they will reduce their spending, and my income and my wealth, directly or indirectly, depend on how much other people are planning to spend. So my plans have to take into account the expectations of others.

An equilibrium requires consistent expectations among individuals. If you posit an exogenous change in the expectations of some people, unless there is only one set of expectations that is consistent with equilibrium, the exogenous change in the expectations of some may very well imply a movement toward another equilibrium with a set of expectations from the set characterizing the previous equilibrium. There may be cases in which the shock to expectations is ephemeral, expectations reverting to what they were previously. Perhaps that was what happened last week. But it is also possible that expectations are volatile, and will continue to fluctuate. If so, who knows where we will wind up? EMH provides no insight into that question.

I started out by saying that I was going to resist the temptation to mock ABCT, but I’m afraid that I must acknowledge that temptation has got the better of me. Here are two charts: the first shows the movement of gold prices from August 2005 to August 2015, the second shows the movement of the S&P 500 from August 2005 to August 2015. I leave it to readers to decide which chart is displaying the more bubble-like price behavior.