Markets are inefficient because they are efficient?

The Efficient Market Hypothesis (EMH) and market efficiency in general has been the subject of much debate in the aftermath of the sub-prime meltdown. Popular conception of EMH has it that asset prices cannot deviate significantly from its fundamentals, an untenable hypothesis given history and especially the recent events.

In this context, a more nuanced understanding of the concept of efficiency may help us appreciate the issue in its right perspective. Efficiency has two dimensions - market prices reflect all publicly available information about the fundamentals and the prices are fundamentally unpredictable. The popular inferences from these two dimensions are that they ensure that "prices are always right" and "it is impossible to beat the market on a sustained basis" respectively.

However there are enough reasons to believe that such highly simplified inferences may not be correct. It needs to be borne in mind that prices reflect only the "publicly available" information, and not "private" (or insider) information that is inevitable in such complex systems. Even more importantly, it also does not reflect the information about small and fleeting mis-pricings that are used by the likes of high-frequency traders. There have been even recent examples of wild market fluctuations largely attributable to the actions of such traders.

Further, as I have blogged about earlier, systemically too prices are extremely vulnerable to even small shocks administered through the random actions of noise traders/trading. Therefore deviations from the fundamentals will be a commonplace feature of equity markets.

In this context, Chris Dillow points to a new working paper by Brock Mendel and Andrei Shleifer where they claim that "rational but uninformed traders occasionally chase noise as if it were information, thereby amplifying sentiment shocks and moving price away from fundamental values". They show that even without large numbers of noise traders and significant sentiment shocks, a small numbers of these noise traders can have an impact on market equilibrium disproportionate to their size in the market. They write about how sophisticated but uninformed investors learn from prices,

"... such investors may entertain more complicated models and use other public information, such as bond ratings, in forming their demands... If ratings agencies usually do a good job of assessing the riskiness of bond offerings, it may be rational for uninformed traders to use these ratings as a rule-of-thumb to assess underlying value. On those occasions when the ratings agencies are wrong, this will induce correlated mistakes among the mass of uninformed traders, which will overwhelm the price impact of any better-informed traders in the market. It is only when the direct news about valuations reaches the uninformed investors that the market would correct itself. In this example, uninformed traders would rationally end up chasing noise thinking that it reflects information."

In other words, markets go wrong because sometimes rational but uninformed traders mistakenly believe that a price rise is driven by informed traders and not by noise traders and these noise traders, however small, occasionally carry enough momentum to tip the scales in favor of their trend. But as Chris Dillow rightly points out, this deviation from fundamentals "is only possible because very often prices really are right and do embody genuine information" and therefore "markets are occasionally inefficient precisely because they are so often efficient".

Interestingly, in view of the considerable range of non-fundamental information on market psychology (animal spirits of the market participants) that prices reflect, Rajiv Sethi has written that EMH be renamed as the invincible markets hypothesis (IMH)!

Update 1 (18/10/2013)

John Cassidy has a nice article that debunks the notion of efficiency with financial markets.

A nudge to decide!

Even as Goerge Loewenstein and Peter Ubel urge caution, Dan Ariely has more of nudge-based solutions to everyday real-life problems. Procrastinator is an iPhone application, developed by the Duke Center for Behavioral Economics, that "aims to help take the pain out of making big decisions in your life"!



As all of us know, "when choosing between two or more very similar options, we tend not to take into account the consequences of not deciding" and experience a "decision paralysis". This is where Procrastinator steps in. It allows you to set deadlines for your hard decisions so that when time is up, if you haven’t chosen an option, Procrastinator chooses for you, much like Octopus Paul! And he seems to have gotten it right always!

Do tax cuts pay for themselves?

One of the most fundamental tenets of supply-side economics is the entrenched belief that tax cuts pay for themselves. This ideological belief, which is unsupported by empirical facts, forms the cornerstone of conservatives' advocacy of tax cuts to boost economic growth. Paul Krugman has three excellent graphics that are self-explanatory.

Despite the higher tax rates, the Carter era saw a steady growth in revenues. In contrast, the Reagan era, with its tax cuts, saw permanent reduction in revenues relative to what they would otherwise have been. As Krugman writes, the Reagan tax cuts saw "a drop in revenues, then a resumption of growth, but no return to the previous trend". Below is the real federal revenue, in 2005 dollars, from 1970 to 1990.



The Clinton and Bush administrations were two two-term administrations, one of which raised taxes, while the other cut them. But the graphics below - of federal revenues and total non-farm payrolls for the respective periods - do not lend support to the claims of supply-siders. In fact, despite the tax cuts, the Bush era federal revenues and employment rate never touched the Clinton period growth trends (despite its tax increases).




This explains why Paul Samuelson described such reasoning "snake-oil economics"!

Update 1 (27/7/2010)

Excellent post in FT by Martin Wolf about the political psychology behind supply-side economics.

Update 2 (1/9/2010)
David Leonhardt writes, "... even Ronald Reagan’s much-lauded 1981 tax cut doesn’t appear to have worked. After he signed it, the economy lost jobs for 16 straight months. It didn’t start gaining jobs until after he had raised taxes, to reduce the deficit, in late 1982."

Rising corporate savings - another reason for more stimulus?

One of the biggest concerns over the past few months has been the anemic private investment environment. This is despite ultra-low interest rates (and it is certain to remain so for atleast the medium-term), inflation well under control, and corporate profits (especially of the larger firms) rising across US, Europe, and Japan. Evidently, given the uncertainty about economic prospects and demand-side conditions, the growing cash-flow is being saved (and/or used to repay debts), instead of being reinvested.

A recent op-ed in the Times by Yves Smith and Rob Parenteau about the trend of businesses across US, Europe, Japan, China, and even India, saving their surpluses (by investing in financial markets) instead of ploughing the profits back into their own enterprises. It points to a 2005 report from JPMorgan Research which noted that, since 2002, American corporations on average ran a net financial surplus of 1.7% of GDP — a drastic change from the previous 40 years, when they had maintained an average deficit of 1.2% of GDP.

Much the same trend has been in evidence in India too, with corporates preferring to pay-off their debts instead of making investments. The latest annual reports of 360 private companies for 2009-10 shows that corporate India has substantially reduced its leverage this year by raising fresh equity and repaying debt. The robust growth in profitability (and resultant internal accruals), increased business confidence, and strength of the equity markets (and resultant increased opportunity to raise equity) have made corporates rely less on the debt markets.

For 2009-10, while equity expanded by 21.5%, total debt rose by only 5.9% (it rose 35% in 2008-09 as firms loaded on debt to tide over the recession), resulting in the cumulative debt-equity ratio for these companies falling from 0.61 to 0.53. Further, due to falling interest rates, the average cost of borrowings (computed as interest cost divided by average debt) fell from 6.2% to 5.4% for the above companies over the past year.

Yves Smith and Parenteau attribute this to a worrying trend of public companies obsessing with quarterly earnings and short-term profits to impress the markets, instead of spending money on expansion and new investments. These companies also prefer to pay their executives exorbitant bonuses, or issue special dividends to shareholders, or indulge in equity buy-backs, or engage in purely financial speculation. They highlight attention on the need to create incentives for corporations to reinvest their profits in business operations - either through "an aggressive tax on retained earnings that are not reinvested within two years" or "a tax on the turnover of corporate financial investments" or fiscal incentives for investments in sunrise sectors.

However, a more immediate concern is the strong possibility that businesses may be hoarding cash in expectation of a double-dip recession and increases in interest rates that would make debts costlier (not so much in India as in the developed economies). This is natural given the uncertainty surrounding economic prospects and demand-side weakness.

Econ 101 teaches us that private sector (households and businesses), government spending/consumption and exports are the three sources of sustaining aggregate demand. With most major economies coupled into a recession, the external sector may not be able to provide much comfort, leaving governments to shoulder the responsibility.

In other words, the increasing trend towards funneling savings towards financial investments (instead of ploughing them back into the business) and/or for repayment of older debts, means that relying on the private sector to pull the economy out of the downturn is not going to be particularly effective. In the absence of private sector demand and bleak prospects with external demand, we are left with only the government sector. Another round of stimulus spending by governments may therefore be essential if the economy has to get back to normal in reasonable time.

A debate in the Economist too explored the same issue and came to explanations that point to similar conclusions. Xavier Gabaix points to three reasons for businesses saving instead of spending - firms still face a macroeconomic 'tail risk' or 'disaster risk'; firms may face tight credit constraints; and in anticipation of higher future taxes (a Ricardian equivalence result), firms start to save now. Hal Varian points to a self-fulfilling prophecy arising out of firms unwillingness to invest given the weak demand in the near-term future.

Andrew Smithers draws the distinction between financial and non-financial sector firms, and writes that despite the rise in total corporate cash flow, the balance sheets of the later have continued to deteriorate. The former make up a disproportionately large share of the corporatee profits. The large numbers of recent equity buy-backs have been also resposible for chanelling investments away from productive investments.

Jesper Koll makes the point that the higher savings is a function of the increased economic uncertainty. he writes, "the higher the cash reserve, the greater the chance of survival during a crisis. Cash is a very tangible cover against hidden liabilities arising from, say, sudden lawsuits, a banking crisis, a global recession, an earthquake, or the political regime changing to imposing stricter regulations. The greater the uncertainty, the greater the value of cash holdings."

Viral Acharya too argues that firms hoard cash in uncertain times, especially since the banking sector is itself in serious crisis. He writes, "The key observation is that firms generally did not hold these kinds of cash balances in previous downturns and that is largely because the banking sector was in good shape. When banks are well-capitalised, they can provide lines of credit to firms. That is a more efficient way for the economy to smooth cash-flow transfers in the cross-section of firms than each firm hoarding large quantities of cash. But firms have substituted away from lines of credit towards cash. This is partly demand as banks are not as strong as they were in previous downturns and risk right now is more aggregate in nature (so less opportunity to smooth across firms, which is the primary benefit of lines of credit). But it is also partly supply driven in that many banks did become under-capitalised and are still deleveraging.

In other words, firms hoard cash "due to the rise in aggregate uncertainty, the quantity of insurance provision in the economy has gone down, and the weak health of the primary providers of liquidity insurance—the banks—has made things worse. This primarily explains why firms are holding more cash and self-insuring."

Update 1 (18/7/2010)
Comparison of changes in number of jobs and corporate profits explains the aforementioned arguement.



Update 2 (27/7/2010)
Richard Koo makes the point that corporate sector is ploughing its profits back to repay debts and repair their battered balance sheets. He writes,

"The US today is suffering from a balance sheet recession, a very rare ailment which happens only after the bursting of a nationwide debt-financed asset price bubble. In this type of recession, the private sector is minimising debt instead of maximising profits because the collapse in asset prices left its balance sheets in a serious state of excess liability and in urgent need of repair. When the private sector is deleveraging even with zero interest rates, the economy enters a deflationary spiral as it loses aggregate demand equal to the sum of unborrowed savings and debt-repayments every year. If left unattended, the economy will continue to contract until either private sector balance sheets are repaired, or the private sector has become too poor to save any money (=depression). The last time this deflationary spiral was allowed to materialize was during the Great Depression in the US...

When the deficit hawks manage to remove the fiscal stimulus while the private sector is still deleveraging, the economy collapses and re-enters the deflationary spiral. That weakness, in turn, prompts another fiscal stimulus, only to see it removed again by the deficit hawks once the economy stabilises. This unfortunate cycle can go on for years if the experience of post-1990 Japan is any guide. The net result is that the economy remains in the doldrums for years, and many unemployed workers will never find jobs in what appears to be structural unemployment even though there is nothing structural about their predicament. Japan took 15 years to come out of its balance sheet recession because of this unfortunate cycle where the necessary medicine was applied only intermittently."

Update 3 (27/7/2010)

More evidence from this Times story about corporate bottom-lines surging (due to aggressive cost-cutting) even as top-lines have been falling or are stagnant. Corporates are evidently deferring investments and using the profits to repair their balance sheets.



Although the most recent downturn was far more severe, profit margins bottomed out at 5.9 percent in 2009 and quickly rebounded. By next year, analysts expect margins to hit 8.9 percent, a record high. Among the 175 companies in the S.& P. 500 that have reported earnings for the second quarter, revenues rose 6.9 percent on average while profits jumped 42.3 percent, according to Thomson Reuters.

Greater monitoring lowers pass percentage?

I have blogged earlier about the problem of low-level equilibrium at which many social systems operate in countries like India. This low-level equilibrium conceals the deeper quality deficiencies by generating politically (or systemically) acceptable salient outcomes. Here is an example from education sector.

The most high-profile barometer of school education in India is the pass percentage in tenth class examinations. This trumps all others like school enrollment rates, teacher and student attendance and even the newer focus areas like learning outcomes assessment in primary schools. Expectedly, pass percentages have seen a steady rise over the years, with the steepest increases coming in recent years, across all states.

However, there are credible enough allegations that this increase is a classic case of grade inflation. Skeptics attribute this increase to liberal valuation of the standardized SSC examination papers, repetition in questions over years, and reduced vigilance against copying during exams, more than any dramatic increase in the quality of education in schools.

However, a new dimension to the debate, which draws on the recently released SSC examination results in the state of Andhra Pradesh, finds that in districts with more focused monitoring (arrived at based on qualitative parameters) of school education, the results (specifically SSC results) were poorer than in districts where the level of monitoring was minimal and things were largely left to the teachers. And the explanation for this observation - with increased centralized monitoring, the ability to indulge in practices like copying were constrained!

Though quality of education increased (due to timely syllabus coverage, higher teacher and student attendance) with greater monitoring, it was not enough to offset the decrease due to the reduction in copying. Improvements in quality of education, or specifically learning outcomes, is most often a slow process, more so in the higher classes, and therefore the increased supervisory focus does not bear immediate results.

What distorts the incentive for the monitoring officials in each district is the fact that their performance is judged mainly through their tenth class results (there is no other universal parameter, that is/can be captured, that can be used to judge academic performance of schools). Therefore any intervention that results in lowering their results, in comparison to those of their peers in other districts, will naturally go against their incentive structure.

In the circumstances, the unfortunate reality is that the possibility of a decrease in pass percentage due to greater monitoring may exert a disincentive effect on administrators in intensifying monitoring of exam invigilation and paper valuation. Further, the possibility of amplifying their performance by liberal valuation and invigilation would also exert a disincentive effect on teachers and supervisory officials from focusing on steps that would improve the real quality of learning outcomes among students.

More evidence against the "austerians"

The recent G-20 summit at Toronto was the clearest signal that collectively the leaders of the major economies had, in the face of rising deficits and debts, decided to move away from any further stimuluses and embrace debt reduction. The leaders pledged "at least" to halve their deficits by 2013. With an estimated collective fiscal adjustment worth around 1% of its combined GDP next year, the Economist decribes it the "biggest synchronised budget contraction in at least four decades".

Notwithstanding this turn into the path of fiscal contraction, the case against fiscal austerity gets stronger with every passing day, atleast for the US. This is especially so given the present macroeconomic environment where austerity could not only tip the economy back into recession and further increase unemployment but also lower tax revenues and worsen the medium-term budget balance.

Faced with the zero-bound, the monetary policy has lost all traction, and efforts to lower long-term rates and reduce the cost of private debt are not likely to yield much without an unacceptably (politically) massive expansion of the Fed's balance sheet.

The San Francisco Fed has this graphic of increasing vaccancies in office, retail, and industrial spaces across the US, a reflection of the weak demand for business investments.



Paul Krugman points to the lock-step nature of co-movement between the US non-residential fixed investment spending (or business investment, as a percentage of GDP) and the US output gap (the percentage difference between real GDP and the CBO’s estimate of potential real GDP) over the past two decades, to argue that business investment should, if anything, be even lower.





Austerians attribute the weak business investment environment to the lack of confidence about economic prospects and aggregate demand due to the massive deficits and debt stocks (that would presumably force people into cutting down on spending in anticipation of higher taxes in future).

The central thrust of the austerians' arguement have been that the massive expansion of the monetary base will unhinge inflationary expectations and the rising deficits and debt stocks (which in turn is attributed to the stimulus spending) will put upward pressure on interest rates besides crowding out private investment. They also argue that since the stimulus spending has contributed to the deficits, phasing it out will reduce the debt stock.

However, these fears are not borne out by any market indicators. Far from the illusory bond market vigilantes driving up the yields, the rates on long-term T-Bonds remain low and have been on a southward trend.

Menzie Chinn points to a series of indicators - annualized 3 month change in price indices, 10 and 1 year inflation expectations, 10 year Treasury-TIPS and 5 year-TIPS spreads, and money supply - and finds no signs of any inflation surge.



Instead, there are ample signs that deflation should be the immediate concern for policy makers across much of the developed world. Deflation would raise real interest rates, exacerbate the debt problems, and push the can further down the recovery path. John Makin of the American Enterprise Institute has warned that the United States and Europe are heading toward "deflation, a classic prolonger of crises that boosts the real burden of debt and crushes profit margins". Paul Krugman uses monthly inflation data to point out that the US economy may already be in the deflation territory. Mike Bryan from the Atlanta Fed too thinks that the US economy may be much closer to deflation than is widely perceived.

Update 1 (15/7/2010)
David Beckworth points to Rebecca Wider's article about inflation expectations falling globally. She has this chart which illustrates the 10-yr break-even expected inflation rates for the UK, Germany, Canada, Italy, and the US using their respective inflation-indexed bond markets (TIPS in the US).



Update 2 (16/7/2010)
Superb explanation by Mark Thoma of why the massive expansion in monetary base has not generated inflation and instead deflation may be on the horizon. Boston Fed’s Rosengren too feels deflation is an emerging risk.

Update 3 (17/7/2010)
In June, the headline figure on consumer prices fell slightly while the core number rose slightly. Here's the 12-month percentage change in core inflation.



Update 4 (18/7/2010)

Paul Krugman points to the steeply falling 10 year TIPS spreads (difference between the interest rate on ordinary government bonds and bonds indexed to inflation). Also the Cleveland Fed too points to declining inflation expectations.



Update 5 (27/7/2010)
Brad DeLong looks at the numbers and writes,

"The Administration's mid-session review - released last week - projects that the unemployment rate will rise in the next several months and will be at 9.3% in February 2011. It projects that Q4/Q4 real GDP growth will be 2.9% this year - and I don't see how we are going to get there with a 2.7% growth rate in the first quarter, a likely 2.0% growth rate in the second quarter, and with the tracking third-quarter growth at at 2.9%. We would need 4.0% growth in the fourth quarter of this year. Nor do I understand where the 1.7% decline in unemployment over 2011 is supposed to come from: a simple Okun's Law coefficient of 2 would suggest that we need 2 x 1.7 + 2.6 = 6% real GDP growth to generate such a decline.

According to Mark Zandi, in the fourth quarter of this year the phase-out of the ARRA is likely to shave 0.3% off the real GDP growth rate. in 2011, the contractionary effects of the ARRA phase-out on the quarterly growth rates are likely to be -0.8%, -1.2%, -0.7%, and -0.2%."

Economy and football - contrasting images of Spain

The World and European football champions also head the unemployment charts among OECD economies!