Every other month or so Scott Sumner writes a defence of the so-called Efficient Market Hypothesis. I have noticed that the commentators already react quite aggressively to Scott’s unwavering support of EMH and my own personal experience is that people – especially people who themselves are active in the financial markets – will strongly oppose the idea of efficient markets.
Why is that? Fundamentally I think that most people think of economics and financial markets based on their personal micro observations rather than based on economic logic. We all have met or heard of completely insane investors that far from can be described as being rational and if such people exists how can we talk about efficient markets? EMH is simply a very hard sell – whether or not it empirically is a good description of the world.
Even though Scott and I agree that EMH probably is the best description of today’s financial markets it might actually be an idea to stop talking about EHM and instead confront the anti-EHM crowd with an alternative. Such an alternative could be Hayek’s description of capitalist market system as the best aggregator of information known to man.
Recently I have been re-reading some of the key chapters in Hayek’s Individualism and Economic Order. The book is full is Hayekian classics such as The Use of Knowledge in Society and The Meaning of Competition and as well as some key chapters discussing calculation in socialist society. Contrary to neo-classical theory which is at the core of EMH Hayekian thinking is based on much less rigid assumptions (and is somewhat less stringent). At the core of Hayek’s thinking is that no social planner has the knowledge to allocate goods and resources in society. Preferences are individual and are changing constantly and so do natural conditions.
We do so to speak not know the “model” of the economy. Contrary to this EHM and rational expectations build on the explicit assumption that the model is known. Hayek on the other hand would strongly object to the notion that the model is known – least at all by policy makers.
Scott uses EHM to argue that since the markets are more or less efficient no central bank forecast will be able to consistently beat the forecast of the market and therefore central bank policy implementation should be build on the use of the market mechanism through NGDP futures.
This makes perfectly good sense, but hold on for a second. What if the “model” of the economy is known why should we bother using NGDP futures when a benevolent central bank could just solve an optimisation problem and solve the model and implement the policy that would ensure the highest level of societal welfare? First of all, there would be a problem which social welfare function to optimize, but lets assume that this (non-trivial!) problem is solved. Then second, would you really think that we could and should leave it to central bankers to define what model is the “right” of the economy (most central banks today rely on New Keynesian models which both Scott and I think make very little sense). Take Scott and me. 90% (I changed that from 99%) of our thinking about monetary issues is the same, but I could come up with a few areas where we do not agree on the theoretical issues and even if we agreed about the model of the economy we could still disagree about the empirical size of the parameters in the model.
This is of course why it is much better to leave it to the market to decide on the implementation of monetary policy through the direct and indirect use of prediction markets (such as macroeconomic forecasting, the implementation process and NGDP futures).
But what if I was in a room full of non-economists and I had to explain why this makes sense. Would I start by outlining a mathematical model and tell them that markets where efficient (most people have no clue what efficient mean – neither do most economists) or would I tell a Hayekian story about how central planning is impossible and markets is the best aggregator of information? I surely would go with the Hayekian story. It is simply much more acceptable to most people than the EHM and radex story – even though Scott and I full well know that it is basically the same story.
That said, it is therefore interesting that it is especially Scott’s Austrian oriented readers who so strongly object to Scott’s insistence that markets are efficient. They should really read Hayek because Hayek is exactly saying that the markets are significantly more efficient than any other form of allocation mechanisms. Yes, he is also saying some – in my view – weird things about mathematics, but overall Hayek thought that we could describe the economy as being efficient and that rational expectations would be a good approximation of the real world. Hayek’s classic description in “Price and Production” from 1933 of his business cycle theory is in fact very much an attempt (which fails in my view) to describe the business cycles within a fundamentally neo-classical set-up.
Scott’s conclusion is to “let a thousand models blossom” so instead of trying to figure out what really is the right model of the economy central bankers should use market information in the conduct and implementation of monetary policy. Would Hayek disagree? I think not…