The Crowd: “Lars, you are fat!”

On Friday I was doing a presentation on the global economy (yes, yes mainly on global monetary policy) for 40-50 colleagues who are working as investment advisors in the Danske Bank group.

As I was about to start my presentation somebody said “The audience have been kind of quiet today”. I thought that was a challenge so I immediately so I jumped on top of a table. That woke up the crowd.

I asked the audience to guess my weight. They all wrote their guesses on a piece of paper. All the guesses were collected and an average guess – the “consensus forecast” – was calculated, while I continued my presentation.

I started my presentation and I naturally started telling why all of my forecasts would be useless – or at least that they should not expect that I would be able to beat the market. I of course wanted to demonstrate exactly that with my little stunt. It was a matter of demonstrating the wisdom of the crowds – or a simple party-version of the Efficient Market Hypothesis.

I am certainly not weighing myself on a daily basis so I was “guestimating” my own weight then I told the audience that my weight is 81 kilograms (fully dressed). I usually think of my own weight as being just below 80 kg, but I was trying to correct it for the fact I was fully dressed – and I added a bit extra because my wife has been teasing me that I gained weight recently.

As always I was completely confident that the “survey” result would come in close to the “right” number. So I was bit surprised when the  “consensus forecast” for my weight came in at 84.6 kg

It was close enough for me to claim that the “market” – or the crowd – was good at “forecasting”, but I must say that I thought the “verdict” was wrong – nearly 85 kg. That is fat. I am not fat…or am I?

So once I came back home I immediately jumped on the scale – for once I hoped to show that the Efficient Market Hypothesis was wrong. But the verdict was even more cruel. 84 kg!

So the “consensus forecast” was only half a kilo wrong and way better than my own guestimate. So not only am I fat, but I was also beaten by the “market” in guessing my own weight.

I need a cake

PS My height is 183 cm – so my Body Mass Index is 25.08 – that is officially overweight (just a little – above 25 is overweight).

PPS I have done this kind of experiments before. See here.

Did Casey Mulligan ever spend any time in the real world?

University of Chicago economics professor Casey Mulligan has a new comment on Economix. In his post “Who cares about Fed funds?” Mulligan has the following remarkable quote:

“New research confirms that the Federal Reserve’s monetary policy has little effect on a number of financial markets, let alone the wider economy.”

Mulligan’s point apparently is that the Federal Reserve is not able to influence financial markets and as a consequence monetary policy is impotent. First of all we have to sadly conclude that monetarism is nonexistent at the University of Chicago – gone is the wisdom of Milton Friedman. I wonder if anybody at the University of Chicago even cares that Friedman would have turned 100 years in a few days.

Anyway, I wonder if Casey Mulligan ever spent any time looking at real financial markets – especially over the past four years. I have in a number of blog posts over the last couple of months demonstrated that the major ups and downs in both the US fixed income and equity markets have been driven by changes in monetary policy stance by the major global central banks – the Fed, the ECB and the People’s Bank of China. I could easy have demonstrated the same to be the case in the global commodity markets.

Maybe Casey Mulligan should have a look on the two graphs below. I think it is pretty hard to NOT to spot the importance of monetary policy changes on the markets.

Of course it would also be interesting to hear an explanation why banks, investment funds, hedge funds etc. around the world hire economists to forecast (guess?) what the Fed and other central banks will do if monetary policy will not have an impact on financial markets. Are bankers irrational Professor Mulligan?

Anyway, I find it incredible that anybody would make these claims and it seems like Casey Mulligan spend very little time looking at actual financial markets. It might be that he can find some odd models where monetary policy is not having an impact on financial markets, but it is certainly not the case in the world I live in.

Let me finally quote Scott Sumner who is as puzzled as I am about Mulligan’s comments:

“Yes, Mulligan is a UC economics professor.  And yes, Milton Friedman is spinning faster and faster in his grave.”

Yes, indeed – Friedman would have been very upset by the fact that University of Chicago now is an institution where money doesn’t matter. It is sad indeed.

Update: Brad Delong is “slightly” more upset about Mulligan’s piece than Scott and I are…

PS Maybe professor Mulligan could explain to me why the US stock market rallied today? Was it a positive supply shock or had it anything to do with what ECB chief Draghi said? And then tell me again that markets do not care about monetary policy…

Forget about those black swans

It has become highly fashionable to talk about “black swans” since the crisis began in 2008 and now even Scott Sumner talks about it in his recent post “Don’t forget about those black swans”. Ok, Scott is actually not obsessed with black swans, but his headline reminded me how much focus there is on “black swans” these days – especially among central bankers and regulators and to some extent also among market participants.

What is a black swan? The black swan theory was popularized by Nassim Taleb in 2007 book “The Black Swan”. Taleb’s idea basically is that the financial markets underprice the risk of extreme events happening. Taleb obviously felt vindicated when crisis hit in 2008. The extreme event happened and it had clearly not been priced by the market in advance.

Lets go back to back to Scott’s post. Here he quotes Matt Yglesias:

Here’s a fun Intrade price anomaly that showed up this morning. The markets indicate that there’s more than a 3 percent chance that neither Barack Obama nor Mitt Romney will win the presidential election. That’s clearly way too high.

Scott then counter Matt by saying that we should not forget “something unusual happening”:

1.  One of the two major candidates is assassinated, and the replacement is elected (as in Mexico’s 1994 election.)

2.  Ditto, except one pulls out due to health problems, or scandal.

3.  A third party candidate comes out of nowhere to get elected.

Scott is of course right. All this could happen and as a consequence it would obviously be wrong if the market had price a 100% chance that nobody else than Obama or Romney would become US president.

Scott and I tend to think that financial markets are (more or less) efficient and as a consequence we would not be gambling men. Scott nonetheless seem to think that the odds are good:

“But 3% is low odds.  It’s basically saying once in ever 130 years you’d expect something really weird to happen in US presidential politics during an election year.   That’s a long time!  Given all the weird things that have happened, how unlikely is it?  Some might counter that none of the three scenarios I’ve outlined have occurred in the US during an election year (my history is weak so I’m not certain.)  But mind-bogglingly unusual things have happened on occasion.  On November 10, 1972, what kind of odds would Intrade have given on neither Nixon nor Agnew being President on January 1 1975?”

Scott certainly have a good point, but I will not question the market on this one. The market pricing is the best assessment of risk we have. If not there would be money in street ready to pick up for anybody – and there is not. Obviously Taleb disagrees as he believe that markets tend to underprice risk. However, I fundamentally think that Taleb is wrong and I don’t see much evidence that market underprice black swan events. The fact that rare events happen is not evidence that the market on average underprice the likelihood of this events.

The fashion long-shot bias and central banks

In the evidence from betting markets seem to indicate that if anything bettors tend to have a favourite-longshot bias meaning that they tend to overprice the likelihood that the favourite will loose elections or sport games. Said in another way if anything bettors tend to overprice the likelihood of a black swan events. I happen to think that this is not a market problem in markets in general, but it nonetheless indicates that if anything the problem is too much focus on black swan events rather than too little focus on them.

This to a very large extent has been the case of the past 4 years – especially in regard to central banking and banking regulation. There seem to be a near-obsession among some policy makers that a new black swan could turn up. How often have we heard the talk about the major risk of bubbles if interest rates are kept too low too long and most of the new financial regulation being push through across the world these days is justified by reference to the risk of some kind of black swan event.

Media and policy makers in my view have become obsessed with extreme events happening – you will be reminded about that every time you go through the security check in any airport in the world.

The obsession with black swan events is highly problematic as the cost of policy makers obsessing about very unlikely events happening lead them to implement very costly regulation that lead to massive waste of resources. Again just think about how many hours you have spend waiting to get through airport security over the last couple of years and if you think that is bad just think of the cost resulting from excessive new regulation of the global financial markets. So my suggestion is clearly to forget about those black swans!

Finally three book recommendations:

Risk by Dan Gardner that tells about the “politics of fear” (of black swans).

The Myth of the Rational Voter by Bryan Caplan explains why democracy tend to lead to irrationality while market lead to rationality. Said in another way policy makers would be more prone to focus on black swans than market participants in free markets would be.

Risk, Uncertain and Profit – Frank Knight’s classic. If you are really interested in the issues of risk and uncertainty then there is no reason at all to read Taleb’s books (I have read both The Black Swan and Fooled by Randomness – they are “fun” and something you can read while you are waitin in line at the security check in the airport, but it is certainly not Nobel prize material). Instead just read Knight’s classic. It is much more insightful. It is actually something that frustrates me a great deal about Taleb’s books – there is really nothing new in what he is saying, but he claims to have come up with everything himself.

Understanding financial markets with MV=PY – a look at the bond market

Recently I have been thinking whether it would be possible to understand all financial market price action through the lens of the equation of exchange – MV=PY. In post I take a look at the bond market.

The bond market – its about PY expectations

A common misunderstanding among economic commentators is to equate easy monetary conditions with low bond yields. However, Milton Friedman long ago told us that bond yields are low when monetary policy have been tight – and not when it has been loose. Any Market Monetarist will tell you that monetary conditions are getting easier when nominal GDP growth is accelerating and and getting tighter when NGDP growth is slowing. So with this Friedmanite and market monetarist insight in mind there should be a relationship between higher bond yields and higher nominal GDP growth. Hence, when market participants expect MV to increase then we should also see bond yields increase.

The graph above shows the correlation between 10-year US bond yields and US NGDP growth. The graph illustrates that there is a fairly close correlation between the two series. Higher bond yields and higher NGDP hence seem to go hand in hand and as we know MV=PY we can conclude that higher bond yields is an indication of looser monetary policy. Furthermore, we should expect to see bond yields to increase – rather than decrease – when monetary policy is eased. Or said in another way – any monetary action that does not lead to an increase in bond yields should not be considered to be monetary easing. 

Therefore, given the present slump we are in we should not be worried that rising bond yields will kill off the recovery – rather we should rejoice when long-term bond yields are rising because that is the best indictor that monetary conditions are becoming easer and that that will push up nominal GDP.

The brief discussion above in my view confirms some key market monetarist positions. First, financial markets are good indicators of the stance of monetary policy. Second, monetary policy works through expectations – with long and variable leads. Third low bond yields is an indication that monetary policy has been tight and not that it is loose.

UPDATE: In my original post I had used some wrong data. Clare Zempel kindly notified me about the mistake(s). I am grateful for the help. As a consequence of the wrong data I have revised part of the original text.

UPDATE 2: David Beckworth has an excellent post arguing the exactly the same as me: “the recent rise in long-term yields can be interpreted as the bond market pricing in a rise in the expected growth of aggregate demand.”. And take a look at David’s graph showing the relationship between expected NGDP growth and 10-year bond yields. Great stuff!

Chuck Norris just pushed S&P500 above 1400

Today S&P500 closed above 1400 for the first time since June 2008. Hence, the US stock market is now well above the levels when Lehman Brothers collapsed in October 2008. So in terms of the US stock market at least the crisis is over. Obviously that can hardly be said for the labour market situation in the US and most European stock markets are still well below the levels of 2008.

So what have happened? Well, I think it is pretty clear that monetary policy has become more easy. Stock prices are up, commodity prices are rising and recently US long-term bond yields have also started to increase. As David Glasner notices in a recent post – the correlation between US stock prices and bond yields is now positive. This is how it used to be during the Great Moderation and is actually an indication that central banks are regaining some credibility.

By credibility I mean that market participants now are beginning to expect that central banks will actually again provide some nominal stability. This have not been directly been articulated. But remember during the Great Moderation the Federal Reserve never directly articulated that it de facto was following a NGDP level target, but as Josh Hendrickson has shown that is exactly what it actually did – and market participants knew that (even though most market participants might not have understood the bigger picture). As a commenter on my blog recently argued (central banks’) credibility is earned with long and variable lags (thank you Steve!). Said in another way one thing is nominal targets and other thing is to demonstrate that you actually are willing to do everything to achieve this target and thereby make the target credible.

Since December 8 when the ECB de facto introduced significant quantitative easing via it’s so-called 3-year LTRO market sentiment has changed. Rightly or wrongly market participants seem to think that the ECB has changed it’s reaction function. While the fear in November-December was that the ECB would not react to the sharp deflationary tendencies in the euro zone it is now clear that the ECB is in fact willing to ease monetary policy. I have earlier shown that the 3y LTRO significantly has reduced the the likelihood of a euro blow up. This has sharply reduced the demand for save haven currencies – particularly for the US dollars, but also the yen and the Swiss franc. Lower dollar demand is of course the same as a (passive) easing of US monetary conditions. You can say that the ECB has eased US monetary policy! This is the opposite of what happened in the Autumn of 2010 when the Fed’s QE2 effectively eased European monetary conditions.

Furthermore, we have actually had a change in a nominal target as the Bank of Japan less than a month ago upped it’s inflation target from 0% to 1% – thereby effectively telling the markets that the bank will step up monetary easing. The result has been clear – just have a look at the slide in the yen over the last month. Did the Bank of Japan announce a massive new QE programme? No it just called in Chuck Norris! This is of course the Chuck Norris effect in play – you don’t have to print money to see monetary policy if you are a credible central bank with a credible target.

So both the ECB and the BoJ has demonstrated that they want to move monetary policy in a more accommodative direction and the financial markets have reacted. The markets seem to think that the major global central banks indeed want to avoid a deflationary collapse and recreate nominal stability. We still don’t know if the markets are right, but I tend to think they are. Yes, neither the Fed nor the ECB have provide a clear definition of their nominal targets, but the Bank of Japan has clearly moved closer.

Effective the signal from the major global central banks is yes, we know monetary policy is potent and we want to use monetary policy to increase NGDP. This is at least how market participants are reading the signals – stock prices are up, so are commodity prices and most important inflation expectations and bond yields are increasing. This is basically the same as saying that money demand in the US, Europe and Japan is declining. Lower money demand equals higher money velocity and remember (if you had forgot) MV=PY. So with unchanged money supply (M) higher V has to lead to higher NGDP (PY). This is the Chuck Norris effect – the central banks don’t need to increase the money base/supply if they can convince market participants that they want an higher NGDP – the markets are doing all the lifting. Furthermore, it should be noted that the much feared global currency war is also helping ease global monetary conditions.

This obviously is very good news for the global economy and if the central banks do not panic once inflation and growth start to inch up and reverse the (passive) easing of monetary policy then it is my guess we could be in for a rather sharp recovery in global growth in the coming quarters. But hey, my blog is not about forecasting markets or the global economy – I do that in my day-job – but what we are seeing in the markets these days to me is a pretty clear indication of how powerful the Chuck Norris effect can be.  If central banks just could realise that and announced much more clear nominal targets then this crisis could be over very fast…

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PS For the record this is not investment advise and should not be seen as such, but rather as an attempt to illustrate how the monetary transmission mechanism works through expectations and credibility.

PPS a similar story…this time from my day-job.

Expectations and the transmission mechanism – why didn’t anybody think of that before?

As I was writing my recent post on the discussion of the importance of expectations in the lead-lag structure in the monetary transmission mechanism I came think that is really somewhat odd how little role the discussion of expectations have had in the history of the theory of transmission mechanism .

Yes, we can find discussions of expectations in the works of for example Ludwig von Mises, John Maynard Keynes and Frank Knight. However, these discussions are not directly linked to the monetary transmission mechanism and it was not really before the development of rational expectations models in the 1970s that expectations started to entering into monetary theory. Today of course New Keynesians, New Classical economists and of course most notably Market Monetarists acknowledge the central role of expectations. While most monetary policy makers still seem rather ignorant about the connection between the monetary transmission mechanism and expectations. And even fewer acknowledge that monetary policy basically becomes endogenous in a world of a perfectly credible nominal target.

A good example of this disconnect between the view of expectations and the view of the monetary transmission mechanism is of course the works of Milton Friedman. Friedman more less prior to the Muth’s famous paper on rational expectation came to the conclusion that you can’t fool everybody all of the time and as consequence monetary policy can not permanently be use to exploit a trade-off between unemployment and inflation. This is of course was one of things that got him his Nobel Prize. However, Friedman to his death continued to talk about monetary policy as working with long and variable lags. However, why would there be long and variable lags if monetary policy was perfectly credible and the economic agents have rational expectations? One answer is – as I earlier suggested – that monetary policy in no way was credible when Friedman did his research on monetary theory and policy. One can say Friedman helped develop rational expectation theory, but never grasped that this would be quite important for how we understand the monetary transmission mechanism.

Friedman, however, was not along. Basically nobody (please correct me if I am wrong!!) prior to the development of New Keynesian theory talked seriously about the importance of expectations in the monetary transmission mechanism. The issue, however, was not ignored. Hence, at the centre of the debate about the gold standard in the 1930s was of course the discussion of the need to tight the hands of policy makers. And Kydland and Prescott did not invent Rules vs Discretion. Henry Simons of course in his famous paper Rules versus Authorities in Monetary Policy from 1936 discussed the issue at length. So in some way economists have always known the importance of expectations in monetary theory. However, they have said, very little about the importance of expectation in the monetary transmission mechanism.

Therefore in many ways the key contribution of Market Monetarism to the development of monetary theory might be that we fully acknowledge the importance of expectations in the transmission mechanism. Yes, New Keynesian like Mike Woodford and Gauti Eggertsson also understand the importance of expectations in the transmission mechanism, but their view of the transmission mechanism seems uniformly focused in the expectations of the future path of real interest rates rather than on a much broader set of asset prices.

However, I might be missing something here so I am very interested in hearing what my readers have to say about this issue. Can we find any pre-rational expectations economists that had expectations at the core of there understand of the monetary transmission mechanism? Cassel? Hawtrey? Wicksell? I am not sure…

PS Don’t say Hayek he missed up badly with expectations in Prices and Production

PPS I will be in London in the coming days on business so I am not sure I will have much time for blogging, but I will make sure to speak a lot about monetary policy…

Long and variable leads and lags

Scott Sumner yesterday posted a excellent overview of some key Market Monetarist positions. I initially thought I would also write a comment on what I think is the main positions of Market Monetarism but then realised that I already done that in my Working Paper on Market Monetarism from last year – “Market  Monetarism – The  Second  Monetarist  Counter-­revolution”

My fundamental view is that I personally do not mind being called an monetarist rather than a Market Monetarist even though I certainly think that Market Monetarism have some qualities that we do not find in traditional monetarism, but I fundamentally think Market Monetarism is a modern restatement of Monetarism rather than something fundamentally new.

I think the most important development in Market Monetarism is exactly that we as Market Monetarists stress the importance of expectations and how expectations of monetary policy can be read directly from market pricing. At the core of traditional monetarism is the assumption of adaptive expectations. However, today all economists acknowledge that economic agents (at least to some extent) are forward-looking and personally I have no problem in expressing that in the form of rational expectations – a view that Scott agrees with as do New Keynesians. However, unlike New Keynesian we stress that we can read these expectations directly from financial market pricing – stock prices, bond yields, commodity prices and exchange rates. Hence, by looking at changes in market pricing we can see whether monetary policy is becoming tighter or looser. This also has to do with our more nuanced view of the monetary transmission mechanism than is found among mainstream economists – including New Keynesians. As Scott express it:

Like monetarists, we assume many different transmission channels, not just interest rates.  Money affects all sorts of asset prices.  One slight difference from traditional monetarism is that we put more weight on the expected future level of NGDP, and hence the expected future hot potato effect.  Higher expected future NGDP tends to increase current AD, and current NGDP.

This is basically also the reason why Scott has stressed that monetary policy works with long and variable leads rather than with long and variable lags as traditionally expressed by Milton Friedman. In my view there is however really no conflict between the two positions and both are possible dependent on the institutional set-up in a given country at a given time.

Imagine the typical monetary policy set-up during the 1960s or 1970s when Friedman was doing research on monetary matters. During this period monetary policy clearly was missing a nominal anchor. Hence, there was no nominal target for monetary policy. Monetary policy was highly discretionary. In this environment it was very hard for market participants to forecast what policies to expect from for example the Federal Reserve. In fact in the 1960s and 1970s the Fed would not even bother to announce to market participant that it had changed monetary policy – it would simply just change the policy – for example interest rates. Furthermore, as the Fed was basically not communicating directly with the markets market participant would have to guess why a certain policy change had been implemented. As a result in such an institutional set-up market participants basically by default would have backward-looking expectations and would only gradually learn about what the Fed was trying to achieve. In such a set-up monetary policy nearly by definition would work with long and variable lags.

Contrary to this is the kind of set-up we had during the Great Moderation. Even though the Federal Reserve had not clearly formulated its policy target (it still hasn’t) market participants had a pretty good idea that the Fed probably was targeting the nominal GDP level or followed a kind of Taylor rule and market participants rarely got surprised by policy changes. Hence, market participants could reasonably deduct from economic and financial developments how policy would be change in the future. During this period monetary policy basically became endogenous. If NGDP was above trend then market participant would expect that monetary policy would be tightened. That would increase money demand and push down money-velocity and push up short-term interest rates. Often the Fed would even hint in what direction monetary policy was headed which would move stock prices, commodity prices, the exchange rates and bond yields in advance for any actual policy change. A good example of this dynamics is what we saw during early 2001. As a market participant I remember that the US stock market would rally on days when weak US macroeconomic data were released as market participants priced in future monetary easing. Hence, during this period monetary policy clear worked with long and variable leads.

In fact if we lived in a world of perfectly credible NGDP level targeting monetary policy would be fully automatic and probably monetary easing and tightening would happen through changes in money demand rather than through changes in the money base. In such a world the lead in monetary policy would be extremely short. This is the Market Monetarist dream world. In fact we could say that not only is “long and variable leads” a description of how the world is, but a normative position of how it should be.

Concluding there is no conflict between whether monetary policy works with long and variable leads or lags, but rather this is strictly dependent on the monetary policy regime and how monetary policy is implemented. A key problem in both the ECB’s and the Fed’s present policies today is that both central banks are far from clear about what nominal targets they have and how to achieve it – in some ways we are back to the pre-Great Moderation days of policy uncertainty. As a consequence market participants will only gradually learn about what the central bank’s real policy objectives are and therefore there is clearly an element of long and variable lags in monetary policy. However, if the Fed tomorrow announced that it would aim to increase NGDP by 15% by the end of 2013 and it would try to achieve that by buying unlimited amounts of foreign currency I am pretty sure we would swiftly move to a world of instantaneously working monetary policy – hence we would move from a quasi-Friedmanian world to a Sumnerian world.

Without rules we live in Friedmanian world – with clear nominal targets we live live in Sumnerian world.

PS Today is a Sumnerian day – hints from both the Fed and the ECB about possible monetary tightening is leading to monetary policy tightening today. Just take a look at US stock markets…(Ok, Greek worries is also playing apart, but that is passive monetary tightening as dollar demand increases)

Why did the A’s stop winning? Scott has the answer

I have been watching Moneyball. It is a great movie, but unlike Scott Sumner and my wife I have actually no clue about movies. However, economics play a huge role in this movie. So that surely made me interested. It is of course very different from Michael Lewis’ excellent book Moneyball, but it is close enough to be an interesting movie even to nerdy economists like myself.

If I was not blogging about monetary policy and theory then there is a good chance I would be blogging about what Bob Tollison called Sportometrics – the economics of sports. It combines two things I love – sports and economics. But why bring Moneyball into a discussion about money and markets? Well, because the story of the Oakland A’s is a pretty good illustration that Scott Sumner is right about the Efficient Market Hypothesis (EMH) – even when it comes to the market of baseball players. So bare with me…

Any American male knows the story about the Oakland A’s but for the rest of you let me just re-tell the story Michael Lewis tells in Moneyball.

The story about the Oakland A’s is the story about the A’s’ general manager Billy Beane who had the view that the market was under-pricing certain skills among baseball players. By investing in players with these under-priced skills he could get a team, which would be more “productivity” than if he had not acknowledged this under-pricing. Furthermore as other teams did not acknowledge this he would increase his chances of winning even against teams with more resources. It’s a beautiful story – especially because theory worked. At least that is how it looked. In the early 2000s the Oakland A’s had much better results than should have been expected given the fact that the A’s was one the teams in the with the lowest budgets in the league. The thesis in Moneyball is that that was possible exactly because Billy Beane consistently used of Sabermetrics – the economics of Baseball.

Whether Lewis’ thesis correct or not is of course debatable, but it is a fact that the Oakland A’s clearly outperformed in this period. However, after Moneyball was published in 2003 the fortune of the Oakland A’s has changed. The A’s has not since then been a consistent “outperformer”. So what happened? Well, Billy Beane was been beaten by his own success and EMH!

Basically Billy Beane was a speculator. He saw a mis-pricing in the market and he speculated by selling overvalued players and buying undervalued players. However, as his success became known – among other things through Lewis’ book – other teams realised that they also could increase their winning chances by applying similar methods. That pushed up the price of undervalued players and the price of overvalued player was pushed down. The market for baseball players simply became (more?) efficient. At least that is the empirical result demonstrated in a 2005-paper An Economic Evaluation of the Moneyball Hypothesisby Jahn K. Hakes and Raymond D. Sauer. Here is the abstract:

Michael Lewis’s book, Moneyball, is the story of an innovative manager who exploits an inefficiency in baseball’s labor market over a prolonged period of time. We evaluate this claim by applying standard econometric procedures to data on player productivity and compensation from 1999 to 2004. These methods support Lewis’s argument that the valuation of different skills was inefficient in the early part of this period, and that this was profitably exploited by managers with the ability to generate and interpret statistical knowledge. This knowledge became increasingly dispersed across baseball teams during this period. Consistent with Lewis’s story and economic reasoning, the spread of this knowledge is associated with the market correcting the original mis-pricing.”

Isn’t it beautiful? The market is not efficient to beginning with, but a speculator comes in and via the price system ensures that the market becomes efficient. This is EMH applied to the baseball market. Hence, if a market like the baseball market, which surely is about a lot more than making money can be described just remotely as efficient why should we not think that the financial markets are efficient? In the financial markets there is not one Billy Beane, but millions of Billy Beanes.

Every bank, every hedgefund and every pension fund in the world employ Billy Beane-types – I am one of them myself – to try to find mis-pricing in the financial markets. We (all the Billy Beanes in the financial markets) are using all kind of different methods – some of them very colourful like technical analysis – but the aggregated result is that the markets are becoming more efficient.

Like Billy Bean the speculators in the financial markets are constantly scanning the markets for mis-priced assets and they are constantly looking for new methods to forecast the market prices. So why should the financial markets be less efficient than the baseball market? I think Scott is right – EMH is a pretty good description of the financial markets or rather I haven’t seen any other general theory that works better across asset classes.

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PS there is of course also the possibility that Billy Beane was just lucky“The sample is simply not big enough” (“Peter Brand” in the movie about why his theory initially did not work).

PPS  In Moneyball the movie the term “Winning streak” is used. That is a bit of a turn off for anybody who has studied a bit of sportometrics. There is not such a thing as a winning streak or a “hot hand” – at least that can not be proved empirically.

PPPS Moneyball is not really about Billy Beane, but rather about Paul DePodesta. In the Moneyball Paul DePodesta is renamed Peter Brand.

PPPPS I have no clue about baseball and find it rather boring…that must be the ultimate disclaimer.

Please fasten your seatbelt and try to beat the market

Scott Sumner and other Market Monetarists (including myself) favour the use of NGDP futures to guide monetary policy. Other than being forward-looking a policy based on market information ensures that the forecast of the future development is not biased – in the market place biases will cost you on the bottom-line. Similarly, I have earlier suggested that central banks should use prediction markets to do forecasting rather rely on in-house forecasts that potentially could be biased due to political pressures.

A common critique of using “market forecasts” in the conduct of monetary policy is that the market often is wrong and that “herd behaviour” dominates price action – just think of Keynes’ famous beauty contest. This is the view of proponents of what has been termed behavioural finance. I have worked in the financial sector for more than a decade and I have surely come across many “special” characters and I therefore have some understanding for the thinking of behaviour theorists. However, one thing is individual characters and their more or less sane predictions and market bets another thing is the collective wisdom of the market.

My experience is that the market is much more sane and better at predicting than the individual market participants. As Scott Sumner I have a strong believe in the power of markets and I generally think that the financial markets can be described as being (more or less) efficient. The individual is no superman, but the collective knowledge of billions of market participants surely has powers that are bigger than superman’s powers. In fact the market might even be more powerful than Chuck Norris!

Economists continue to debate the empirical evidence of market efficiency, but the so-called Efficient-Market Hypothesis (EMH) can be hard to test empirically. However, on Thursday I got the chance to test the EMH on a small sample of market participants.

I was doing a presentation for 8 Swedish market participants who were on a visit to Copenhagen. I knew that they had to fly back to Stockholm on a fight at 18:10. So I organized a small competition.

I asked the 8 clever Swedes to write down their individual “bets” on when they would hear the famous words “Please fasten your seatbelts” and the person who was closest to the actual time would win a bottle of champagne (markets only work if you provide the proper incentives).

“Fasten your seatbelts” was said at 18:09. The “consensus” forecast from the 8 Swedes was 18:14 – a miss of 5 minutes (the “average” forecast was 8 minutes wrong). Not too bad I think given the number of uncertainties in such a prediction – just imagine what Scandinavian winter can do to the take-off time.

What, however, is more impressive is that only one of the 8 Swedes were better than the consensus forecast. Carl Johan missed by only 1 minute with his forecast of 18:08. Hence, 7 out 8 had a worse forecast than the consensus forecast. Said in another way only one managed to beat the market.

This is of course a bit of fun and games, but to me it also is a pretty good illustration of the fact that the collective wisdom in market is quite efficient.

I showed the results to one of my colleagues who have been a trader in the financial markets for two decades – so you can say he has been making a living beating the market. The first thing he noted was that two of the forecasts was quite off the mark – 14 minutes to early (Erik) and 14 minutes to late (Michael). My colleague said “they would have been dead in the market”. And then he explained that Erik and Michael probably went for the long shot after having rationalized that they probably would not have any chance going for the consensus forecast – after all we were playing “the-winner-takes-it-all” game. Erik and Michael in other words used what Philip Tetlock (inspired by Isaiah Berlin) has called a Hedgehog strategy – contrary to a Fox strategy. “Foxes” tend to place their bets close to the consensus, while “hedgehogs” tend to be contrarians.

My colleague explained that this strategy might have worked with the “market design” I had set up, but in the real world there is a cost of participating in the game. It is not free to go for the long shot. This is of course completely correct and in the real market place you so to speak have to pay an entrance fee. This, however, just means that the incentive to move closer to the consensus is increased, which reinforces the case for the Efficient-Market Hypothesis. But even without these incentives my little experiment shows that it can be extremely hard to beat the market – and even if we played the game over and over again I would doubt that somebody would emerge as a consistent “consensus beater”.

From a monetary policy perspective the experiment also reinforces the case for the use of market based forecasting in the conduct and guidance of monetary policy through NGDP futures or more simple prediction markets. After all how many central bankers are as clever as Carl Johan?

PS Carl Johan works for a hedge fund!

PPS if you are interested in predictions markets you should have a look at Robin Hanson’s blog Overcoming Bias and Chris Masse’s blog Midas Oracle.

UPDATE: See this fantastic illustration of the Wisdom of the Crowd.

Update 2: Scott Sumner has yet another good post on EMH.

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