Maybe Scott should talk about Hayek instead of EMH

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…

Leave a comment


  1. Trevor Adcock

     /  February 15, 2012

    I think the EMH and rational expectations have the advantage of being very clear in meaning and in policy consequences. It seems like you would mostly trade clarity for confusion.
    Hayek’s position also seems to be more applicable to free banking, then to asset price targeting schemes. Hayek, certainly in his writings on the Austrian Business Cycle, did not believe in anything like rational expectations or EMH.

  2. But we don’t have competition amongst institutional arrangements. A futures market is one possible institutional arrangement. A private system projecting the path of MV is another. Competition in currency is another.
    We have stock markets privately because the alternative institutional arrangements have proven to be worse. If the Fed chooses a futures market, the institutional arrangement will be a chosen winner.
    This Lachmann article may give a better sense for Austrians’ concerns about these types of things: Ludwig Lachmann. 1988. “Speculative Markets and Economic Complexit.,” Economic Affairs 8 (2): 7–10.

    • rhmurphy, you are right about that. We are “assuming” central banks do exist. However, I would certain not disagree that private supply of money is another way to ensure stable money (and a stable NGDP).

  3. By the way, ‘none’ means not one, as in ‘none of the above’. The prefix is ‘non-‘, which just means not or the absence of. For example, it’s ‘non-economist’ rather than ‘none-economist’. The former refers to someone who is not an economist, while the latter means something like not one economist. Even then, while ‘non-economist’ is technically correct, the hyphen is often omitted unless the prefix is being used in an irregular or ambiguous way–‘noneconomist’ is probably right, I think.

    I’m not trying to be condescending. I realise that English is not your first language, but I noticed this mistake in more than one place. I just think you’d rather be told outright than continue making the same error–it’s a very easy mistake to make.

  4. Thx Lee…that actually mean that you are reading what I write;-)

  5. JJA

     /  February 15, 2012

    There is a difference saying that:
    1) the markets are the best known way to arrange the distribution of resources; or
    2) the markets are efficient. (In the mathematical sense I understand the term.)
    The difference is quite much like Winston Churchill saying “It has been said that democracy is the worst form of government except all the others that have been tried.”

    Rational expectations / rational decision making and other assumptions behind EMH may not stand the scrutiny of studies of human cognition and decision making processes. Actually those studies make even stronger argument against central planning. Hence markets still turn out to be better than the alternatives.

  6. “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.”

    Lars I think it goes deeper than that. As someone with some experience as a market participant the EMH just doesn’t ring true. Not because many market participants are “irrational” but that to the contrary some of the most ratonal strategies-in terms of being successful-are predicated on the idea that the market is not rational.

    I really do think-and you’d probably get a lot of agreement on this from guys on a commodity trading floor or at the Chcago Board of Trade-that the EMH is the darling of economists with little first hand knowledge as a market participant .

    How do you thik that outsized returns are made? If the market is rational you can’t, at best it may function as a high yield savings account-but with more risk. Jon Paulson cleaned up in 2008 because the market was irrational in its assumptions about the future of the housing market-that prices would never stop rising,.

    Don’t know if you remember what happened to Jim Cramer-host of Mad MOney and a former very successful hedge fund trader. He gives investment advice-as opposed to trading which is short term-but some tapes on the Internet surfaced where he talked about how he used to manipulate the futures market early to pump them up. Then he’d dump them.

    Jon Stewart-the left comdedian political news guy at the Daily Show-got hold of this and ripped Cramer a new one on air. Cramer perhaps wished he hadn’t done the show.

    What really got Stewart was the idea that Cramer looks upon the market as a casino to manipulate rather than a “rational adding machine.”

    That phrase was Stewart’s. Yet while someone like Stewart may stronlgy disapprove of this it is reality. The market is not a rational adding machine and only “civilians” like the EMH econonmists could think it is

    Hayek is better as a microeconist at least-as a macroeconomist he was stillborn.

  7. Incidentally I dont really see what it helps to say “well that may be your micro experience but on the macro level it is rational” after all, as a marekt participant you can only act at the micro level.

  8. By the way as you as usual knock Keynes I cant resist pointing out that he was a pretty successful investor. I know Scott tried to to claim this is exaggerated but is record is certainly more impressive than anything he’s done.

  9. Steve Horwitz

     /  February 16, 2012


    I think you are deeply mistaken here. Hayek and Austrian economics clearly and thoroughly rejects the EMH and rightly so. You are reading Hayek through neoclassical lenses and not through his own framework. He is most emphatically not saying that markets are efficient aggregators of information or any such thing. He is making a MUCH weaker claim.

    First, he is not, as EMH is, talking about the properties of equilibrium prices. He is talking about DISequilibrium prices. He is not claiming that prices aggregate information. He is claiming that disequilibrium prices are *surrogates* for the underlying information, which is a very different thing. He’s also very clear to say that disequilibrium prices will contain errors and mistakes, and not just of the RE variety, but genuine error.

    His claim is only that disequilibrium prices in a free market make possible the use of knowledge through their role as surrogates for the underlying knowledge/preferences etc. that would otherwise go unused. He is making NO claim about “efficiency” or “optimality” or any other such thing. He’s simply saying markets let us do things that we can’t do without them. The 1945 paper MUST be read as part of the socialist calculation debate, where these issues are clear.

    There is nothing in Hayek or Austrian economics to even suggest that the world, as it is, is anything resembling efficient. That’s a proposition we strongly reject, if “efficiency” is understood in convention equilibrium or optimality terms.

    I strongly recommend Esteban Thomsen’s *Prices and Knowledge* on this if you want a book length treatment. If you want my two cents in more depth, go here: . Finally, Pete Boettke has much to say here:

    This is old hat among Austrians. We are not rejecting the EMH thoughtlessly. We have long rejected those arguments for very good reasons from within our framework. (Same for rational expectations.)

    • Steve,

      I might not have stated this clearly enough. I do NOT think Hayek and other Austrians are endorsing EHM and/or rational expectations. However, from a PRACTICAL perspective if you want to argue as Scott and I are doing that markets (for example via NGDP futures) should “implement” monetary policy rather than central bank discretion then it would maybe be easier to convince people using Hayek’s arguments rather than EMH and radex.

      I do acknowledge that Austrians are very skeptical about rational expectations. Nonetheless Mises in Human Action uses Lincoln Law’s to describe who he thinks of expectations. That is pretty close to rational expectation – at least in spirit.

      Finally, the Austrian claim surely must be that markets are more “efficient” than any other allocation mechanism. Yes, yes not efficient in the neo-classical sense because Austrian simply reject the concept of “efficiency” (in the way they oddly reject math, but logic…).

  10. Benjamin Cole

     /  February 16, 2012

    Mike Sax-

    I think if you consider EMH in the larger picture you will get it. Given the size of the market, how much do pure actors skin off for themselves (and in the process make the market that much more efficient)?

    Yes, on rare occasion, I have had insights better than the market, or perhaps “inside knowledge.” My subsequent actions made the market (minutely) that much more efficient by applying the appropriate price pressures on the market.

    The point is, in huge rough terms, EMH works. For macroeconomics, you need to be roughly right, not exactly wrong. Don’t get lost in the trees, remember the huge, huge forest.

    I applaud you if you are able to beat the market consistently. (I notice hedges have not been doing so lately). But you are making the market more efficient by doing so.

  11. Mike, I think Benjamin pretty much said want I mean. EMH “works” in rough terms.

    By my own experience of being daily on a trading floor for more than a decade is that there are rational and irrational people on the floor. However, the “system” also ensures that there are quite clear limits to how irrational people are allowed to be. Furthermore, all the model of for example FX rates I have done is that the more information I put into my models the closer my forecast will come to market forecasts.

    EHM simply mean that all AVAILABLE information is already reflected in market pricing.

  12. Benjamin, I can’t claim to always beat the market, just that I have done so. LOL My best time was believe it or not 2008 in September when I loaded up on puts on the banks.

    I do find Hayek’s work on price signals interesting. Again I find his macro work useless-my opinion to be sure though it seems that most people at the time agreed with me even Milton Friedman-but his micro work is interesting. I read a recent book by him “Socialism-the Great Conceit” and was-surprisngly-quite impressed. I didn’t expect to be

  13. I just checked out the Mankiw link. I’m sorry I need more to show he wasn’t a good investor than that he lost money in 1920 and was able to borrow money from a wealthy father.

    Many successful investors have had a wealthy benefactor. But having available funds to invest doesn’t ensure you success either.

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