EMH and “The Market”

In comments, Mike linked to one of his posts from a couple months ago where he quotes William Easterly:

The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market. This applies also to other asset markets like housing prices.

Mike goes on to describe a paper called The Limits to Arbitrage. Under the realistic assumptions that only big players arbitrage and there is an agency problem where those big traders have information about fundamental prices that the people that hire them do not ((Realistic assumptions, yes, but how sensitive are the results to these assumptions? and how would they interact with other behavioral assumptions (e.g. why did principals hire the agents in the first place)? what happens as the arbitrageur uses more and more of his own money?)), even these big traders can’t stay solvent long enough. Thus, Easterly’s contention is false.

I don’t see the connection. Nothing in that paper suggest market prices don’t incorporate all available public information. Yes, arbitrageurs know more than the public. If their principals allowed it, they’d make trades on that information, but they don’t so they can’t. There are no profit opportunities.

The intellectual history of the EMH is basically:

  1. Fama names the EMH
  2. People test EMH making assumptions about asset pricing (e.g. CAPM)
  3. Early tests don’t reject EMH, but later tests do
  4. Fama observes these rejections are of the joint test of the asset pricing model and EMH… the problem could be with the asset pricing model
  5. People try different pricing models and discover there aren’t any good ones (i.e. the joint test keeps getting rejected)
  6. The Limits of Arbitrage suggests the problem is with liquidity constraints
  7. People again say this is a problem with EMH
  8. Cue Fama…

Its funny. I’m beginning to think that EMH isn’t a testable hypothesis. Its a subsidiary hypothesis, like in cosmology the assumption that the physical constants are in fact constant, that makes it possible to test other hypothesis. Without the EMH, we can use any ad-hoc explanation to explain any particular behavior. Under this view, anomalies teach us about asset pricing models and not the rationality of markets.

True, Fama’s work depended on arbitrage having no limits, but it should be easy (as in, not easy at all) to redefine efficiency to include the liquidity constraints of arbitrageurs. Then we can say markets are constrained efficient. I have no idea what this would mean for the allocation of capital in the real economy (the paper points out that the extent of the agency problems vary by asset class but I don’t imagine asset classes are much correlated with “capital classes” or sectors of the real economy). And policy implications?

6 thoughts on “EMH and “The Market””

  1. I’m not that familiar either, but don’t bubbles contradict the EMH? Assuming you believe in bubbles of course.

  2. The assumption is about information available ex-ante. Bubbles ex-post are “new economies” ex-ante.

    I’m having a hard time parsing out the usual sense of “efficient” with the idea that there’s no profit opportunities. The finance people seem to conflate the two. Its more clear that there’s no profit opportunities in a bubble, but I’m not sure that capital is being efficiently allocated. Maybe there’s a theorem, but its probable that even bubbles can be ex-ante efficient (in the economic sense)… If the planner had only the information available to in 1999, maybe he would have put as much capital into the tech sector as the market did.

  3. Money is a bubble and it’s not clear to me that it’s not efficient, in either sense.

    Not only does the price of money deviates from the NPV of its dividend stream (zero in all periods) but also from the NPV of its ex-ante expected dividend stream 😉

  4. NPV of its dividend stream is negative if there’s inflation!

    “If the planner had only the information available to in 1999, maybe he would have put as much capital into the tech sector as the market did.” Would the planner have built as many houses in the nevada desert? I doubt it, but it’s untestable isn’t it.

    For a market fundamentalist, markets work everywhere and always and are always correct. So I don’t think anything I could write would convince you, would it? Any price deviation could be based on available information and unmeasurable expectations, etc.

  5. gabe, there’s two observationally equivalent theories. Its not fundamentalist to point this out.

    However, if you assume EMH you can test other theories. That seems like a plus.

Comments are closed.