Happy and Not-So-Happy Markets

The problem with the Efficient Market Hypothesis, EMH, is eventually proponents have to assume it and whatever happens becomes its confirmation. This makes it unprovable and useless, but better that than wrong.

How compatible are efficient markets and psychology? Can psychology just be treated as an exogenous variable to efficient markets? I would call this the happy markets theory, or the markets are efficient except when they are not theory.  Was the market failure the failure to anticipate such a change, to anticipate the effects of such a change, or in the reaction to such a change? Were prices too high before, too low now, both, or neither?  What are markets failing to anticipate next? What are they overreacting to now?  Will they fall by half or double tomorrow?  Are prices anything other than the whims of participants?  There is nothing wrong with treating psychology as exogenous other than making a mockery of EMH. It is notable how the same reasons are used at times like these, psychology, technology, .. and there may well be some truth in them, but such truth would be far more significant than the meaninglessness of EMH.

A Hyper-Ricardian Hypothesis

Conservative economists simply assume recessions don't exist, that they can't exist, that there are no idle resources, no involuntary unemployment. Since everything is already optimal and in equilibrium, the economy is a zero sum game and any attempt at change can only make things worse. Because of this no stimulus is even possible as it can only redirect resources from their current use to the use of government. There is even a bit of truth in this during normal times when the economy actually is operating at capacity. There is no cure for recessions because they are figments of our imagination. It certainly saves a lot of work trying to predict, explain, and remedy them. In this bizarro world, there is no output gap, empty homes and idle factories are just speculations for higher future prices and the unemployed are just enjoying leisure. Putting more people to work is just denying them their leisure and recessions are just long awaited and much desired vacations. If you believe this, not only is fiscal stimulus impossible, even monetary policy is unnecessary so one has to ask them why it should be pursued. One can only imagine what other innovations they might suggest, an end to unemployment and welfare, balanced budgets, and the rest of liquidationist policies.

Now over the long haul stimulus would not be stimulative because the economy would be operating near capacity and it would just redirect otherwise occupied resources within the economy, possibly to less desirable ends. But the same is not true in the short term if there are idle resources. In fact, if Ricardian equivalence holds there is little reason to expect people have not already taken these government stimulus actions into account in their planning from the start and have planned for the government to do just this for them in a situation like this. Call this the Hyper-Ricardian Hypothesis. In that case to not do it would be disappointing expectations that had been previously established.  Far from people countering fiscal action to make it ineffective, they will have planned for it and be relying on it to smooth their consumption.  Lack of stimulus could mean they may not be able to.  

Ricardian Equivalence

I think of it as rational expectations and efficient markets theory taken to its farcical limit, the market always efficient, the economy always operating optimally, unemployment and recessions figments of our imagination. It shows how ludicrous a theory it can be and if you take it seriously, you have just missed the joke.

The Low Interest Rate Myth

Probably the most common explanation for the financial crisis is that interest rates were too low for too long.  I would dispute this.  The whole point of our financial ponzi scheme was to promise and keep interest rates higher than what they would otherwise have been.  Had only good lending been permitted, vast sums would have had no investment opportunity driving interest rates far lower than they had been.  Interest rates were not too low but too high given the available investment opportunities.  So when people ask, how can more of the same which got us into this trouble solve our problems they are incorrect.  This is not more of the same but something very different, the truly low interest rates the investment possibilities offer us.  It is the spur in our sides to take more risk to build a better future because our current one is not very promising.  

Incentives and Investments

The incentives were wrong, but the incentives are always wrong. It is in the interest of those that profit from the incentives to insure they are wrong so they can benefit from them. That is why it requires an honest regulator, but despite the incentives rather then because of them, as their incentives are wrong as well.

If only good lending was allowed, then interest rates would have had to have dropped further and lenders would have to decide whether to continue to lend or to speculate or consume. If they continued to lend, the bubble would have been sustained, speculate and it would have been diverted into equities, consume and it would have expanded the economy. Any of these would have been a better solution than what we had. The big problem is when there is a paucity of good investments for the amount of saving people want, the only thing left to invest in is ponzi schemes.

On the Causes of the Current Crisis

While the low interest rates and abundance of savings amplified the result, it was bad lending that really created it. Bad lending is not only bad in itself but turns even good lending bad by increasing asset prices beyond their true value. Part of the job of regulating the value of money is regulating credit. Failing to do the latter is failing to do the former.

Whenever one hears of the profits of financial innovation the presumption should be someone is getting robbed and if you don't know who, it is probably you. There were no profits, only hidden future losses for the taxpayer to pick up. The innovation consists of fooling others and looting the treasury.

Animal Spirits, Knowledge and Psychology

Why do we make mistakes in economic calculations? What do we mean by animal spirits? Are these a cause or a result? In psychology as a cause theory, it is not that people don't learn from the past, but rather, learn too well from the recent past, and not well enough from the distant past, that outside of their experience, and end up repeating the mistakes of their forebearers. There does seem to be a disconnect between what we think we learn and reality though, that what we may learn may be false or incomplete such that we always have new lessons to learn as well as some we need to unlearn. In that, it is less of psychology as irrational emotionality than as bounded rationality limited by the truthfulness of our conceptions. Thus it seems both knowledge and psychology play a part in our mistakes.