Free Market

[Cyrus]

I've posted about this once before.

[mosta]

Orthodox neoclassical economics asserts as a scientific fact that interference with a market necessarily produces inefficiencies. This conclusion is based on the very strong (ie, ridiculous) assumptions of complete, perfect information and no transactions costs. When you introduce imperfect information, transactions costs, monitoring costs, asymmetries of power, and so on, the derived equilibriums either a. no longer exist; b. are absurd (the "boiling oil solution", ie Hobbes (see Parsons for remarkable prescience) or c. exist but are inefficient. Eg, the efficiency wage--whereby the labor market equlibrium wage results involuntary unemployment as a way of reducing monitoring costs and providing the threat of firing. analogous analysis applies in capital markets with regard to company management, and in commodities markets, eg with used cars. this work goes back to the seventies, but in usual fashion the (pseudo) "nobel" prizes are just catching up. having said that markets are inefficient, I think they're usually better than bureaucrats or dictators. I worked in one of the closest earthly approximations of an classical market--open outcry derivatives exchange--and we made our living largely by working the system. and as those opportunities are cleaned up, traders will leave for lack of opportunity and the market will cease to exist.

when the statement is made that the current market stock price is the most accurate prediction of the discounted value of blah blah blah. my first reaction is to say, you've got to be kidding. on further consideration however, the statement is quite reasonable if you look at the point slightly differently: market prices are no less accurate than any other guesses generally, because no one has any idea and there is no way to know and it's largely random.

microeconomics, as a theory of individual behavior, is complete junk. it's either tautological (anything anyone does can be interpreted as maximizing some kind of utility; and any prediction/strategy is rational on set of probabilities--as much as people knock english and anthro departments, it amazes me that economists can announce "revealed preference" theory (the very essence of tautology) and still be allowed on campus--at least those other folks don't pretend to be scientists)))))))) or it's simply demonstrably false, if you construct any kind of meaningful scenario to demonstrate inconsistent preferences (when you allow prestige and pride and friendship to be accounted for in valuations (I wouldn't sell it for any price; I wouldn't buy from him at any price).

I've always found it bizarre how proud the orthodox types are of the equilibrium solution. they take it as mathematical scientific proof of the rightness of certain social policy. ken arrow himself in his nobel acceptance speech tends more towards the opposite: that the solution is a reductio ad absurdum of the assumptions. and beyond that, I wonder how many practicing economists, much less political commentators, can even appreciate the abstruseness of the solution. really you need to have a pretty sophisticated appreciation of mathematics to understand how a pareto optimal equilibrium (and how much weaker could that be!) doesn't follow immediately from complete information and free exchange. and most of the econ types don't appreciate it, I'm willing to bet all I have on that--get one to explain to you what a counter-example would look like. and how in the world do you make so much of such an obscure, technical point even if you do understand it? ideology is very weird and disturbing.

[mosta]

just to emphasize the point, in lay terms: the arrow-debreu orthodox equilibrium solution: if you take a bunch of guys and distribute a bunch of stuff randomly among them (commodities), and they all like or dislike the different kinds of things to different degrees, and every one of them knows what every other one has, and you leave them alone in a room, free to swap with each other as much as they want--when you come back, eventually, they will have finished trading, and no one of them could be happier with other stuff without making someone else less happy--ie no more mutually satisfactory trading opportunities exist. is that very surprizing--that if everyone knows what everyone has and is free trade eventually there will be no more good trading opportunities? well this conclusion is supposed by certain...fools (?--hard not to say it) as scientific justification for a rabid ideology. they never think to question the worth of the assumptions as a model for social settings, or never want to because they like the conclusion. arrow, who found the solution, at least knew better. and on a side note, the way that the equilibrium wouldn't exist is if they ended up trading in a pattern that never halted, like in some kind of circle. what's the social significance of that possibility--none really. and another note, this pareto optimum of everyone being relative well off, really says very little. for istance, one guy having everything is pareto optimal, bc everything as some non-zero utility so giving anything to anyone else would make him worse off. pareto optimum is violated on if both parties are happier if there were a trade.

[sam h]

These were very good posts Mosta. I think you are right that the particularly combination of insularity and hubris in economics makes for some crazy situations. You're right too that you can see this in some of the Nobel awards. The fact that they gave it to Douglass North, basically for just pointing out something which is intuitively obvious to anybody without his head lodged in his own ass, is pretty indicative of the problem.

[Utah]

I have been rethinking this and as always, thinking about the market is tricky.

The key principle to remember is that all available information is already discounted into the market. Therefore, it is impossible to make an irrational decision when purchasing stock in a fairly efficient market. (with one exception - see below). The reason is that the price of the stock has, by the nature of the efficient market, been set correctly. All expert, good, medium, and bad opinions are baked in. It is impossible for any one person to beat the market unless they have information the market doesnt have. That is why the monkeys throwing darts do as well as the expert stock pickers.

Also, there is never a correlation between any 2 stock points absent new information (except for tiny arbatrage situations). This means that there is no real slope to stock prices. If there were (i.e., it was predictable) experts would immediately buy the stock and drive up the price to meet where the slope was going.

Lets look at your argument on slope irrationality. Lets say speculators buy one day and sell the next. For years these guys made a killing. However, the speculators on the last day got killed. Why were these speculators any more irrational than the speculators that made a fortune?

The only way to irrationally pick a stock is to possess information the market doesnt have and then bet against the direction the stock is going to move as a result of that information.

[BadBoyBenny]

[ QUOTE ]
Assumption: Market actors act rationally and in their best interests

[/ QUOTE ]

I wouldn't say this is true. I think the free market theory would assume that people are most likley to act in what they perceive to be their best interests most of the time. Its more of a general observation than a hard and fast rule.

I think a more problematic assumption is that markets can regulate themselves.

This is why we don't live in free market society.

[adios]

The "dot.com" bubble was a fraud perpetrated on investors by Wall Street investment bankers in part IMO. Investment bankers willingness to underwrite bogus business models caused a massive misallocation of capital. IMO it wasn't the dot.com companies that caused the market to go up so high, it was the one-time inflated profits of the Internet infrastructure companies like CSCO, SUNW, etc. that were caused by the expenditure of the capital raised for the dot.coms. Even after the dot.coms began to flounder, Wall Street investment banks were able to issue bonds to keep the boom in the purchase of infrastructure alive. Investors extrpolated profit growth from these infrastructure companies too far out into the future. My understanding is that the dot.com bubble was very similar to what happened in the stock market when the automobile started getting popular in the early 20th century. There's no doubt that the economic boom in the U.S. 20 years later or so was fueled by the maturation of the auto industry. Another part of the dot.com bubble was a lack of transparancy in company finances due to fraudulant accounting and negligent auditing, perhaps fraudulant auditing as well. Competitors to those companies doing bogus accounting believed that the margins stated were valid and over invested to keep up.

[adios]

One little gem that Ray pointed out to me awhile back was that a lot of stocks "fly under the radar screen" i.e. they receive zero analyst coverage. There have been studies that have validated the "Neglect Effect" which is that the best performing groups of stocks are those that receive zero analyst coverage. We're talking about small cap companies. The valuation of the entire market is dominated by a relatively small number of companies that of course are large cap and receive tons of analyst coverage.

[BadBoyBenny]

Utah,

I normally agree with your posts but I don't like this one. I just don't buy the efficient market theory. Everyone interprets the same information differently, and the market is nothing more than an aggregate of perceptions, some better than others.


[ QUOTE ]
All expert, good, medium, and bad opinions are baked in.

[/ QUOTE ]

This is exactly my point. You don't need additional information, you just a better intepretation of the available information. Also, just because the information is out there doesn't mean everyone of every side of a stock transaction has read the information.

With an efficient market theory, everyone who buys a stock would be making a perfectly rational theory that there is no better place in the world for their money than that particular stock, while the person selling the same stock would obvioulsy think something very different.

[ QUOTE ]
That is why the monkeys throwing darts do as well as the expert stock pickers.

[/ QUOTE ]

This was always a hard one for me to argue with, that the world's great investors were just at some etreme edge of variance. Like a fish who plays terribly but is a huge long winner because he has beat the odds and drawn out again and again.

Here is the most famous value investor/inefficient market believer's refutation of that point. I would be interested in your critque.

http://www.tilsonfunds.com/superinvestors.html

[BadBoyBenny]

All of what you said was a big part of it. But at the end of the day, there was still people even supposed experts making absolutely terrible decisions. This always lead me to question whether our soceity values the wrong qualities when determininig who the experts are.

BTW Henry Blodget, you've probably heard of him did an interesting series for slate magazine a few months ago called the Wall Street Defense Manual. You would probably find it interesting.

http://www.slate.com/Default.aspx?id=2105036