Tuesday, April 22, 2014

Financial Markets Are Still Efficient (Approximately).

A brilliant post by guest blogger Scott Sumner on Econlog (Econolog.econolib.org, April 21, 2014) : "Why the EMH is truer than supply and demand."

It is well worth reproducing it in full: 
"My previous post discussed the strangeness of the efficient markets hypothesis. Here I'll defend its utility.
In the field of economics, all models represent simplifications of reality. Thus when we consider whether the EMH is true, it makes no sense to compare it to something like Newtonian physics. Yes, even Newtonian physics is only approximately true, but the approximation is much better than almost anything we observe in economics. So let's compare apples with apples.
Supply and demand has become the archetype model of economics. It's a workhorse widely used to explain the behavior in all sorts of markets, from haircuts and dry clearers to automakers and PC producers. Of course if you read the fine print the model is, strictly speaking, only applicable to a very restricted set of markets, essential grain producers. But almost all economists use it in a much wider range of applications, with justification. It's really, really useful.
But is it true? One of the most important implications of S&D is that producers are price takers. This assumption is what underlies the existence of a supply curve. If firms are not price takers then no supply curve exists. You can't have a supply and demand model without the assumption of firms being price takers.

But are they price takers? Not really. The vast majority of firms, even in highly competitive industries such as laundromats, dry cleaners and pizza shops, could raise prices by 5% and still hold on to a substantial share of their customers. Exxon might not be able to do so, but most small businesses could. This means the supply and demand model is not literally "true."
Fortunately, S&D is incredibly useful, even if not strictly true.
I would argue the EMH is truer that the S&D model. And by EMH I am actually only talking about the assumption that asset price deviations from trend are essentially unforecastable. Specific versions such as the CAPM may be flawed in other ways. However I believe the random walk model is truer than S&D, and also quite useful. But how can we test the EMH?
Many academics look for "anomalies." This is asking both too much and too little. Contrary to widespread belief, the EMH does not claim that a search of 20 million statistical patterns would fail to identify 1 million anomalies that show non-random price movements at the 5% level, or 200,000 at the 1% level. On the other hand, I'd also argue that it's asking too much of academics to suggest they need to find get-rich-schemes that violate the EMH, it should be enough to prove that at least someone has done so (say Warren Buffett.)
As an analogy, an economist looking for signs that the most famous secret in alchemy--turning lead into gold--had been discovered should not have to identify the magic formula, but rather merely show that gold prices are behaving in a way consistent with the fact that someone had discovered this sort of chemical process.
Eugene Fama understood that the only meaningful test of the random walk was to look for evidence that others had found anomalies. The initial tests showed no evidence; mutual funds excess returns were serially uncorrelated, whereas they would be correlated if a subset of investors had found the magic formula. Later work with Kenneth French slightly modified that conclusion. There was some evidence of stock picking ability, but too small to overcome the expense ratios of mutual funds. So now the EMH is only approximately true. But since it's a part of economics, we should have known that all along. No economic model is precisely true.
OK, but is it useful? I see three uses:
1. For ordinary investors, it suggests you'd want to stick to indexed funds.
2. For academics, it suggests that asset prices contain the optimal forecasts, and hence you should use something like TIPS spreads rather than the output of VAR models when trying to identify the optimal forecast of inflation. And you should use the response of asset markets to monetary policy announcements to evaluate the effectiveness of programs like QE, not subsequent movements in the economy.
3. For policymakers, it suggests that central banks and/or bank regulators should not try to identify bubbles. And that central banks should create and subsidize NGDP future markets. And that SEC officials should actually pay attention when whistleblowers bring in evidence that hedge fund returns are inconsistent with the predictions of the EMH (i.e. the Madoff case.)
To conclude, the EMH is a very useful model. It's also more true than the S&D model, as the pricing power of firms in so-called "competitive industries" where S&D is widely applied is actually much greater than the excess returns identified by Fama and French.
From now on any commenter who tells me the EMH is not true, should also tell me whether they think S&D is true, and if so, why it's true."

Saturday, April 12, 2014

What I Have Been Reading

 Europe: The Struggle for Supremacy, 1453 to the Present by Brendan Simms, professor of the History of International Relations at the University of Cambridge.

The author recounts “the story of highly competitive and mutually suspicious monarchies and republics; of empires, revolution, rivalry, unification and utopias”. The idea of a European success story due in the main to the competition between states and nations is not new, as readers of Eric L. Jones’ The European Miracle know since this latter book publication in 1981.

Neither is the other central geopolitical idea according to which whoever controls the core of Europe controls the entire continent, and whoever controls all of Europe can dominate the world, as Charles V, Cromwell, Pitt and other British rulers, NapolĂ©on, Bismarck, Hitler, Stalin and Roosevelt clearly realized. Halford John Mackinder new as much as early as 1904 when he wrote “The geographical pivot of history” for The Geographical Journal.

Simms emphasizes the continuing fractured nature of the continent as well as the central role of Germany, under the guise first of the Holy Roman Empire, and later as the Second and Third Reich, which has been a constant preoccupation of Europeans because of its geography, its power, and its policies.

Europe indeed is a good read, and Simms strategic and geopolitical approach is illuminating. The enthusiastic comments on the book, however, seem to me a bit exaggerated. What I really enjoyed, among other brilliant insights, is the following analysis of the euro crisis (pp. 527-528):

“If Greece and Ireland actually defaulted, this would cast doubt on the value of previously sacrosanct government bonds and precipitate a general collapse in Spain, Portugal and Italy as investors fled the state bond market. It might even destroy the entire euro-system itself and tip the whole continent and thus probably the entire world into recession. For this reason, the EU and the IMF sought to prop up Irish and Greek finances through a series of largely German-funded ‘bailouts’, which lent money  -- often at high interest rates – to cover the shortfall, in return for a commitment to further austerity measures to bring the national finances in order. The central actor here was Germany, where a struggle erupted between the establishment, which feared that a Greek or Irish default would destroy their own banking system, which was heavily invested in the relevant bonds, and the population at large which was increasingly weary of funding yet another ‘bailout’ for improvident peripheral economies and was registering that fact in the regional elections. By the middle of 2011, in order to avoid further electoral losses, Chancellor Merkel had retreated from her original joint position with Paris in defence of the bondholders, towards an insistence that international investors would have to share some of the losses. This stance, however reasonable in itself, not only infuriated the French, whose banks were even more exposed to Greek debt, but also increased the chance of an escalating sovereign default across substantial parts of the Union.
Taken together (with deep divergences regarding international relations and military interventions, JJR), all this amounted to a severe and possibly terminal challenge to the European project. At the time of writing (2013, JJR) Europe remains in one of its deepest crises since the Second World War.”


And as “Germany was becoming a more ‘normal’ and thus more ‘assertive’ nation, as it left the past behind it … a ‘central secession’ from the EU, by which Germany simply washed its hands of Europe, and reintroduced the Deutschemark, could no longer be completely excluded.”

As I wrote in a previous post, Germany, indeed, is the key to the solution of the “Euro problem”. This should mean, according to the Simms's analysis, the coming breakup of the euro that is more openly discussed in Germany nowadays.


Tuesday, April 8, 2014

The Threat of Global Deflation

It is real and impending according to American Enterprise Institute economist John Makin, here.

And it could cripple the global economy. While the trend affects China and the US as well as Europe, the Eurozone is doing worse than the two other main economic powers.

It is high time to preempt deflation since, given the levels of debt to Gdp ratio in many countries, a cumulative debt-deflation process would be really destructive.

The specific problem of the Eurozone, however, is that national economic interests of northern and southern members clash with each other, regarding to what the adequate ECB monetary policy should be, due to the disequilibrium real exchange rates that the euro forces on national economies. It thus seems unlikely that a radical turnaround of ECB policy could be agreed upon in order to prevent a further fall of the eurozone inflation, which for March was reported at a 0.5 percent year-over-year pace, down from a 0.7 percent pace in February. Indeed the risk that I warned of in my previous post of november 11, 2013, has been growing despite optimistic forecasts of an imminent recovery by government officials.

Monday, November 11, 2013

“Strong” Euro, Deflationary Risk, and Globalization Bashing

 Euro's excess strength implies an increased risk of deflation in the eurozone and a continued "globalization bashing" in public opinion.

Indeed the ECB surprise rate cut reflects (at long last) a growing concern over the inflated price of the Euro and the risk of deflation in the Eurozone that it creates.

Deflation is a problem because lower prices mean lower incomes and ultimately profits, so businesses cut spending on everything from new capital investment to wages and jobs, while consumers cut on their spending too and try to deleverage. Everyone is poorer and the cuts in corporate and household spending can bring further price cuts and usher the EU economy in a deflationary spiral whereas growth is already paltry and falling. The EU inflation rate is currently at 0.7% a year, well below the official 2.0% target and the EU official growth rate forecast for the year has recently been revised downwards from 1.2% to 1.1%.

With lower incomes debtors have a harder time repaying fixed debt payments (interests). The ratio of interest payments to current national income increases, increasing also the risks of default of debtors while EU banks hold hundreds of billions of southern governments bonds. And in theses countries too the debt/Gdp ratio keeps rising despite optimistic official declarations to the contrary.

In itself, the recent strength of the Euro price versus the Dollar (and thus the Yuan) determines a weakening blow to the Eurozone economy because it hampers exports to the rest of the world and boosts imports from the rest of the world, depressing the production of the Eurozone firms exporting to the rest of the world and of the Eurozone firms that compete with the imports from the rest of the world.

This explains why a growing and vocal share of the opinion in the Eurozone condemns “globalization”. Open markets (free trade) mixed with a massively overvalued currency can destroy an economy. Confronted with rigid wages, decreased incomes, and rising taxes rates (in recession governments need to increase transfers and social spending to stay in power while their tax receipts contract) exporters file for bankruptcy as well as firms faced with an increased competition from imports.

 There is no way out of such a dangerous situation without a major return of the Euro price to an equilibrium level with the Dollar and the Yuan, meaning approximately a 1 to 1 parity with the Dollar. The smallish adjustment that followed Mr. Draghi’s mini-cut of interest rates (from 0.5 to 0.25%) is dramatically inadequate to the task. A major correction is, however, “what it takes to save the Euro”, or, more to the point, to ”save the Eurozone economies”, even though even a major external adjustment of the Euro price would not in itself be enough to correct the competitive unbalances between individual countries within the Eurozone. Further corrections of exchanges rates between Italy, Spain, France and Germany would be necessary, on top of a major depreciation of the Euro relative to the dollar (and the Yuan), for these countries to return to sustained growth. Hence the necessary return to national currencies. The price of the currency is not the only determinant of growth of course, but with external prices of national products and services overvalued by 25% or 30% and imports undervalued by the same proportion, no return to growth is possible.

Unfortunately there is a wide and growing divergence about monetary policy within the ECB between representatives of the “north” and of the “south”. It follows that it is likely that ECB’s policy will not be radically changed towards expansion at a time when the US Federal Reserve has delayed the ending of quantitative easing.  These divergences of monetary policies on both sides of the Atlantic prevent any major correction of the Euro’s excessive pricing in the short run while making the euro quite popular with international investors. But the risk is growing that such an unbalance is unsustainable. That’s why the risk ratings of euro debtors are downgraded and it is a sign of further weakness in the Eurozone economies, until a new crisis of the euro, echoing that of last year, returns and compels the eurocrats to adopt some radical new stance.