Quotation of the Day…

by Don Boudreaux on June 16, 2011

in Economics, Financial Markets, Prices

… from pages 36-37 of John H. Cochrane, “How Did Paul Krugman Get It So Wrong?Economic Affairs, June 2011 (Vol. 31):

Krugman writes as if the volatility of stock prices alone disproves market efficiency, and believers in efficient marketers [sic] have just ignored it all these years.  This is a canard that Krugman should know better than to pass on, no matter how rhetorically convenient.  There is nothing about ‘efficiency’ that promises ‘stability’.  Stable price growth would in fact be a major violation of efficiency as it would imply easy profits.

Be Sociable, Share!



26 comments    Share Share    Print    Email


Doug June 16, 2011 at 3:15 pm

That article is only available via a pay wall. Kinda hard to evaluate it since it costs money to read….

vidyohs June 16, 2011 at 3:16 pm

Seems not everyone can view the linked article. Sigh, woe woe.

It seems to me that stable price growth would be predictable price growth, and thus not only make for easy profits but non-risky ones at that.

If that were the case everyone would be in a stock showing stable price growth and we would all sit back and be eventually brought to wealth.

How easy and simple is that, how did we miss it?

Iain June 16, 2011 at 3:26 pm

Doesn’t the volatility of the stock market actually prove the efficiency of markets as they respond instantaneously to new information?

Methinks1776 June 16, 2011 at 4:10 pm

In general, yes. That prices move around means that new information is being priced in.

On the other hand, a lot of volatility could indicate inefficiency – for instance, low liquidity or perversions in the market resulting from trading prohibitions imposed by regulators (note the flash crash, stock specific flash crashes since, and the drop in the price of silver recently for instance).

Price stability is not the point of public securities markets. Liquidity (which lowers volatility, btw) and price discovery is.

Dave June 16, 2011 at 3:27 pm

I’m all for kicking Krugman for not understanding stuff (like economics, for instance), but I didn’t think Austrians (or bloggers who name their site after one) were beholden to EMH either…

Rick Hull June 16, 2011 at 3:39 pm

My understanding is that EMH is a theoretical underpinning of Chicago / Monetarist thinking. So if EMH can be undermined, then that whole school goes away. I think Austrians are sympathetic to EMH and likely wholly accept it in a praxeological formation. But Austrians pin their understanding on acting man, and if EMH results from acting man, then so be it.

Methinks1776 June 16, 2011 at 4:17 pm

I don’t know if I understand you correctly.

As one of my bosses (an oil options arbitrageur) said to me many years ago “If markets were not efficient in the long run, we wouldn’t make any money. If markets were efficient in the short run, we wouldn’t make any money.”

Markets are not strong efficient (non-public information is not priced in and not all assets enjoy enough liquidity to trade at fair), but unless there’s a structural problem with the market (for instance, people are prevented from trading with each other because of various laws or a lack of technology), they are pretty efficient and arbitrageurs ensure that they remain so by profiting from price deviations. That drive to profit from inefficiencies results in more efficient markets. This, too me, seems consistent with what you’re presenting as the Austrian view on efficient markets, Rick.

Ameet June 16, 2011 at 4:42 pm

Or, in the words of Ben Graham: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

Rick Hull June 16, 2011 at 4:55 pm

> That drive to profit from inefficiencies results in more efficient markets. This, too me, seems consistent with what you’re presenting as the Austrian view on efficient markets, Rick.

Yep, pretty much. I don’t have a great grasp on EMH, in strong or weak form. I think that Austrians agree with EMH generally and informally. I suspect there is a devil some of the details, depending on exactly how it is formulated. And there are attacks on formal EMH that may or may not be easily dismissed. But these attacks are a concern more for the Chicago school than Austrian.

This is certainly not an area of rigorous study for me. Just a would-be-scholar’s understanding…

Economic Freedom June 16, 2011 at 9:14 pm

I think that Austrians agree with EMH generally and informally.

Not really. See this downloadable PDF by Frank Shostak from the Mises Institute:

“In Defense of Fundamental Analysis:
A Critique of the Efficient Market Hypothesis”

AC June 16, 2011 at 3:44 pm

Boo, inefficient journal access.

AC June 16, 2011 at 4:14 pm

You can get a copy from Cochrane’s web site:

mcwop June 16, 2011 at 4:16 pm

I hate the term “efficient” or “inefficient” used in conjunction with markets. You either have a market or you do not. Markets are neither efficient or inefficient, they are profitable or not, emerging, commoditized, and pricing can be volatile or stable based on demand characteristics and/or barriers.

Ameet June 16, 2011 at 4:46 pm

Personally, I like the use of “efficient” for markets, even though value investors seem to dislike EMH (though they rely on markets being efficient at recognizing value in the long term), because markets in general are more efficient at allocating scarce resources than the government is.

Chris O'Leary June 16, 2011 at 4:52 pm

Reminds me of the fact that disease clusters are exactly what you would expect in a natural system; completely uniform distributions are much more unlikely, if you think about it.

Complete stability might make some logical sense, but it’s not a common characteristic of a living system.

Only dead ones.

Gordon Richens June 16, 2011 at 4:58 pm

The only proof I need that the markets are inefficient is the fact that I am a participant.

WhiskeyJim June 16, 2011 at 6:00 pm

I’ve always been confused by the efficient market hypothesis, the idea of the ‘rational’ market, and what seems to me to be attempts to relate the ‘invisible hand’ to such constructs.

Markets are much more like a rich dotty old man who on any given day, depending on prevailing ‘wisdom,’ chooses to sell his goods either very expensively or very cheap.

That markets are by their inherent structure immensely irrational is what makes free markets so innovative, exploring, and yes, creatively destructive and efficient over time. They by their nature explore new ideas which turn out to be either wrong or right.

I do not understand how economists from any school could entertain any ‘rational’ hypothesis of markets. That it is has been used as a critique of ‘free markets’ since the financial collapse is lunacy.

That super humans can regulate ‘rationality’ is even worse. In ‘Animal Spirits,’ the argument is that we need regulation to offset our irrationality. On the contrary, it was ‘rationality’ that brought us price controls. It was irrationality, against all common wisdom and payback models, that brought us personal computers.

Ken June 16, 2011 at 6:17 pm


Rational markets/expectation “states that agents’ predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random.” The way I think about it is that I act in my own self interest, i.e., rationally. I don’t do things that I think will hurt me or go against my self interest. And there are plenty of trade offs to be made. Of course, I could be wrong about any particular decision, but bad decisions lead to good decisions due to a learning process, so I won’t be wrong systematically.

Thinking of markets as a single person acting one way today and differently tomorrow seems wrong. Markets are collections of people acting in their own self interest, not collections of people acting collectively in concert; when I go to Target to buy something, it is independent of the reasons everyone else is there. Some may be wrong at time, but not systematically. The errors made are spread randomly across all decision makers in the market.


WhiskeyJim June 16, 2011 at 9:11 pm

Thank you Ken. My rambling point is this; today’s commonly held beliefs and self-interested rationality, which as a collection forms a market ‘trend,’ is often tomorrow’s irrationality. That causes great market volatility and even bankruptcy.

To call such a market ‘rational’ does not seem rational to me.

Sure, people do what is in their ‘best interest.’ If I spend $300k on my house to make my wife happy, and leave 2 bathrooms unfinished while building a pool while the hot tub doesn’t work, then have to sell my house for $250k because my wife leaves me, I have always acted in my self-interest. But in terms of the housing market, and my own small market in self-viability, I have been anything but rational.

Whole industries have acted in their self-interest while ending up being totally irrational. If we call a market rational because at any point in time individual actors believe they are being rational at the time, I propose we are saying nothing at all.

I obviously need to sort out the terms to better explain this.. sorry.

Ken June 16, 2011 at 10:18 pm


I see what you’re saying, but keep in mind when talking about housing markets that the government has been actively and massively distorting the markets. If the price of something goes up, this is a clear signal to start producing more; however, the increase in housing prices wasn’t a natural reflection of housing demand. The government was actively diverting resources into the housing market by creating incentives for people to buy homes. This created an artificial demand, creating artificially high prices, sending the absolute wrong signal to home builders to build more homes.

Finally, when the corruption of it all sank it, since no more resources could be diverted into the housing market, the market started to normalize and reflect the natural demand for housing. Well the difference between the natural level of demand compared to the artificial levels created by government intervention turned out to be huge.

“If we call a market rational because at any point in time individual actors believe they are being rational at the time, I propose we are saying nothing at all.”

That’s not what I was saying; I understand rereading my post what a tautology my comment looked like. What I was saying is that when people think they are acting in their own self interest, they typically are. Bad decisions and bad luck happen all the time, but having made bad decisions before, and learning from other people’s mistakes, people learn and start making better decisions. As they start to make better decisions, what people think is in their self-interest actually is. Since people learn and get better at acting in their own self interest, we can expect people in general to actually be acting in their own self interest.

The occurances where people’s decisions will not be in their interest can be regarded as random fluctuations within a population. Systematic bad decisions like the one in the recent housing market are aberations and typically reflect distortions in the market. Also, keep in mind that most (in the mid to hi 90th percentile) people still are quite capable of affording their homes. So even with massive distortions people in general still make decisions that actually are in their best interest.


WhiskeyJim June 17, 2011 at 2:37 pm

I appreciate your helpful thoughts. Allow me to test your patience by stepping back –

Is it possible we are speaking of two different aspects of markets; you the data sets, me, the underlying constructs?

We can in some sense say that market data on the whole is the product of rationality, describing rationality as deviancy from the normative distribution. We can assess the utility of that rationality in that unemployment is dropping, or GDP is returning to historic rates, or that PE’s are coming into line with past trends.

But the fact is that the underlying businesses, their relationships, and their structures, are all unique and contextually driven. Markets will never be the same as they were 20 years or even 2 years ago. Over time, that unique evolution matters, and it can not be predicted without understanding the system’s interaction with its particular context or landscape, and how that interaction has a recursive effect on both; the interface between landscape and the complex organism defines its existence and adaptation.

The general failure of metrics in economics is not so much that it depends on a utility function as that it concentrates on the meta-data rather than the evolving relationships of the actors themselves. I argue that economic models must include those changing relationships because they define the organism.

I submit it is more accurate to say that markets, like any complex system, search and evolve in a context-driven actualization of their potential, and that distortions are part of the way they search, and not very effectively. But then, that is like saying that creativity and innovation or evolution is messy, when of course it is. Markets, like ants foraging for food, grope more than they plan. Further, concepts of equilibrium and rationality obstruct what is actually occurring; the system is evolving, not moving in and out of stasis.

Consider this; we are always learning, so the day of ‘rationality’ never arrives. Today’s rationality is tomorrow’s irrationality. For example, the housing market will continue to fall until it clears, including the debt that saving the banks delayed. Then it will flatten and begin again to generally rise. At what point is it constructive to call the resulting price graph ‘rational’ or driven by rationality, other than to say that the market (and its individual actors) is continually searching for survival and adapting to optimize its existence? In so doing, the complex organism itself changes the landscape in which it operates, including its perception of it (the housing market could easily become unsustainable without stupid government interventions). That we can compare how past housing markets resolved using metrics will only be partially accurate in that underlying contexts and the market itself have changed in ways we can not quantify.

Complexity is in my mind the greatest argument for free markets and bankruptcy because the alternatives delay the learning and creative process, which is painful and ugly and beautiful enough as it is. We reject government meddling not so much because it does not maximize Pareto outcomes due to the self-preservative aspects of beuraucracy, but because it preserves current states and delays adaptation (which in biology is called evolution), and in business is called creative destruction (which is a redundant term; creativity implies destruction of what went before). Kling’s idea of PSST in this context makes all the sense in the world.

We can never ‘go back’ any more than we can revert to Cro-magnon man. That is not a function of rationality. It is a function of adaptation.

Am I arguing semantics?

Chucklehead June 17, 2011 at 3:36 am

Since value is subjective, a market is never 100% correct, but is always self correcting. Like a pendulum swinging, once it corrects to much, the rate of change diminishes until it reverses.
The efficient market hypothesis relies on the law of large numbers, and can only work in a macro sense with lots of data points.
Okay this is B.S., but its all I got.

Ironman June 17, 2011 at 12:09 am

“Efficient” and “volatility” are the wrong words to describe how stock prices come to be. Substitute “chaotic” and “occasionally really noisy” and you will have a better picture of what’s really going on under the market’s hood.

Ref: http://tinyurl.com/3ln3por

Lionel from France June 17, 2011 at 4:32 am

Cochrane is absolutely right.

n2k June 17, 2011 at 10:10 am

Efficiency is a function of the time, effort (number of contacts required), and cost necessary to complete a transaction with little correlation to price volatility.

Volatility is more a function of “randomness.” Randomness is the range of variability of a complex adaptive system. The primary concern is to determine how wide the tolerances (trading range) may be without affecting the outcome of commercial activity by specifying the largest possible tolerance that preserves functionality. Tighter tolerances are more difficult to achieve but enhance the quality while looser tolerances are easier to achieve but may adversely affect the operation. In determining the degree of randomness the component parameters of predictability and risk can be bounded (hedged and insured) whereas the component of uncertainty cannot be bounded (only insured) with any degree of precision. But uncertainty must be considered. Ignoring uncertainty is done at one’s own peril (no-money down NINJA MBSs). I argue that one-size-fits-all governance metrics are too loose an operational tolerance to be functional because they lack clarity and precision due to non-correlative information such as Too-Big-To-Fail (TBTF) financial institutions that are, in reality, Too-Random-To-Regulate (TRTR).

STATISTICULOUS June 17, 2011 at 11:10 am

The question is: Efficient compared to what? Compared with any other means of exchange or pricing, it’s incredibly efficient. Theoretically, it’s probably more of the weak case of efficiency- some inefficiencies can occur (bubbles and cycles etc.) but the best way of allowing for correction is to allow for market adjustment. ie let bubbles burst and losses be felt. It is the attempt at socializing losses that cause structural inefficiencies.

Previous post:

Next post: