Rare disasters and the efficient markets hypothesis

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One common strand in financial economics research is that financial markets are not perfectly efficient, i.e. they do not immediately and consistently incorporate all facts about the world in prices. I have several feeds set up for new papers in the area and at least five new papers come out each week finding that while markets are far more efficient than random, there are a number of departures from perfect efficiency.

I had always wondered why this was true: surely if there really are all these easily-exploitable bets then there would be at least some market participants who would exploit the hell out of them. Markets do not come to rest at the median view of everyone, but the position where no one wants to trade—so it doesn't matter if most people are 'behavioural'.

If the inefficiencies—i.e. prices that differ from fundamental values—cannot be bet on then there's a question of why: if it's down to regulation then that's hardly surprising and doesn't really tell us anything about markets; if it's down to the (non-regulatory) cost of trading then it's not an inefficiency. It's more socially efficient all things considered to not trade on those inefficiencies—i.e. the social benefits of getting to the true price are outweighed by the social costs needed to get there.

Well a new paper seems to give a strong undergirding to my thoughts here. Entitled "Disaster risk and its implications for asset pricing" (pdf) and authored by Jerry Tsai and Jessica Wachter (hat tip to Robin Hanson), it says that most of these inconsistencies are parsimoniously accounted for by the risks of catastrophic disasters like the Great Depression.

These make certain sorts of assets (like stocks) less attractive by dint of the fact there is a very small chance that they might tank a huge amount. Otherwise there seems to be a big puzzle why stocks return so much more than bonds.

After laying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this paper we survey recent models of disaster risk that provide explanations for the equity premium puzzle, the volatility puzzle, return predictability and other features of the aggregate stock market. We show how these models can also explain violations of the expectations hypothesis in bond pricing, and the implied volatility skew in option pricing. We review both modeling techniques and results and consider both endowment and production economies. We show that these models provide a parsimonious and unifying framework for understanding puzzles in asset pricing.

This probably leaves a few market puzzles unexplained—perhaps many—but I expect these may eventually yield simple, plausible and efficiency-preserving explanations. As Eugene Fama points out in a brilliantly clear introduction to and history of the EMH it is very hard to test market efficiency since you must always make assumptions about risk at the same time.

Economic Nonsense: 2. Some prices should be legally capped

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Prices do more than tell us how much we have to pay for things; they also convey important information that motivates people to act.  When prices rise for things in short supply, they tempt producers to bring more supply onto the market, alleviating the shortage.  Prices motivate people to put investment into particular sectors of the market, raising future supply there. Governments since that of Hammurabi over 4,000 years ago have at times sought to fix prices, often in response to political pressures: the Adam Smith Institute's Director, Dr. Eamonn Butler, examined the history of this kind of price fixing in Forty Centuries of Wage and Price Controls.  When prices are fixed, however, their role as conveyors of information is lost, and their ability to motivate people to act is compromised.

If energy prices, for example, were fixed, it would make energy less attractive as an investment, reducing the future supply of it and perhaps leading to blackouts.

Fixing the price of rents is popular with current tenants, but it will limit the future supply of rental property.  Rents set artificially below market rates leads to poor maintenance as landlords no longer have the same incentive to maintain and renovate properties.  Fixed rents attract fewer people to rent out property, and encourage landlords to take properties off the rental market.  The Swedish economist, Assar Lindbeck, famously said  "next to bombing, rent control seems in many cases to be the most efficient technique so far known for destroying cities."  It could be argued that it is more effective, since bombing takes out demand as well as supply.

The market has many self-correcting mechanisms that price controls prevent coming into play.  The high prices caused by shortages tell more producers to enter the market; the low prices caused by gluts lead them to direct their resources elsewhere.  This activity depends on the flow of information that prices generate, a flow that is stopped when prices are fixed by law.

When the typo reveals something of interest

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It is, of course, jejeune to mock today's newspapers for having typos in headlines. For while the near total absence of subeditors does lead to such errors things were not so much better in the past. Private Eye has been calling it the Grauniad for years as a result of that paper (and PE does swear that it was true although others are more sceptical) managing to misspell its own masthead one day. But this link to a Boris Johnson column is particularly delicious:

Capitalism can same lives: Ed doesn't get that

By the time you read this we're sure it will have been changed. But the joy of this is that it's exactly capitalism that not only saves lives, as Johnson avers, but also capitalism and its handmaiden, free markets, that vary lives. It's socialism and planning that produces the monotony. Eastern Europe (and parts of the UK sadly) is littered with concrete monstrosities, stack a prole worker flats (panelaki in Czech, Brezneviki in Russian, horrible in every language) where the indistinguishable masses were to live their indistinguishable lives between indistinguishable walls. Venezuela's Bolivarian socialism has brought the monotony of no toilet paper for anyone to all.

That people can make a shilling or two by catering to niche tastes, that a way to make further profits is to slice and dice and vary one's offerings is precisely what does produce the variety that the modern market economy offers. Depending upon who you believe the island of Manhattan currently has 1 billion or 10 billion different items offered for sale, right now. This is a cornucopia of choice that no planned economy has ever managed to produce. And it's also a complexity that no planned economy could ever deal with: there's simply not enough computing power available to us to be able to calculate the interactions between that many items.

As with the phrase in vino veritas, or the way that a slip of the tongue can reveal the inner complexity of thought, so sometimes a typo can be an instructive mistake, making us think about the underlying point. The very joy of capitalism is that it doesn't "same" lives, it's the dead hand of the state that does that.

Economic Nonsense: 1. Self-sufficiency and buying locally are beneficial

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No, the reverse is true.  Depending on others for some of our needs and having access to goods from distant markets are beneficial, whereas self-sufficiency and localism usually leave people poorer.  When we buy things from others we have access to their skills and specializations, skills that can make goods better and cheaper than we could make ourselves. Households that make their own clothes and pottery are poorer than those that can buy cheaper, mass-produced goods.  It takes them more time and more resources than it takes producers who specialize.  The same is true on a larger scale for communities and nations.  Buying from others and buying from outsiders leaves people richer.

People who can buy from distant sellers can buy more cheaply, and are richer by the money they save.  Requiring people to buy locally often means making them pay more than they would otherwise need to, leaving them less money to spend on other things.

When governments of developing countries impose tariffs and quotas on imported goods in the name of "protecting infant industries" they are making their citizens pay more than they need to.  A prohibitive tariff on imported US tractors, for example, means that farmers have to pay more for locally-produced ones, making their produce more expensive.  The protected local tractor makers benefit, of course, but it is at the expense of local buyers.  The process opens up opportunities for corruption and cronyism as local producers lobby, and occasionally bribe, ministers to impose such "protection."

Wealth is created by trade and exchange, and is increased when they are increased.  Self-sufficiency and buying locally both introduce restraints on trade and exchange and lead to people being poorer than they need to be.  They are not beneficial.

The nanny state's children

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Scotland is seeing a hasty transfer of power from the people to the state. And a few components, including the SNP's unfaltering support from pro-independence voters that they expect to rely on for the near future, are making the transition happen with ease. Even in the face of a growing number of universally free things to adjust people to the state making our financial decisions, nothing of late has quite managed to reach the blatant level of state intrusion and awaken in people such fervent objection as the “named person” law.

This “service” means named persons will be assigned by the state to every child in the country until the age of 18. It is now set to be enforced in 2016 after the Children and Young People (Scotland) Act 2014 passed its final stages as a bill in the Scottish Parliament last year. Social workers, health workers and school teachers acting in a dual capacity of both their profession and as state informants, will have legal responsibilities that can rival those of the parent, while powers to intervene in private life and share personal information with government agencies will be handed to the state.

Educational charities and parents have joined forces under the banner of the NO2NP campaign and last week sought judicial review of the decision to enforce this law. By its opponents, the move is believed to be outwith the government’s legislative competence and to be incompatible with data protection rights and rights afforded to every citizen by the European Convention of Human Rights. In the judgement Lord Pentland said that the challenge brought before the Outer House of the Court of Session “failed on all points”, and approved the legislation. The campaigners expected there would be more than one hearing and so are not defeated as they consider their next legal steps to be heard by at least three judges in the Inner House.

It is important this policy is universal, proponents tell us, because children with additional support needs are not always immediately obvious to services and so this can ensure that intervention happens earlier to prevent crises at later stages in children's lives. A justification that has failed to quieten or satisfy parents’ concerns. But the creators of the legislation want to see it implemented at any expense. Even if it means creating bitter resentment among the vast majority of parents who are getting things right and do not want a named person overseeing everything they are doing. 

State-dictated outcomes are presupposed to be superior to all else by the legislation. But parents do not necessarily agree. The one-size-fits-all approach neglects to consider the fact that parenting is unique to each family. Should "named persons", who don’t know children well, be given the authority to have a greater say than parents - in the eyes of the law - as to what their children ought to be doing then circumstances and behaviours may be misconstrued, leading to unwarranted consequences. It is understandable that more and more parents are viewing the legislation as a breach of their human rights. Their children are being assigned an informant to the state without the option to opt out.

The impact on parents is one thing. But teachers, too, who are required to be instrumental in this new dynamic, have no say nor even a choice in the matter. It has not been made clear when an educator stops being an educator and assumes the roles and responsibilities of the named person. 

So when parents become suspicious of who they reveal information to, for fear that they are confiding in a middle-man between them and some investigator higher in the chain, more harm than good will be done. An environment of mistrust conducive to relationship breakdowns will be created. Not to mention the added time pressures and weight on teachers’ shoulders that the extra duties carry.

Early signs of the ostracising effects it will have are already visible in the Highlands where people were surprised to find it had been prematurely implemented as part of a pilot scheme. We are also seeing the wasted expenditure that this will entail, as referrals to services have risen. 

To make social workers responsible for a population’s children is a costly blanket bureaucracy. And at a time when public services are under severe strain, it is ill-conceived that scarce resources should be drawn from the most vulnerable and urgent cases in order to pry on the 95% of families this legislation will never be necessary for. The case may have failed on all points thus far, but it is in the lack of justification by those behind it where we discover the greatest weaknesses.

Most strikingly important, though, is that every parent from the offset is being treated as potentially guilty of something until proven innocent. And they have to keep on proving their innocence until their child is an adult. It is a sinister state of affairs, indeed, when the onus lies on the general public to prove why we do not want legislation imposed on us.

Paternity leave: interrogating the evidence

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Labour pledges to double paid paternity leave from two weeks to four weeks, and increase statutory paternity pay from £120pw to £260pw. We can do simple reasoning about the short- and long-term effects: to begin with it's a benefit for workers, and then contracts adjust to take it into account as they are re-negotiated across the economy. Since it costs the firm more than it's worth to workers wages go down by more than the benefit, workers lose out and firms may lose out.

But maybe there are positive externalities—i.e. even though the workers are more or less bound to lose out, maybe there are benefits to other people (like their children, their families, or society) that are not accounted for in their market decisions there.

Thankfully we have evidence from other countries, principally Scandinavia, as to what effects. These reforms might have. A 2011 paper looking at the Norwegian reforms found that they did nothing to affect labour market outcomes (and may have widened the division between men and women) and nothing to affect kids' schooling outcomes.

However a 2010 paper (newer, gated version), also looking at the Norwegian reform, found that extra paternity leave led to extra long-term involvement with children, to the detriment of their labour market outcomes—lifetime earnings dropped 2.1%.

Other evidence suggests that paternity reforms affect the household division of labour, making it more egalitarian, in a way that lasts. Iceland evidence suggests this leads to lower divorces and narrower wage divides twixt men and women.

The literature on maternity leave has a similar result: it worsens women's labour market outcomes but has no effect on children's outcomes.

In general we see roughly the same results for men as for women but the case is not open and shut—if people have a strong preference for women and men to be have more similar careers then the external benefits may outweigh the cost to the affected workers.

Nominal GDP targeting constituency on the rise

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Just as the ASI releases a new paper on the benefits of nominal GDP level targeting over inflation targeting, two economists at the Harvard Kennedy School have a new paper on its benefits in developing countries. They join a chorus saying nominal GDP targeting—stabilising the total amount of spending in the economy instead of an index of prices like we currently do with inflation targeting—may outperform the status quo.

Entitled "Nominal GDP Targeting for Developing Countries", helpfully, and written by Pranjul Bhandari and Jeffrey Frankel, it explains how inflation targeting fares poorly when there are large supply-side shocks.

Interest in nominal GDP (NGDP) targeting has come in the context of large advanced economies. Developing countries are better suited for it, however, in light of big supply shocks and terms of trade shocks, such as monsoon rains and oil import price shocks in the case of India. Under annual inflation targeting (IT), the full impact of adverse supply shocks is felt as lost real GDP. NGDP targeting automatically accommodates such shocks, while retaining the advantage of anchoring expectations. We derive the condition under which NGDP targeting would dominate other regimes such as annual IT, to achieve objectives of output and price stability. We estimate key parameters for the case of India and conclude that the condition may indeed hold.

The paper is mainly a restatement of common points in nominal GDP targeting's favour; indeed it leaves out many of the crucial elements of NGDPLT as I see it—using market measures of expectations, targeting the forecast rather than the out-turn, doing policy more automatically than leaving it down to central bankers.

The real point of interest is just how many papers coming out are considering nominal GDP targeting or advocating for it, compared to inflation targeting or other policy rules. It suggests to me, like Prof. Sumner has been saying, that perhaps we are seeing 'the NGDP moment'.

New ASI paper: The real problem was nominal

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The edited text of Prof. Scott Sumner's 2014 Adam Smith Lecture, "The Real Problem Was Nominal" explaining how central banks caused the great recession, has been published as a new ASI report this morning.

Prof. Scott Sumner, who inspired the US programme of QE3 and was dubbed ‘the blogger who saved the US economy’ by The Atlantic, explains how central banks—not bankers—caused the 2007-8 crash. He goes on further, showing how the European Central Bank is repeating the mistakes the Fed and the Bank of England made in the dark days. And he argues that they can solve the slump and prevent future crises with a market-based, rule-based, stability-focused monetary policy of targeting the level of  nominal GDP.

Here is a link to the full pdf.

Killing the myth of the anomie of modern life once and for all

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An interesting little paper regarding the rise of most of the population up out of blue collar jobs into white collar ones. Or, as we might also put it, from proletariat to bourgeiosie:

Rising individualism in the United States over the last 150 years is mainly associated with a societal shift toward more white-collar occupations, according to new research published in Psychological Science, a journal of the Association for Psychological Science. The study, which looked at various cultural indicators -- including word usage in books, trends in baby names, and shifts in family structure -- suggests that a shift toward greater individualism is systematically correlated with socioeconomic trends, but not with trends in urbanization or environmental demands such as frequency of diseases or disasters.

"Across many markers of individualism, social class was the only factor that systematically preceded changes in individualism over time, tentatively suggesting a causal relationship between them," explains psychological scientist and study author Igor Grossmann of the University of Waterloo.

Both Adam Smith and Karl Marx warned about the problems of the "excessive" division of labour. Smith pointed out that the man who performed the same boring task again and again might become brutalised to the point of being a beast. And Marx certainly railed against the boredom of industrial work: what later became known as anomie. The interesting thing about this finding is that it's telling us that the death of those industrial jobs in the boring factories is actually the cure for this.

"We were surprised that only one of the six tested cultural psychological theories was any good for statistically predicting changes in US individualism over time," says Grossmann. "The only theoretical claim that we found systematic support for is the one suggesting that the rise in individualism is due to societal changes in social class, from blue collar to white collar occupations."

So as we all move from those factory jobs into service ones we seem to all be getting richer, that's certainly the experience of the past century. Plus we all seem to be gaining greater liberty to live our lives as we would wish (that is indeed the same thing as individuality). Plus, of course, we all get to do indoor work with no heavy lifting.

Difficult to see what is wrong with this really. But perhaps the most important point is that that anomie is decreasing, that brutalism that was warned against. The good old days really are right now.