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November 5, 2009

Economist's View - 6 new articles

Is Market Efficiency the Culprit?

Eugene Fama defends the efficient market hypothesis against the charge that it helped to cause the financial crisis. He says the EMH couldn't have caused the crisis because hardly anyone believes it (of course he still says it's true "for almost all practical purposes" -- clearly one side or the other is deviating from the rational belief):

Q&A: Is Market Efficiency the Culprit?, by Eugene Fama: Justin Fox ("The Myth of the Rational Market") and many other financial writers claim that much of the blame for the financial meltdown is attributable to a misguided faith in market efficiency that encouraged market participants to accept security prices as the best estimate of value rather than conduct their own investigation. Is this a fair assessment? If so, how should policymakers respond? EFF: The premise of the Fox book is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH), which posits that market prices reflect all available information. The claim is that the world's investors and their advisors in the financial industry bought into this model. Because they ceased to investigate the true value of assets, we have been hit with "bubbles" in asset prices. The most recent is the rise and sharp decline in real estate prices which froze financial markets and led to the worst recession since the Great Depression of the 1930s. The book is fun reading, but its main premise is fantasy. Most investing is done by active managers who don't believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. The recent problems of commercial and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finally, MBA students who aspire to high paying positions in the financial industry have a tough time finding a job if they accept the EMH. I continue to believe the EMH is a solid view of the world for almost all practical purposes. But it's pretty clear I'm in the minority. If the EMH took over the investment world, I missed it. The Fox book is an example of a general phenomenon. Finance, financial markets, and financial institutions are in disrepute. The popular story is that together, they caused the current recession. I think one can take an entirely different position: financial markets and financial institutions were casualties rather than the cause of the recession. But suppose we buy into the more common negative current view of finance. There is still a big open question. Beginning in the early 1980s, the developed world and some big players in the developing world experienced a period of extraordinary growth. It's reasonable to argue that in facilitating the flow of world savings to productive uses around the world, financial markets and financial institutions played a big role in this growth. Despite any role of finance in the current recession, are the market naysayers really ready to argue that worldwide wealth would be higher today if financial markets and financial institutions didn't develop as they did?

Toward the end of the book, Fox concludes that passive investing is the right choice for almost all investors. My academic friends in behavioral finance (for example, Richard Thaler) almost always end up with a similar conclusion. In my view, this is an admission that the EMH provides a good view of the world for almost all practical purposes. At which point, I say I won.

[Still traveling, but this one's live.]

Update: Justin Fox responds.

Update: Paul Krugman comments on the assertions about growth in developing countries since 1980.

What's Wrong with Modern Macroeconomics?

The travel references are referring to this. (My first trip to Germany - I set up a bunch of posts before I left - through Sunday just in case - but will add what I can.)

Wal-Mart versus Amazon?

James Surowiecki looks at the latest price war:

Priced to Go, by James Surowiecki: In the spring of 1992, the airline industry ... found itself in the middle of a full-fledged price war. In a matter of months, the airlines collectively lost four billion dollars. ...[A]t bottom it was just like other price wars: all the companies involved got hurt.

So you might wonder why Wal-Mart recently decided to start its own price war, taking on Amazon in the online book market. ...Amazon and Wal-Mart are surely losing money every time they sell one of the discounted titles. The more they sell, the less they make. That doesn't sound like good business.

It's easy to see how price wars get started. In industries where a lot of competitors are selling the same product—mangoes, gasoline, DVD players—price is the easiest way to distinguish yourself. The hope is that if you cut prices enough you can increase your market share, and ... your profits. But this works only if your competitors won't, or can't, follow suit. More likely, they'll cut prices, too, and you'll end up selling the same share of mangoes, only at a lower price...: everyone loses. ...
The best way to win a price war, then, is not to play in the first place. Instead, you can compete in other areas: customer service or quality. Or you can collude...—since overt collusion is usually illegal—you can employ subtler tactics ... like making public statements about the importance of "stable pricing." The idea is to let your competitors know that you're not eager to slash prices—but that, if a price war does start, you'll fight to the bitter end. One way to establish that peace-preserving threat of mutual assured destruction is to commit yourself beforehand, which helps explain why so many retailers promise to match any competitor's advertised price. Consumers view these guarantees as conducive to lower prices. But ... offering a price-matching guarantee should make it less likely that competitors will slash prices, since they know that any cuts they make will immediately be matched. It's the retail version of the doomsday machine.
These tactics and deterrents don't always work, though, which is why price wars keep breaking out. Sometimes it's rational: when a company is genuinely more efficient than its competitors, lowering prices is usually a smart move. (That's how competition is supposed to work.) More often, price wars are reckless gambles. ...
Amazon and Wal-Mart hardly seem reckless, though. So why did they go to war? The answer is that they didn't, really. Sure, Wal-Mart is making a statement that it's a player in the online world, but the real goal of this conflict isn't to lure readers away from Amazon... It's to lure them online, away from big booksellers and other retailers, and then sell them other stuff... It's textbook loss-leader economics. ...

The real competition in this price war is not between Wal-Mart and Amazon but between those behemoths and everyone else—and the damage everyone else is incurring is deliberate, not collateral. Wal-Mart and Amazon have figured out how to fight a price war and win: make sure someone else takes the blows.

[Traveling: Preset to post automatically.]

One more time, is CEO pay justified?: ...

One more time, is CEO pay justified?:

Banker Bonus Rain, by Nancy Folbre, Economix: ...Wall Street firms have always been famous for their generous bonuses to managers and traders — their so-called "rainmakers." The graph ... shows that employee bonuses have actually exceeded the estimated pre-tax profits of United States securities dealers in many years. What is especially striking is the high level of these bonuses in 2007 and 2008, years in which profits were negative. ...
Much of the justification offered for current pay caps in the United States rests on indignation about government bailouts. As long as companies are not subsidized by taxpayer money, perhaps market forces should be allowed to determine pay.
But do market forces determine pay the way most economists assume? Many arguments to the contrary are effectively mobilized by the University of Massachusetts economist James Crotty in a recent working paper.
Top executives of financial firms often choose the very board members who are expected to monitor their pay decisions.
Investment banking is a demanding job. "Rainmakers" typically work long hours under high stress. Yet the number of highly qualified graduates from top colleges eager to enter investment banking has typically far exceeded the demand. Why hasn't the excess of supply over demand failed to drive earnings down?
The importance of personal networks and contacts gives rainmakers leverage. As the Nobel laureate Oliver Williamson emphasizes, the threat of withdrawing from or disrupting productive relationships can give employees considerable power. The apprenticeship structure of the job gives senior managers and traders control over their successors.
The very qualities that contribute to success on the trading floor — including aggressive use of technical expertise — may be deployed in joint efforts to reduce competition from new job entrants...
In any case, highly paid employees in finance earn large premiums compared to their counterparts in other industries — pay differences that persist even when virtually all measurable differences in individual characteristics are taken into account. ...
Deregulation made it easier for rainmakers to conceal risks that short-term profits would morph into long-run losses. The oligopolistic structure of the industry — now more concentrated than ever as a result of bank failures and mergers — made it easier for them to collude.
Financial firms are investing heavily in lobbying to block efforts to make the industry more competitive. Their rainmakers are still pretty good at making rain for one another.

The article doesn't directly answer the question "is CEO pay justified?," but I will. No it isn't, and the way the pay is structured has led to bad incentives within these firms that contributed to our current problems (too much emphasis on short-term profits at the expense of what is best for stockholders in the long-run). There are still a few apologists -- those who argue that CEO pay is justified by their high productivity, i.e. by what they add to the firm, but their numbers are dwindling.

[Traveling: Preset to post automatically.]

"Selling Stocks Short: Ever Controversial"

Why is there so much controversy over short selling?:

Selling stocks short: Ever controversial, by Gerald P. Dwyer, Macroblog: Selling securities short has been a controversial practice as long as financial markets have existed, and the recent financial crisis brought short selling to the fore yet again. In the last week, a bill to impose new restrictions on short selling was introduced.
And earlier this month in its inaugural conference, the Atlanta Fed's new Center for Financial Innovation and Stability (CenFIS) provided a forum for discussing the topic of short selling.
Why does short selling have such a bad reputation? Financial economists generally have a positive view of short selling because short sellers take positions with risk of loss based on their view of a firm's prospects. Some others, though, generally do not take such a benign view of short selling.
Attitudes toward short selling reflect views about speculation. As Stuart Banner notes, a common historical view was that "[s]peculation was both productive and wasteful; it satisfied an evident demand, but its practitioners added no value to the community" (Banner 1998, p. 23). Banning short selling also has a long history. In the United Kingdom, "An act to prevent the infamous practice of stock-jobbing" was passed in 1734, an effort that attempted to ban short selling and was not repealed until 1860. In the United States, contracts to sell stock not owned at the time of sale were unenforceable in New York courts from 1792 to 1858.
Possibly short selling has a bad reputation partly because of its association with "bear raids." A bear raid is a set of trades in which a stock is sold short at a high price, negative rumors are spread to cause the price to fall, and then the short sales are covered by purchasing the stock at the lower price. Some discussions of bear raids suggest that buying stock on the way back up is a way of adding to the raider's profits from manipulating the stock price.
Bear raids are similar to speculators' manipulation of foreign exchange (Friedman 1953). Both are based on attempts to move a financial market price independent of any underlying development. Successful instances of bear raids and exchange-rate manipulation are similar in another way: They are far less frequent than complaints about them.
Selling securities short has a long and controversial history. While it's not clear whether proposed legislation on short selling will be enacted, it's a good bet that short selling's risks and benefits will be debated for quite some time.
Banner, Stuart. 1998. Anglo-American Securities Regulation. Cambridge: Cambridge University Press.

Friedman, Milton. 1953. "The Case for Flexible Exchange Rates." In Essays in Positive Economics, pp. 157-203. Chicago: University of Chicago Press.

[Traveling: Preset to post automatically.]

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