Saturday, August 08, 2009

Krugman Reviews Book He Didn't Read

I read the cover of Justin Fox's Myth of the Rational Market, and wrote a blog post defending the 'efficient markets hypothesis'. Justin Fox noted that I didn't read his book, because if I did he would have noted Fox's rather balanced treatment. True enough. So I read his book, and actually liked it a great deal. I debated Fox in a very collegial Blog War. He presents both sides in his book, and basically gives one a lot of color on the milieu and personalities involved in the debate. But basically, he says this guy (eg, Fama) thinks markets should be called efficient, and this other guy (eg, Dick Thaler) thinks markets should be called 'inefficient'. But Fox does not draw any such conclusion himself, or give one data to suggest one side is generally right. People disagree, pointing to various evidence as definitive, evidence the other side thinks is more anecdotal or irrelevant. Ships passing in the night, as in most big debates.

So it was fun, knowing so much about 'efficient markets', how extremely hard it is to generate alpha, and reading Fox's book carefully (I read it again for my blog war), to read Paul Krugman's review of Fox's book in the New York Times. In it, Krugman demonstrates he has strong opinions disproportionate to any evidence, and displays the measured analysis of an anonymous blog commenter.

In this sense, efficient-market acolytes were like any other academic movement. But unlike, say, deconstructionist literary theorists, finance professors had an enormous impact on the business world — and, not incidentally, some of them made a lot of money in the process.

This is pure ad hominem, that EHM believers are simply believe in 'efficient markets' because they can brow-beat businesses into paying them a lot of money consulting. It is not an argument, and Krugman is no one to talk. He received $50k as a consultant for Enron before this fraudulent entity blew up, probably for classic perfunctory work that big name consultants do. I used to work at Moody's, and know he got paid a good chunk for a day's work, giving a cliche-ridden seminar on economics and meeting executives, around 2000. Who knows how many companies paid Krugman for such services. Why do you think so many make big bucks giving speeches to big companies? It's stupid, easy work, flattering powerful people in that disengenous way the muck-raking intellegentsia does. I'm not saying I wouldn't take $50k to tell Google how incredibly smart they all are (as evidenced by hiring me to tell them so). I'm just saying I wouldn't say the essense of those who disagree with me is they are craven, monied interests with ties to big business, as if that really sheds any light on anything but myself.
The quintessential collaboration between big money and academic superstars was the hedge fund Long-Term Capital Management, whose partners included Scholes and Robert Merton, with whom Scholes shared another finance Nobel. L.T.C.M. eventually imploded, nearly taking the world economy down with it. But efficient-markets theory retained its hold on financial thought.
If he actually knew something about hedge funds in general, or LTCM in particular, he would know that Merton and Scholes where marketing props. The strategies LTCM employed were neither derived by, or managed by Scholes and Merton. The LTCM strategy had nothing to do with a tweak to the Black-Scholes option formula.
Lawrence Summers, now a senior official in the Obama administration, began a paper on financial markets thus: “THERE ARE IDIOTS. Look around.” And a whole counter culture emerged in the form of “behavioral finance,” which argued that investors are irrational in predictable ways.
And here is the essense of Krugman. THERE ARE IDIOTS. All caps, to emphasize the screaming. He thinks those who disagree with him are lying bastards (such as those who take money from companies consulting), or those who just don't have his IQ. Idiots and/or liars. There's no other reason to disagree with him on policy.

There are two ways to think about markets. In one, the market is an idiot, like people who aren't smart enough to have PhDs in economics from MIT. Prices are thus invariably too low or too high. Pray tell, can you tell me a specific market price today that is too high or too low? No? Ok, lecture me again on AOL circa 1999, housing in 2006, or RCA in 1929. Boring! It is much smarter to approach markets as if markets are rational. As there are literally thousands of prices in thousands of markets, some are too low or too high, but it is not obvious which because most are priced 'just right' given the information available. If you think it is easy, as implied by an irrational market, you don't check your assumptions enough. Several, perhaps hundreds, prices are wrong, but it takes a lot of smart analysis to figure out which.

Now, this would all be typical Krugman overreach, except that he is reviewing Fox's book, Myth of the Rational Market, which as Fox noted responding to my negative comments, if you actually read you will find is a very balanced portrait of efficient markets. Good point. 'Don't judge a book by its cover', is actually a good cliche. You don't learn in there that markets are 'irrational', or that those creating that theory were biased, lazy, bought, or otherwise infringed. But clearly Krugman just takes the title and says here's another brick in my case why we need more government.
Justin Fox’s “Myth of the Rational Market” brilliantly tells the story of how that edifice [efficient markets] was built — and why so few were willing to acknowledge that it was a house built on sand.
I doubt Krugman read past page 2, because nowhere does Fox state that the EMH is a house of sand, metaphorically or otherwise. The theory has esteemed detractors, but that's about it. Indeed, it seems ultimately a semantics debate (ie, 'efficient' implies 'perfect' to some).

I also doubt Fox will have a problem with Krugman's review because a NY Times review from a famous intellectual is always welcomed, even if totally off base. I would like to think that if a famous person reviewed Finding Alpha, and praised it to high heaven for something I did not say or intend, I would note I appreciate the love, but must correct my reviewer (alas, I'm untested).

If I could fault Fox's book it would be twofold. First, it is a highly limited book, adding narrative, but no constructive argument to either side in the debate. Such a book has its place on the bookshelf, but it is not part of the intellectual debate, more like learning about Hitler's childhood, which is interesting but really doesn't explain the concentration camps or Operation Barbarossa. Secondly, Fox's book title and its jacket, leads to this kind of interpretation, and when interviewed he encourages this interpretation from overzealous interviewers. This is intellectually dishonest, because it merely plays into the inconsistent opinion that markets are stupid by those same professionals that said absolutely nothing about weakening mortgage standards prior to 2007 (to take one example). For Mark Haynes, bloviator general on CNBC, to spout markets are inefficient takes a lot of chutzpah, because he sure had the motive, means, and opportunity, to set the market straight in the past two bubbles, but merely cheered them on, then after the collapse says 'It was so obvious!' It's pathetic.

Krugman thinks that a major intellectual debate is as simple as one side having bad intelligence or bad faith. This is a stupid way to view such disagreements, one Krugman makes repeatedly in his prominent screeds. As Oscar Wilde states 'Education is an admirable thing, but is well to remember from time to time that nothing that is worth knowing can be taught.' I understand the paradox of not being able to teach creativity, but one would think educated people could learn temperament and humility are part of wisdom,. Unfortunately, esteemed intellectuals lack these virtues in spades, making them disproportionately moronic.


Anonymous said...

let's go with majority rule to determine whether an assertion/opinion is correct...john mauldin piles on the emh in his most recent rant ( it's in print it must be true...

David said...

Generally I don't mind Mauldin, but his latest piece was disappointing. I've sent him a couple of Eric's links, but don't expect much.

dan said...

The problem is that people are arguing about EMH without defining it. Everyone has their own definition and according which EMH is either definitely right or definitely wrong. If the definition is: 'prices reflect all available public information', I don't think there is any way to test it.

Now, if you believe as a consequence of EMH (as Fama does) that prices reflect the best estimate of intrinsic value, then you got a problem. The fact that you cannot make money from irrationality of markets (or Larry Summer's idiots) is irrelevant. I knew was overpriced and that it did not reflect 'intrinsic value', yet I lost money because markets irrationality continued. I've been complaining about a real estate bubble for the past 5 years. Thank god, I did not act on my intuition because I would have gone bankrupt long before being proven right and making money.

There are many reasons that make it impossible to take advantage of market manias or panics. You need a lot of capital, the strategies are hard to market (I remember Buffet heavily criticized when he refused to invest in internet companies during the bubble), but most importantly market irrationality is impossible to model, time and predict (the so called noise trader risk). Think of price having two components one rational or fundamental component and an irrational component that is impossible to predict. The second component will not be any different than random noise. So, just because you would not have been able to make money from collapse, does not mean that the price was correct and reflected intrinsic value. That seems to be your argument and doesn't make intuitive sense.

Also, if you follow Fama, where do you draw the line? If prices reflect intrinsic value and that the market is 'right', then the only reason you would have high returns is because of high risk.

That seems to be the intuition behind Fama's metaphysical risk factors. You either have to tie returns to some sort of a behavioral story or to fundamental (perhaps unoberservable) risk.

J Mann said...

Dan, if you (an individual investor) can't make money from the irrationality of markets, that's one thing. But are you really saying that (1) market irrationality is knowable but (2) even highly capitalized, long term funds can't make money from that knowable irrationality?

dan said...

Yes, and there are a few reasons for this: First, there are legitimate market frictions such as short constraints. Second you need a lot of capital (as Keynes said the market can stay irrational longer than you can stay solvent). Third, these strategies are extremely risky. Soros' Quantum fund lost $700 million (when 700M was a lot of money) shorting Nasdaq too soon. They would have made billions had they kept that position for another quarter, but they had to close it down after heavy loses. Finally, these strategies are hard to market. During the bubble, it was much easier to find investors for a fund focused on dot-com stocks than a fund focused on long term growth. As I said even Buffet received heavy criticism for not participating in the bubble.

So if anything it's easier for an individual investor to invest in market 'irrationality'. You still face the same risk, but don't have to worry about outflows, margin calls, or investors calling up asking why the fund is down 90% betting on a bubble at the wrong time. I don't think they'll take the explanation 'market will revert back to fundamentals long term' too well.

Bruschettaboy said...

If he actually knew something about hedge funds in general, or LTCM in particular, he would know that Merton and Scholes where marketing props

probably true of Merton but emphatically not true of Scholes; he was very active in, for example, designing the Swapco collateral management structure which was a big part of the eventual problem. Nicholas Dunbar's "Inventing Money", describes in detail how a number of LTCM's practices were built around Scholes' almost pathological focus on tax efficiency.

Eric Falkenstein said...

Bruschettaboy: 1) every description of the crisis, from July through October 1998, never mentions Merton or Scholes. They were irrelevant. 2) The main bets they had on at the end were simple directional gambles. 3) if tax avoidance and collateral management was Scholes' main job, this has nothing to do with the EMH

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