I’ve been reading The Father of Spin. It’s about Edward L. Bernays and others who lay claim to the title in the USA. Bernays was the nephew of Sigmund Freud, who would likely have been displeased to see how Bernays used Freud’s ideas not on individuals but on broader groups, even whole societies to create preferences for products as diverse as bacon, cigarettes, and even political candidates. The point for us to remember is that preference are not “given” but are molded and shaped in the course of public deliberation and, regrettably, by advertising and other propaganda campaigns. But what does any of this have to do with efficient markets?
The efficient market hypothesis (EMH) has, arguably, guided much of the thinking and theorizing about market mechanisms for some years. According to “The Efficient Market Hypothesis on Trial: A Survey,” by Philip S. Russel and Violet M. Torby,
“The EMH has provided the theoretical basis for much of the financial market research during the seventies and the eighties.” But the EMH is being questioned more and more again because of the influence of psychological behavioral studies.Bernays “spin” is but one of the problems with the framing that sits behind the efficient market hypothesis, and other neoclassical economics assumptions. The point here is to cast doubt both on the short-term efficiency of markets and on assumptions of human rationality that underlie much of economic theorizing. It isn’t that it’s all wrong, but that it ought to be taken with a grain of salt if not aspirin. Neoclassical theory is one way to think about humans, and for longer term views it may have some value, but one ought not to bet one’s life or one’s retirement on it. As the ‘EMH on Trial’ points out, it may be better to be informed by the fact that in the long run things tend to work around an efficient market trend, but remember, as did Keynes that markets can stay aberrant longer than any of us can stay solvent.
Speculative frenzy or irrational optimism, and irrational pessimism that often sets in after bubbles burst, and wrenches its way deeper into the mind whey secular bear markets play themselves out, are part of the cognitive psychology that sits in the mind of “efficient markets” critics. So each of us ought not to let such thinking be far from our thoughts either.
When we hear economists laying claim to ideas of improving efficiency, or stock market cheerleaders telling us stories of new economy, we had better beware. We had better remember that spin and politics go hand in hand, that crony capitalism is the name of at least part of the game here, and that kleptocracy is the name of the game writ large throughout history.
Government is not all bad. Business is not all bad. Even corporations are not bad (well we might draw a line here unless the court system repeals excessive rights now granted to corporations).
But none is all good either. Neither can any of us as individuals claim to be other than an enigma—some good, some evil.
With that in mind, let’s look at contemporary America through the eyes of William Greider, author of Secrets of the Temple: How the Federal Reserve Runs the Country, and One World Ready or Not. Greider’s “America’s Truth Deficit” tells us to beware of media spin. Greider also tells us to beware of economics spin, political spin, …. Here are the concluding paragraphs of Greider’s article:
…Washington defines "national interest" primarily in terms of advancing the global reach of our multinational enterprises. Elites are persuaded by the reigning orthodoxy that subsidiary domestic interests will ultimately benefit too. The distinctive power of America's globalized companies is reflected in trade patterns. Nearly half of American exports and imports are not traded in open markets - the price auction idealized by neoclassical economics - but within the companies themselves, moving materials and components back and forth among their far-flung factories. A trade deficit does not show on the company's balance sheet, only on the nation's. In recent years, much of the trade deficit has reflected the value-added production and jobs that companies moved elsewhere.And to dispel in advance any thoughts that either Greider or I harbor angst exclusively against those now in power, consider Greider’s similar icy blast against the economics theory under girding the last Administration:
The United States is thus especially vulnerable to the downward pressures on working-class wages that exist on both ends of the global system. American producers are generally free - and even encouraged by Washington - to shift production to low-wage locations. Companies regularly use this cost-cutting technique as a competitive weapon without regard to the domestic consequences. The practice works for companies and investors, but not so well for a nation.
INDEED, the cumulative effects of retarding labor incomes worldwide repeatedly threatens stagnation or worse for the entire system. Workers, to put it crudely, cannot buy what the world can make. Too much capital leads to the speculative "bubbles" that bounce around the world, visiting financial crisis on rich and poor alike.
At a different moment in history, American leadership might have stepped up to these disorders and led the way to solutions. If globalization is to continue without encountering more crisis and random destruction, governments must together shift the balance of power so labor incomes can rise in step with rising productivity and profits. If the United States is to avert its own reckoning, it must take decisive action to draw firm limits on its exposure to trade deficits, that is, resign its position as the open-armed buyer of last resort. In effect, Washington would also reform its own national interest imperatives so that they more closely resemble what other nations already embrace. Ultimately, American remedial action may protect the global system from its own crisis - the moment when trading partners discover they have just lost their best customer.
But to describe plausible remedies is to explain why none are likely. The webs of mutual interests connecting government, corporate boardrooms and Wall Street are too deeply woven, as are habits of thought among policy makers and politicians. So I do not expect anything fundamental will be altered in time. We are going to find out if the dissenters are right.
Finally, more extended and “wonkish,” here are a few snippets from “The Efficient Market Hypothesis on Trial”
lb. The Initial Euphoria and Subsequent Discontentment
… In a market consisting of human beings, it seems logical that explanations rooted in human and social psychology would hold great promise in advancing our understanding of stock market behavior. More recent research has attempted to explain the persistence of anomalies by adopting a psychological perspective. Evidence in the psychology literature reveals that individuals have limited information processing capabilities, exhibit systematic bias in processing information, are prone to making mistakes, and often tend to rely on the opinion of others. The damaging attacks on the assumption of human rationality have been spearheaded by Kahneman and Tversky (1986) in their path breaking article on prospect theory. The findings of Kahneman and Tversky have brought into question expected utility theory which has been used descriptively and predictively in the finance and economics literature. They argue that when faced with the complex task of assigning probabilities to uncertain outcomes, individuals often tend to use cognitive heuristics. While useful in reducing the task to a manageable proportion, these heuristics often lead to systematic biases.
Using simple decision tasks, Kahneman and Tversky are able to demonstrate consistent decision inconsistencies by manipulating the decision frame. While expected utility theory would predict that individuals would evaluate alternatives in terms of the impact on these alternatives on their final wealth position, it is often found that individuals tend to violate expected utility theory predictions by evaluating the situation in terms of gains and losses relative to some reference point. The usefulness and validity of Kahneman and Tversky's propositions have been established by several replications and extensions for situations involving uncertainty by researchers in the fields of accounting, economics, finance, and psychology. Rabin and Thaler (2001) show that expected utility theory’s explanation of risk aversion is not plausible by providing examples of how the theory can be wrong and misleading. They call for a better model of describing choice under uncertainty. It is now widely agreed that the failure of expected utility theory is due to the failure to recognize the psychological principles governing decision tasks.
The literature on cognitive psychology provides a promising framework for analyzing investors' behavior in the stock market. By dropping the stringent assumption of rationality in conventional models, it might be possible to explain some of the persistent anomalous findings….
2c. Models of Human Behavior
The EMH and John Maynard Keynes’ (1936) philosophy represent two extreme views of the stock market. EMH is built on the assumptions of investor rationality. This image is in stark contrast to Keynes’ philosophy in which he pictures the stock market as a "casino" guided by "animal spirit". He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements.
In the EMH, investors have a long-term perspective and return on investment is determined by a rational calculation based on changes in the long-run income flows. However, in the Keynesian analysis, investors have shorter horizons and returns represent changes in short-run price fluctuations. As Crotty (1990) notes in his comparison of Keynes, Tobin, and Minsky, stockholders are increasingly concerned with short-term gains and thus have very short-term planning horizons.
If we regard the rational decision making process of the EMH as one that is guided by a complete knowledge of factors governing the decision, it is immediately seen that the EMH is flawed. It fails to provide a realistic framework for the formation of expectations. It is difficult to argue for investor decision making being rational under EMH, given the uncertainty factor. To make a rational decision would involve knowledge of future income flows and also the appropriate discount factor, both of which are unknowable. Like Keynes, many people would agree that few, if any, have sufficient knowledge to make it possible to forecast investment yields.
Thus, in the real world, the investor is not faced with risk (as in EMH analysis), but rather uncertainty, a factor that is given a central role by Keynes. He argues that the future is uncertain and can never be determined. He is also clear in emphasizing that uncertainty is different from probability. The difference can be illustrated with Keynes’ own example. There is risk in the game of roulette where there is a known set of possible outcomes. The risk is that the player does not know which will eventuate, but it is possible to calculate the probability of each outcome occurring. There is, however, uncertainty in knowing the prospect of a future European war. While possible, there is no basis on which to form any calculable probability.
Without objective evidence on which to base their expectation of prices, it becomes intuitively appealing that individuals would base their opinions on other members of their group, an idea emphasized by Keynes. In his analogy of the stock market as a "beauty contest", Keynes notes that the goal of the investor is often to pick the girl that others would consider prettiest rather than choosing the one he/she thinks is prettiest. Keynes proposes that individuals tend to conform to the behavior of the majority or the average. What is irrational at the individual level, becomes conventional and realistic in Keynesian analysis. Thus the stock market can be subject to waves of optimistic or pessimistic sentiment when no solid basis exists for such sentiment, and movements in stock prices are caused largely by changes in the perception of ignorant speculators. He also observes that, while on the one hand, decision making is individualistic, a significant degree of order and coherence is infused by the institutional and social structures.
Capital markets have evolved as highly 'liquid institutions' wherein individual investors can transact at will. Given that transactions occur in an uncertain environment, it is legitimate to hypothesize an element of speculation (gambling spirit) in trading. It is evident that many investors do not buy stocks for "keeps" but rather to resell them in the very near future in the hope of making a gain. Will such investors be guided primarily by changes in fundamental values? Probably not. Anecdotal evidence abounds with day trading as a prime example. While one cannot conclude that the market consists merely of speculators, it is plausible that they may form a substantial group, even with the enormous growth of institutional investors. And, if we agree with that, we will have to concede the debate to Keynes. Keynes’ provocative observations such as "casino", "animal spirits", musical chair", "beauty contest", "mass psychology of ignorant speculators", made in the thirties seem to fit in very well with the stock market behavior of today.
4a.Summary
Undoubtedly, the studies based on EMH have made an invaluable contribution to our understanding of the securities market. However, there seems to be growing discontentment with the theory. A limited survey of the contemporary literature shows that criticism of EMH has gained both voice and momentum during recent years. While it is true that the market responds to new information, it is now clear that information is not the only variable affecting security valuation. Recent years have witnessed a new wave of researchers who have provided thought provoking, theoretical arguments and supporting empirical evidence to show that security prices could deviate from their equilibrium values due to psychological factors, fads, and noise trading.
4b. A Look into the Future
While the trial of EMH continues, we expect that the final outcome of the raging debate will be a compromise between competing schools of thought. In our opinion, knowledge of the dynamics of stock market behavior would perhaps be best advanced by adopting a multidisciplinary approach that incorporates both qualitative and quantitative research tools. To this end, we do not call for the abandonment of the EMH paradigm, but rather propose that the hitherto popular EMH paradigm be refined to embody the psychological and speculative aspects of the stock market. As Einhorn (1976) remarked, "We should always be open to the idea of developing new paradigms incorporating some aspect of decision making that has heretofore been neglected." [Einhorn, 205]
4b4c. Directions for Future Research
It is likely that the quest for a coherent theory of the stock market will continue to stimulate the intellect of academic researchers. It is apparent that, over the years, the field has made much progress and that without such sustained research efforts the issue would remain unresolved. The fresh insights on the speculative component have opened up several avenues for fruitful research. In our opinion, the critics of EMH must continue providing unambiguous, consistent, and direct empirical evidence on the irrational aspect of stock market behavior for their findings to be completely accepted in the discipline. Akerlof and Yellen (1985) show that even small amounts of irrationality could have significant economic effects. De Long, Schleifer, Summers and Waldmann (1989) observe that noise trading can have an adverse impact on other market participants. The social welfare implications of an irrational and speculative stock market, and the policies to control such behavior (if desirable) could be a profitable area for future research. In closing, with the EMH on trial, the field of securities market research is truly at the threshold of an exciting phase.[references in original]
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