Doug Henwood wrote that "markets can stay irrational a lot longer than you can stay solvent." Doesn't this suggest that market players are undercapitalized?
On 9/20/06, Michael McIntyre <mcintyremichael at mac.com> wrote:
> You're right that I was using "efficient" in a colloquial sense. If
> there's any technical sense behind it, it's that volatile commodity
> markets do cause deadweight losses. A stable coffee price of $1.00
> per pound is Pareto-superior to a coffee price that swings between
> $0.25 and $1.75 per pound, with an average price over time of $1.00.
>
> The question of whether market participants are rational can get
> tricky. I think Jon Elster is right that there's a peculiar form of
> irrationality that he calls "hyper-rationality." This involves
> taking Baylesian probability theory to its absurd conclusions. For a
> Baylesian, decision-making under conditions of incomplete information
> are no different from decisions under conditions of complete
> information, no matter how incomplete your information. You simply
> ignore what you don't know and make a decision based on what you do
> know. One of Elster's favorite examples is child custody cases.
> Decisions in these cases matter a lot, but judges infrequently know
> what they need to know to make good decisions. So, judges end up
> making decisions (because they have to) based on information that is
> readily available, but almost inconsequential. (In one of Elster's
> cases, if I recall correctly, the father got custody because he was
> one block closer to the child's school). From a Baylesian
> perspective, that's rational. For most people, I'd guess, not so much.
>
> I remember once trying to make a really rational decision in
> financial markets. In the late 90s I was trying to figure out how to
> allocate my TIAA-CREF money. Being an avid reader of LBO, I knew
> that this bubble was going to burst sometime, so I spent a lot of
> time worrying about whether I should move all of my retirement money
> out of stocks. So, I had to make a decision on financial risk based
> on quite a bit of information. I knew that stocks were overpriced.
> I knew that the tech boom was really out of hand. But I decided to
> stay in a fund that was about 55% in stocks at the time. Why? (1) I
> was a good 25 years from retirement, and so short or even medium-term
> stock prices weren't a big concern for me. In fact, a price
> correction fairly early in my career had its good points. It meant
> that I was buying low. (2) If I did get out of stocks and wanted to
> end up ahead, I'd also have to know when to get back into stocks. I
> decided I wasn't that smart. Now, if I'd been 5 years away from
> retirement, I would have gotten out of stocks and breathed a sigh of
> relief. If agents were rational, I think markets would be pretty
> good at pricing in this kind of risk.
>
> On the other hand, what if I were a trading in oil futures, or some
> complex oil futures derivative that I might have understood right
> after I read _Wall Street_, but don't now? Then I'd be forced to
> trade based on my guess about what the price of oil will be in a
> year. That's a decision much more like the judge trying to award
> custody. The information that matters is impossible to know, and the
> information that's at hand has only limited value. Prices based on
> decisions made under that kind of uncertainty, rather than under
> conditions of calculable risk, can get apeshit crazy. Today's
> headlines may have almost nothing to do with the price of oil in a
> year, but they're the only information you have, so prices swing like
> nuts.
>
> (Now, probably, from a technical economic point of view risk and
> uncertainty aren't dichotomous like this. You'd have to think of a
> continuum where risk represents decision-making with a small
> confidence interval and uncertainty represents decision-making with a
> large confidence interval, and lots of decisions fall somewhere in
> the middle).
>
> So, the conclusion is - markets in uncertainty, even though they can
> be modeled like risk markets, act very differently. But markets have
> to generate prices in cases of uncertainty, just like in cases of
> risk. It's those cases where markets are "inefficient".
>
> And yes, all of that with "rational" or "hyperrational" agents. I'm
> not so sure about mob psychology. You could argue that "mob
> psychology" merely means that people make "rational" decisions based
> solely on the most readily available information, the current trend
> of prices. This is the kind of "rationality" that you see touted in
> books like _Blink_. It's also the kind of "rationality" that Samuel
> Popkin lauded in his book, _The Rational Voter_, about 15 years ago.
> (This was an attack on the school, going back to Philip Converse,
> that points out how ill-informed voters are. Popkin argues that
> voters are very rational. They're so rational that they forego the
> costs of information-gathering.)
>
> Instead of calling it mob psychology, why not just come out and say
> that most people are dumbasses? "Dumbass" would be a technical term
> meaning that:
> (1) Most people don't know very much.
> (2) Most people "know" things that aren't true.
> (3) Most people can't evaluate which things they "know" are likely to
> be true and which are not.
> (4) Most people can't tell which things they know are important and
> which aren't for a particular decision.
> (5) Most people, even when they have all the pieces of information
> they need right in front of them to make a rational decision, can't
> reason their way through to a valid conclusion.
>
> Model that!
>
> Michael McIntyre
>
> On Sep 20, 2006, at 10:04 AM, Doug Henwood wrote:
>
> >
> > On Sep 20, 2006, at 9:14 AM, Michael McIntyre wrote:
> >
> >> I wouldn't call a market where prices go apeshit crazy (my words)
> >> an efficient market, so my intent was never to give an opening to
> >> capitalist apologetics. When it comes to markets and information,
> >> I guess I'm much more in line with Stiglitz, Akerloff, etc. who
> >> emphasize how information asymmetries lead to inefficient
> >> markets. For example, I think it was Akerloff who wrote the early
> >> paper "The Market in Lemons" about used car prices.
> >
> > Yup it was Akerlof.
> >
> > But what exactly do you mean by efficiency? In financial theory, an
> > efficient market is simply one that reflects all available
> > information, which is pretty much true of all deep, liquid
> > financial markets. The quality of that information is another
> > matter entirely.
> >
> > Stiglitz & Akerlof want to assume that market participants are
> > rational, even though they may be differently informed. The first
> > time I met Stiglitz, late in the dot.com boom, he asked "Why do
> > people buy those stocks?" That's a different POV from, say, Robert
> > Shiller (or master speculators like George Soros) who believe that
> > markets are venues for mob psychology, which means you can have
> > lots of periods of apeshit craziness that can go on for a long
> > time. As the old saying has it - which was quoted somewhere
> > yesterday on the Amaranth disaster - markets can stay irrational a
> > lot longer than you can stay solvent. Markets that efficiently
> > reflect apeshit craziness can be efficient in the financial sense,
> > if not in the colloquial or engineering sense.
> >
> > Doug
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