In a week when the Vix is at a seven-year high and the markets are back to the trading range of the summer of 2017, now seems like a good time to revisit the theme of market efficiency. Here is a link to the pre-publication version of an academic paper I published this year in the Review of Economic Dynamics.
The paper is a formal model of an argument I’ve been making for a while. Although it’s not possible for the average punter to make a buck in the financial markets we should definitely NOT trust the financial markets to do a good job allocating capital intertemporally. As Richard Thaler explained in his review of Justin Fox’s book The Myth of the Rational Market, the efficient markets hypothesis (EMH) has two components.
The first, ‘no free lunch’ asserts that unless you have inside information, it is impossible to outperform the market except through dumb luck. That is almost certainly correct, although even that part of the EMH is disputed by some.
The second, ‘the price is right’, asserts that the financial markets allocate capital efficiently over time. Efficiently, here, means that there is no intervention by government that could make us all better off. That, despite the protestations of radical free-marketeers, is almost certainly wrong. My paper explains why.
The financial markets facilitate trade with people not yet born. If you buy a stock and sell it twenty years later, there is a good chance the buyer wasn’t alive when you made the purchase. When you buy the stock for the long-run, you are betting that the buyer, twenty years from now, will pay more than you did. And the buyer is making the same forecast about the whims of some other buyer in the yet more distant future. This never-ending chain of market trades leads to the possibility that self-fulfilling prophecies lead to inefficient cycles of booms and crashes.
For the cognoscenti, here is the abstract from my paper
“This paper constructs a general equilibrium model where asset price fluctuations are caused by random shocks to beliefs about the future price level that reallocate consumption across generations. In this model, asset prices are volatile, and price-earnings ratios are persistent, even though there is no fundamental uncertainty and financial markets are sequentially complete. I show that the model can explain a substantial risk premium while generating smooth time series for consumption. In my model, asset price fluctuations are Pareto inefficient and there is a role for treasury or central bank intervention to stabilize asset price volatility. ”
Have fun trading everyone and I wish you all a very happy 2019.