By Scott Sumner
The New York Review of Books has a very interesting interview of George Soros. At one point he is asked about the recent revolution in the Ukraine. Here is part of his response, and then a follow-up question:
[Soros] Contrary to all rational expectations, a group of citizens armed with not much more than sticks and shields made of cardboard boxes and metal garbage can lids overwhelmed a police force firing live ammunition. There were many casualties, but the citizens prevailed. It was a veritable miracle.
Schmitz: How could such a thing happen? How do you explain it?
Soros: It fits right into my human uncertainty principle, but it also reveals a remarkable similarity between human affairs and quantum physics of which I was previously unaware. According to Max Planck, among others, subatomic phenomena have a dual character: they can manifest themselves as particles or waves. Something similar applies to human beings: they are partly freestanding individuals or particles and partly components of larger entities that behave like waves. The impact they make on reality depends on which alternative dominates their behavior. There are potential tipping points from one alternative to the other but it is uncertain when they will occur and the uncertainty can be resolved only in retrospect.
On February 20 a tipping point was reached when the people on Maidan Square were so determined to defend Ukraine that they forgot about their individual mortality. What gave their suicidal stand historic significance is that it succeeded.
I was intrigued by the quantum mechanics analogy. At the same time I wasn’t entirely convinced. I’m certainly no expert on quantum superposition, but I believe the claim is that something exists in two states simultaneously. The idea is so paradoxical that some physicists believe the universe splits in two when an observation is made. Rather than being random, we can say that both outcomes happen deterministically, but in different universes. (Please correct me if this is wrong.)
I don’t find it all that paradoxical that people sometimes behave like individuals and at other times behave like members of a mob. But I do find the Efficient Markets Hypothesis to be somewhat paradoxical. This hypothesis says that individual traders cannot know more than the market, and hence deviations of assets prices from trend are essentially unforecastable. Consider the following example:
A very knowledgeable trader walks onto the floor of a market where gold is actively traded. To make things simple, let’s assume that there is no risk premium, and that the futures price equal the expected future spot price. Suppose October 2014 gold futures are trading at $1300, but this very smart trader believes that gold will be trading at $1360 in October. Is this information valuable?
In one sense the answer is no. The market forecast is freely available, and is much more reliable. But in another sense the answer is yes. If the trader decides to act on his knowledge, the market will become even more efficient. The market price will immediately represent a more accurate forecast of the expected future spot price.
The average opinion of traders is dumb; the average of their opinions is brilliant. (Have I used ‘average’ the same way both times?)
Alternatively, let’s suppose markets are efficient. What makes them efficient? Lots of traders who dig up information on the value of gold. And why do they do that? Because they believe markets are inefficient.
One of my favorite examples is the joke about the two university of Chicago professors walking along a sidewalk. One says “Look, a $100 bill.” The other replies, ” That’s not possible, someone would have picked it up already.” When I tell my students the joke, I ask them whether it is a pro-EMH joke or an anti-EMH joke. But here’s the problem, I’m not quite sure myself. Consider the following two interpretations:
A. The EMH represents Truth with a capital T. In that case the joke seems to be mocking those who believe in the EMH.
B. The EMH is a highly useful theory. For philosophical pragmatists it doesn’t get any better than that. In that case the joke seems to be supportive of the EMH.
I prefer B. I don’t know about you, but I often see money lying on the sidewalk. But it’s always coins or small bills. Not once in my life have I seen a $100 bill. And now the EMH tells me why I shouldn’t waste my time walking around fruitlessly hoping I’ll find a $100 bill down there. I should look up at the birds and the trees and the clouds. I should enjoy life.
But then who will pick up the $100 bills? Two groups of people. Those who foolishly think they will be able to find them if they look hard enough. (Oddly, some of those foolish people will find them.) And those who know it’s a very long shot but enjoy treasure hunting. Or enjoy looking at sidewalks. Some of them will also be successful. Especially those who know where to look—like very early in the morning outside an expensive nightclub. Or in an area where there are lots of drug deals. There are enough people like that to keep sidewalks cleared of $100s.
I enjoy collecting old prints. And because I enjoy doing so, I help to keep the old print market efficient. But not sidewalks, and not stock markets. Someone else will have to do those jobs.
PS. I recommend the Soros interview—most of it is much better than the passage I quoted.