Recent stock market gyrations illustrate one interesting phenomenon. Each time the administration promises an easing in the “trade tensions” it itself created, the stock market picks up. Every time the promises are not realized, the market drops. And the process starts again.
Today’s Wall Street Journal writes (“Stocks Turn Higher on Trade Hopes,” May 15, 2019):
Stocks erased declines from earlier in the day after Treasury Secretary Steven Mnuchin said U.S. negotiators are likely to travel to Beijing soon and reports emerged that the Trump administration is putting off a final decision on whether to impose broad tariffs on automobile and auto-part imports.
Updates on global trade policy have swung markets in recent days, with stocks rising and falling on shifting bets about the U.S. and China eventually reaching an agreement.
The efficiency of financial markets does not mean that they can predict correctly, which is obviously impossible. It only means that all available information is incorporated in buying, selling, and prices. This information includes what investors think that other investors will think and do, the so-called self-referential character of financial markets, which further changes risk into uncertainty (where no odds can be estimated, a distinction due to Frank Knight).
Investors are ordinary people, but they have skin in the game, which gives them incentives to search for information and avoid “rational ignorance” (that is, the rationality of not spending resources on information that will not help one improve one’s situation, which is typical of the voter who has only one vote).
One way investors resemble ordinary individuals is their political naivety. Their incentives do not seem, at least currently, to prevent them from trusting the state, even when government spokesmen regularly mislead and manipulate them.
Politicians, on the other hand, have an incentive to lie more than ordinary individuals because the consequences of their actions are complex and unknowable by the rationally-ignorant and myopic voter, who will rapidly forget politicians’ words and deeds. (On the short memory of voters, see Christopher Achen and Larry Bartels, Democracy for Realists, which I reviewed in the Summer 2017 issue of Regulation.)
READER COMMENTS
Phil H
May 15 2019 at 11:03pm
“Politicians…have an incentive to lie…because the consequences of their actions are complex and unknowable by the rationally-ignorant and myopic voter”
If you’re going to make an argument against democracy, it’s going to need more than one paragraph.
“The efficiency of financial markets…means that all available information is incorporated in buying, selling, and prices…[Investors’] incentives do not seem, at least currently, to prevent them from trusting the state…”
These two statements are directly contradictory.
Jon Murphy
May 16 2019 at 6:20am
1) It’s not necessarily an argument against democracy to acknowledge the incentives facing politicians. The Federalist Papers, for example, are full of such discussions. That is the whole point of the separation of powers, after all.
2) There’s a difference between information and interpretation. A person may have all relevant information but may interpret the information differently based on any number of conditions. There is no contradiction between Pierre’s two statements. One is about information. The other is interpretive frameworks
Phil H
May 16 2019 at 7:39am
“…The Federalist Papers…”
Sure, that was kind of my point. These issues are complex and involved, and a little hint in a paragraph isn’t going to make clear whatever stance Lemieux wants to take. If he is making a serious criticism of the democratic systems we have in place, or suggesting that it creates serious distortions, then he will have to say so much more clearly.
(2) No, I think you’re wrong to say there is no contradiction. L is making the claim that investors are in some ways fooled by government statements. By definition, he is also claiming that there is enough information out there to demonstrate the falsity of (some) government statements (otherwise, how would L know?!). But if the investors are fooled by the government, then they are failing to incorporate the information that L knows (that demonstrates to him the falsity of government statements). Therefore, they are not incorporating *all* information.
Jon Murphy
May 16 2019 at 8:03am
Fine, but then that’s not an argument against democracy as you originally said.
Again, difference between interpretation and information. To incorporate all information does not imply infallibility or omniscience. Furthermore, it does not imply the quality of the information is perfect.
Phil H
May 17 2019 at 2:24am
Hi, Jon.
I actually think this is quite an important point, and that you are materially misrepresenting what the efficient market hypothesis is.
The distinction you are making (information/interpretation) does not, cannot exist in the EMH. The EMH says that all information has been incorporated into prices, and that market prices therefore represent the best estimate of value that is humanly possible. The EMH gives us a definition of correct (not the same as absolute correctness, of course), i.e. the outcome price of an efficient market. That’s the whole point of the EMH: it literally collapses that information/interpretation distinction. It doesn’t matter what interpretation you have, under the EMH, the market price is the only correct conclusion to be reached, given all the information available.
Of course the EMH may not be true, but I took this post to be arguing that it is true, or close to true.
Pierre Lemieux
May 18 2019 at 12:11pm
The way I understand it, the EMH does not exclude errors (false or badly interpreted information); it only states that these errors are incorporated in prices. What we have to better understand, perhaps, is why some errors are more common, for example, those leading to bubbles or to political naivety. Perhaps trust in the state is a bubble. Why don’t individual incentives lead to the correction of those errors?
Phil H
May 19 2019 at 5:56am
Thanks, Pierre.
I think I see what you’re saying, but I don’t see how it can possibly be correct.
(1) If the EMH means that erroneous interpretations of information can be incorporated into prices, then the EMH becomes instantly meaningless. After all, for any piece of information, there is always an infinite range of possible erroneous interpretations (including, “no action necessary,” making the incorporation of any people information indistinguishable from non-incorporation). It would render the EMH empty of content.
(2) The very notion of “error” is at odds with what you’re saying. If an observer is able to recognise what the market has done as “error”, then that’s another piece of information. As long as investors persist in their error, they have failed to incorporate the recognition of the error, and they thus disprove the EMH.
Benjamin Cole
May 16 2019 at 10:13am
When the voters disagree with my views, they are myopic and ignorant.
When they agree, they are incisively insightful.
Pierre Lemieux
May 16 2019 at 11:41pm
I suggest that for somebody who has some knowledge of public choice economics, they are always myopic and rationally ignorant. That’s one of the main reasons to limit the democratic state and avoid what Bertrand de Jouvenel called “totalitarian democracy.”
Benjamin Cole
May 17 2019 at 10:52pm
PL—
Can you point to a successful nation, by your standards?
Sometimes Libertarians point to Singapore, but the city-state actually operates one of the most dirigiste economies on the planet.
Pierre Lemieux
May 18 2019 at 12:56am
If by “a nation” one means a group of individuals under a particular state, a successful nation would be one in which individuals can be successful (that is, satisfy their individual preferences, or engage in “the pursuit of happiness”) as much as possible. It is difficult to name one that is most successful, since their states all interfere in different ways with this process. Depending on what your own preferences are, you might prefer one or the other among the not-too-nationalized ones (“nationalized” being used here in the usual sense of control by the nation-state).
Benjamin Cole
May 18 2019 at 8:06pm
Yes, to your preferences what is the most successful Nation on the planet?
Pierre Lemieux
May 16 2019 at 11:45pm
I suggest that for somebody who has some knowledge of public choice economics, they are always myopic and rationally ignorant. That’s one of the main reasons to limit the democratic state and avoid what Bertrand de Jouvenel called “totalitarian democracy.”
Matthias Görgens
May 16 2019 at 12:02pm
What makes you think the investors are politically naive and trusting?
Even an announcement that only has eg a five percent chance of coming true will change the market price. So changes in market prices occuring at all does not mean that investors take officials at face value.
Pierre Lemieux
May 16 2019 at 11:42pm
I suggest that for somebody who has some knowledge of public choice economics, they are always myopic and rationally ignorant. That’s one of the main reasons to limit the democratic state and avoid what Bertrand de Jouvenel called “totalitarian democracy.”
Pierre Lemieux
May 16 2019 at 11:53pm
In the case of trade, repeated indications that a trade agreement was coming and the contrary news that followed have been believed. You can see a similar problem with the Fed, of which every pronouncement is taken as God’s word. But it is even more naive to believe politicians, who have a clearer incentive to lie (and which indeed lie regularly).
Comments are closed.