To my co-blogger Ken:
I haven’t seen you in a while, so we haven’t had time to talk about any of the usual stuff, therefore I’m taking this opportunity to submit a modest proposal for your consideration.
As you know, one of the areas where we disagree about economics issues is the subject of the efficient market hypothesis. I tend to believe those economists who say that the free market is efficient, that is, it makes the best possible use of materials and information.
Obviously, this isn’t perfectly true. In fact, it can’t be, because the reason for believing there are few inefficiencies is because people will spot them and take advantage of them for profit, which tends to eliminate them. Further, there are all sorts of inefficiencies caused by things like monopolies and asymetric information. Still, I usually believe the efficient market hypothesis explains much of the market.
You, on the other hand, seem to believe there are a number of persistent inefficiencies that aren’t being eliminated. In particular, you ascribe a lot of inefficiency to short-term thinking in the capital markets.
My response to this has always been to ask why the long-term players don’t just buy the stuff the short-term guys are undervaluing. Or why don’t they take a short position on the stuff the short-term guys are overvaluing? If the short-term guys are pressuring a company’s management into squeezing the company for short-term gains, why don’t some smart traders buy the company and make even more money by holding it for the long term? If short-term thinking is a problem, why aren’t the long-term investors picking up the money?
I’ve just been reading Michael Lewis’s The Big Short: Inside the Doomsday Machine. Everything in it could be wrong–I have no way to tell, but people I trust say it’s right–but I think it sheds some light on our conflict. The book is about the subprime mortgage crisis, as seen from the point of view of the handful of traders who took very big bets against subprime mortgage bonds. It’s a very good read, and I highly recommend it to anyone who wants to understand how we got into this mess.
If the subprime mortgage crisis is a representative example, the short answer to why markets are inefficient seems to be that you are right about there being too much short-term thinking. The major subprime investors were enjoying the cashflow from the mortgage payments (or from various derivatives) far too much, and this made it hard for them to see the dismal future ahead.
As to my question of why someone didn’t clean up with a little long-term investment, I think The Big Short sheds a bit of light there too. The natural enemy of long-term investment is unpredictability, and this unpredictability arose for three reasons:
- First, there was a lot of fraud going on. Home owners, mortgage originators, rating services, and investment bankers lied like mad to create the subprime bond market. This is essentially a problem of asymmetric information. Who could invest long-term when you’re not sure what’s really going on?
- Second, large amounts of money were controlled by relatively small numbers of traders, so it only took a few stupid people to invest billions of dollars in a losing proposition. This blew the economic assumption of rationality right out of the water.
- Third, once a few people started making money from subprime loans, traders faced a lopsided incentive system: If they didn’t invest in the subprime market and it made money, they’d look like fools to their bosses and investors. But if they did invest in subprime bonds and the market went sour…well, nobody else saw that coming either, right?
In short, the market was inefficient due to fraud, stupidity, and cowardice.
According to Lewis, one surprising outcome of this mess is that most of the traders on either side of the subprime market made out okay. Win or lose, they earned millions in fees and incentives. Even Howie Hubler, who Lewis says lost more money than any other single trader in Wall Street history, took home millions of dollars and apparently landed okay.
Ken, I don’t know if Lewis is right, and I don’t know if I’ve correctly understood everything I’ve read, but if I’ve got this right, I can see only one inescapable conclusion: You and I need to become traders.