This is one thing to me which seems to me to be a genuine failing of an efficient market. Over the medium term, ignoring the low-frequency, high-risk event gives you a margin over your competition. Hence you succeed at their expense and they fail/get bought out by you etc.
As a simple example (the general argument applies to all sectors and all forms of risk), consider a bank ("safe bank") keeping $X in reserve to handle unforeseen events. Another bank ("risky bank") which keeps only $X/2 in reserve.
Risky bank will have a advantage over safe bank at all times except when an event requiring between $X/2 and $X occurs. Should such a rare event occur, risky bank would fail and safe bank survive.
Once the frequencies of such events drop to low enough levels (once ever 5? 10? 20? 40? years), there is no market pressure on the riskier bank to plan for the problem (and in fact the opposite, the market will destroy safe bank).
The actual time period is I think determined by how long it takes risky bank to out-compete safe bank and so drive it from the market as a significant force.
1. There is not much in the way of market pressure in the "Great Moderation" banking system (weak regulation, deposit guarantees) to drive out risky banks - they are a net gain for investors (ignoring the agency effect of bankers screwing their shareholders through bonuses), since bank failures represent a form of subsidy to the financial system. Some shareholders get some of the stock wiped out, but it is all limited liability; others profit magnificently.
2. The libertarian banking system that we saw in C19th (little regulation, no systematic deposit guarantees) does seem to have the right market pressure, but it seems to be yet more unstable since we saw it face regular bank runs followed by grand-scale financial collapse - the 19th century was more economically unstable than the 20th century for this reason, with the UK (then dominant in finance) having 5 major financial crises; one of which (the 1873 panic) led to a depression lasting 2 years longer than the Great Depression. So your frequency's "low enough levels" seems to be around every 20 to 25 years.
3. So deposit guarantees of institutions in exchange for effective regulation that avoids the dangerous effects of excessive leverage, so outlawing your risky bank, seems to be the way forward. Unfortunately it is in the interests of these financial institutions to subvert regulation, so designing such regulation is hard ("who could have forseen that the banks accounts could have mispriced risky assets and moved gigantic liabilities off balance sheet yet again?")
This isn't really a Black Swan issue, it's an agency issue where neither depositors nor regulators understand what banks are doing. But Black Swans do tend to crowd around important, hard to figure out areas of endeavour.
> This is one thing to me which seems to me to be a genuine failing of an efficient market.
You seem to assume that all risk is meant to be carried by the banks. As you note, such a thing is possible (up to the risk-bearing capacity of any given bank), but such banks would be very expensive. Consequently, most customers bank with riskier institutions and this places more of the risk back onto them.
So, in actual fact, this is the market doing what it does pretty well: solving a hyper-distributed problem with heterogenous agents with numerous complex, incompatible preferences.
Sometimes we don't like the outcome. That doesn't mean that the market has "failed"; it just means that we don't like the outcome.
The market is a solution to a problem (or perhaps a set of problems). In the example of in the grandparent's post, that solution does not adequately deal with the problem at hand. This makes it a bad solution.
Even if we can't think of a better solution right now, we shouldn't stick our collective heads in the sand when we notice errors in our current approach. Highlighting errors is important, because even if we can't fix them right now, we may be able to in the future. If we don't know about the flaws in our current approach, it it impossible to even attempt to think of ways to improve them.
The market is an emergent phenomenon. It's not a designed institution. Hayek talks about this misattribution as the root cause of a lot of misunderstanding.
People do think of ways to adjust for things about the market that they don't like. Those adjustments are generally imposed from outside by force of law and quite a few of them are later modified or removed because they had seriously unpleasant side-effects (such as the total disappearance of a market).
Being angry at an emergent phenomenon like markets is like being angry at the weather, or upset about evolution. It's pointless.
There are certainly aspects of our market economy that are emergent. Trade is as old as humanity itself, but not all aspects of the economy are so old, nor as immutable.
The modern corporation, for example, is a relatively new invention. Depending on your definition, anywhere between a few centuries and a few decades old. Compared to the time scale on which human evolution has taken place, that's practically nothing. In those decades or centuries, we and our ancestors have chosen particular shapes for our economy. Not all of those choices are final.
Whether the choices that influenced this particular example can be changed, I don't know, nor do I feel qualified to hazard a guess. However, I stand by my original point: it makes no sense to refuse to consider how we might improve the system.
Modern humans have never refused to consider how to improve everything.
But it is important to realise when we're licked. We can't solve the TSP in linear time, we can't travel faster than light and it looks like -- in both theory and practice -- markets are better at solving economic problems than planned alternatives.
The problem is that any two competitors X and Y, in any field.
If X does not plan for low-probability failure and Y does, then Y will not have the additional inefficiency/overhead and so X will out-compete Y.
If the time frame for low-probability failure is long enough, and if being out-competed means the end of your business, then an efficient market means that risks which typically take longer than time T to manifest will not be handled, where T is the time for X to out-compete Y, given their advantage.
Once consumers/investors decide that the risks are sufficiently low over the time horizon they care about, they will not mitigate risks over longer time horizons.
This isn't just a failing of an efficient market - it's a "failing" of any system with a time horizon.
Politics has similar incentives (election in 2012, who cares about 2013?), as does software development (who cares about code maintenance after I leave), management, etc.
I agree with you main point but I do think I should pick you up on the use of 'efficient' which I think is wrong in a technical way.
In an 'efficient' market all future risk is included in the analysis of current value meaning that if it was an 'efficient' market this would actually not be a problem. However it is just one of many* ways that markets are not in reality 'efficient' in the economics sense as the assumptions required to prove them just do not match up to the real world.
In an 'efficient' market all future risk is included in the analysis of current value meaning that if it was an 'efficient' market this would actually not be a problem.
The EMH claims that all future time discounted risk known to market participants is included in the analysis of current value.
If you want to show the markets are not efficient, go achieve excess risk-adjusted returns. The sole claim of the EMH is that you can't do that. The EMH doesn't claim that market participants will not take risks, nor does it claim that investors/customers will not apply time discounting to those risks.
The book is worth a read. Alarming large numbers of economists base work working up from these models and theories based on them.
You might have noticed a little recent global credit crunch which was not predicted by most economists but was predicted and modeled by the author of the book I linked who is an economist (so I don't lump them all together) but the overall level of the state of economics is so poor as a discipline at understanding the overall economy it should be embarrassing to them.
I am genuinely interested if someone has a critical analysis of the Debunking Economics book that points out how and where it wrong but when I last looked I couldn't find any serious attacks online (minor nitpicks only) but I think it is largely being ignored by those who disagree so I haven't found their counter arguments.
Economists don't predict most events, because most events in economics are unpredictable. It's a subject of complex, chaotic systems.
If you take this as your starting point for critique (the weathermen didn't predict Weather Event X!!!), you will always win the argument because you're beating up a strawman. No economist has ever seriously claimed specific predictive power.
All an economist can give you is generalised statements of causality, most of which will be unobservable. Steve Keen was not the first to point this out. Quite a few economists from various schools have picked flaws with general equilibria models of macroeconomic phenomena (ie, using calculus to describe people, markets and countries).
The weathermen can give you probability ranges for various events and their models include the possibility of storms. Many widely used economic models do not have the capability to model crashes at all. Many models don't cover banks, debt or money at all.
I don't expect a model to tell me that the markets will crash tomorrow but I would have expected widely use models to indicate that we were in dangerous period in 2005-2007 and that the upwards path was impossible to sustain over a 10 year period.
Economists can give probabilities too; it depends on the type of model used.
Predicting a crash immediately before it happens is not so difficult. Lots of economists were clanging the alarm bells all through the mid-00s. Predicting exactly when and exactly what the trigger would be? Basically impossible. Economists don't do that (it's left to advisors, pundits and newsletter salesmen).
Agree exact timing is not identifiable but the amount of warnings before 2007 was really pretty low. Maybe there are some that can be added to this list and it would be interesting to see if there were any with very different approaches:
So there were a few but they generally weren't in the mainstream of economics (from Krugman to the Chicago School) which generally did a very bad job. Roubini did call it but none of the others on the list I linked to were people I had heard of before 2008 (but I haven't formally studied economics).
Many of the common models taught and used never indicate crashes, this sort of thing should just be thrown out. Most of them also don't really include the financial industry (including debt).
Comments
This is one thing to me which seems to me to be a genuine failing of an efficient market. Over the medium term, ignoring the low-frequency, high-risk event gives you a margin over your competition. Hence you succeed at their expense and they fail/get bought out by you etc.
As a simple example (the general argument applies to all sectors and all forms of risk), consider a bank ("safe bank") keeping $X in reserve to handle unforeseen events. Another bank ("risky bank") which keeps only $X/2 in reserve.
Risky bank will have a advantage over safe bank at all times except when an event requiring between $X/2 and $X occurs. Should such a rare event occur, risky bank would fail and safe bank survive.
Once the frequencies of such events drop to low enough levels (once ever 5? 10? 20? 40? years), there is no market pressure on the riskier bank to plan for the problem (and in fact the opposite, the market will destroy safe bank).
The actual time period is I think determined by how long it takes risky bank to out-compete safe bank and so drive it from the market as a significant force.
Three banking models:
1. There is not much in the way of market pressure in the "Great Moderation" banking system (weak regulation, deposit guarantees) to drive out risky banks - they are a net gain for investors (ignoring the agency effect of bankers screwing their shareholders through bonuses), since bank failures represent a form of subsidy to the financial system. Some shareholders get some of the stock wiped out, but it is all limited liability; others profit magnificently.
2. The libertarian banking system that we saw in C19th (little regulation, no systematic deposit guarantees) does seem to have the right market pressure, but it seems to be yet more unstable since we saw it face regular bank runs followed by grand-scale financial collapse - the 19th century was more economically unstable than the 20th century for this reason, with the UK (then dominant in finance) having 5 major financial crises; one of which (the 1873 panic) led to a depression lasting 2 years longer than the Great Depression. So your frequency's "low enough levels" seems to be around every 20 to 25 years.
3. So deposit guarantees of institutions in exchange for effective regulation that avoids the dangerous effects of excessive leverage, so outlawing your risky bank, seems to be the way forward. Unfortunately it is in the interests of these financial institutions to subvert regulation, so designing such regulation is hard ("who could have forseen that the banks accounts could have mispriced risky assets and moved gigantic liabilities off balance sheet yet again?")
This isn't really a Black Swan issue, it's an agency issue where neither depositors nor regulators understand what banks are doing. But Black Swans do tend to crowd around important, hard to figure out areas of endeavour.
Sorry, I was only using banks as an example. My attempt to state the general case here:
https://news.ycombinator.com/item?id=4942341
I think it is exactly a black swan issue. The markets punish companies which do not compete sufficiently effectively.
Companies which plan for low-probability events are less effective in the medium term than companies which don't.
> This is one thing to me which seems to me to be a genuine failing of an efficient market.
You seem to assume that all risk is meant to be carried by the banks. As you note, such a thing is possible (up to the risk-bearing capacity of any given bank), but such banks would be very expensive. Consequently, most customers bank with riskier institutions and this places more of the risk back onto them.
So, in actual fact, this is the market doing what it does pretty well: solving a hyper-distributed problem with heterogenous agents with numerous complex, incompatible preferences.
Sometimes we don't like the outcome. That doesn't mean that the market has "failed"; it just means that we don't like the outcome.
The market is a solution to a problem (or perhaps a set of problems). In the example of in the grandparent's post, that solution does not adequately deal with the problem at hand. This makes it a bad solution.
Even if we can't think of a better solution right now, we shouldn't stick our collective heads in the sand when we notice errors in our current approach. Highlighting errors is important, because even if we can't fix them right now, we may be able to in the future. If we don't know about the flaws in our current approach, it it impossible to even attempt to think of ways to improve them.
The market is an emergent phenomenon. It's not a designed institution. Hayek talks about this misattribution as the root cause of a lot of misunderstanding.
People do think of ways to adjust for things about the market that they don't like. Those adjustments are generally imposed from outside by force of law and quite a few of them are later modified or removed because they had seriously unpleasant side-effects (such as the total disappearance of a market).
Being angry at an emergent phenomenon like markets is like being angry at the weather, or upset about evolution. It's pointless.
There are certainly aspects of our market economy that are emergent. Trade is as old as humanity itself, but not all aspects of the economy are so old, nor as immutable.
The modern corporation, for example, is a relatively new invention. Depending on your definition, anywhere between a few centuries and a few decades old. Compared to the time scale on which human evolution has taken place, that's practically nothing. In those decades or centuries, we and our ancestors have chosen particular shapes for our economy. Not all of those choices are final.
Whether the choices that influenced this particular example can be changed, I don't know, nor do I feel qualified to hazard a guess. However, I stand by my original point: it makes no sense to refuse to consider how we might improve the system.
Modern humans have never refused to consider how to improve everything.
But it is important to realise when we're licked. We can't solve the TSP in linear time, we can't travel faster than light and it looks like -- in both theory and practice -- markets are better at solving economic problems than planned alternatives.
The problem is not restricted to banking.
The problem is that any two competitors X and Y, in any field.
If X does not plan for low-probability failure and Y does, then Y will not have the additional inefficiency/overhead and so X will out-compete Y.
If the time frame for low-probability failure is long enough, and if being out-competed means the end of your business, then an efficient market means that risks which typically take longer than time T to manifest will not be handled, where T is the time for X to out-compete Y, given their advantage.
What's your point? Customers will choose the mix of cost and risk that makes them comfortable.
I guess that my point is that anyone who thinks that a market will give them long-term stable institutions/companies is wrong.
I think that conclusion is likely to be surprising/controversial to some/many people.
> I guess that my point is that anyone who thinks that a market will give them long-term stable institutions/companies is wrong.
Definitely. It's a complex, dynamic system that requires enormous amounts of failure, misattribution and foolish optimism to work.
The beautiful thing is that it turns these human inevitabilities from negatives into positives.
Once consumers/investors decide that the risks are sufficiently low over the time horizon they care about, they will not mitigate risks over longer time horizons.
This isn't just a failing of an efficient market - it's a "failing" of any system with a time horizon.
Politics has similar incentives (election in 2012, who cares about 2013?), as does software development (who cares about code maintenance after I leave), management, etc.
I agree with you main point but I do think I should pick you up on the use of 'efficient' which I think is wrong in a technical way.
In an 'efficient' market all future risk is included in the analysis of current value meaning that if it was an 'efficient' market this would actually not be a problem. However it is just one of many* ways that markets are not in reality 'efficient' in the economics sense as the assumptions required to prove them just do not match up to the real world.
* http://www.amazon.com/Debunking-Economics-Revised-Expanded-D...
In an 'efficient' market all future risk is included in the analysis of current value meaning that if it was an 'efficient' market this would actually not be a problem.
The EMH claims that all future time discounted risk known to market participants is included in the analysis of current value.
If you want to show the markets are not efficient, go achieve excess risk-adjusted returns. The sole claim of the EMH is that you can't do that. The EMH doesn't claim that market participants will not take risks, nor does it claim that investors/customers will not apply time discounting to those risks.
You need to avoid lumping all economists into a single heading. It's easy to debunk abstract models by saying "they're not a model of the real world!"
Well, yes. The economists know that.
The book is worth a read. Alarming large numbers of economists base work working up from these models and theories based on them.
You might have noticed a little recent global credit crunch which was not predicted by most economists but was predicted and modeled by the author of the book I linked who is an economist (so I don't lump them all together) but the overall level of the state of economics is so poor as a discipline at understanding the overall economy it should be embarrassing to them.
I am genuinely interested if someone has a critical analysis of the Debunking Economics book that points out how and where it wrong but when I last looked I couldn't find any serious attacks online (minor nitpicks only) but I think it is largely being ignored by those who disagree so I haven't found their counter arguments.
Economists don't predict most events, because most events in economics are unpredictable. It's a subject of complex, chaotic systems.
If you take this as your starting point for critique (the weathermen didn't predict Weather Event X!!!), you will always win the argument because you're beating up a strawman. No economist has ever seriously claimed specific predictive power.
All an economist can give you is generalised statements of causality, most of which will be unobservable. Steve Keen was not the first to point this out. Quite a few economists from various schools have picked flaws with general equilibria models of macroeconomic phenomena (ie, using calculus to describe people, markets and countries).
The weathermen can give you probability ranges for various events and their models include the possibility of storms. Many widely used economic models do not have the capability to model crashes at all. Many models don't cover banks, debt or money at all.
I don't expect a model to tell me that the markets will crash tomorrow but I would have expected widely use models to indicate that we were in dangerous period in 2005-2007 and that the upwards path was impossible to sustain over a 10 year period.
Economists can give probabilities too; it depends on the type of model used.
Predicting a crash immediately before it happens is not so difficult. Lots of economists were clanging the alarm bells all through the mid-00s. Predicting exactly when and exactly what the trigger would be? Basically impossible. Economists don't do that (it's left to advisors, pundits and newsletter salesmen).
Agree exact timing is not identifiable but the amount of warnings before 2007 was really pretty low. Maybe there are some that can be added to this list and it would be interesting to see if there were any with very different approaches:
http://www.debtdeflation.com/blogs/2009/07/15/no-one-saw-thi...
So there were a few but they generally weren't in the mainstream of economics (from Krugman to the Chicago School) which generally did a very bad job. Roubini did call it but none of the others on the list I linked to were people I had heard of before 2008 (but I haven't formally studied economics).
Many of the common models taught and used never indicate crashes, this sort of thing should just be thrown out. Most of them also don't really include the financial industry (including debt).