When are markets “rational”?

Last month’s award of the Nobel Price in economics set off a great deal of chortling because one of the three recipients, Eugene Fama, received the award for saying that markets are efficient at capital allocation and another, Robert Schiller, received the award for saying they are not. Typical is this response by John Kay:

The Royal Swedish Academy of Sciences continues to astonish the public when awarding the Nobel Memorial Prize in Economics. In 2011 it celebrated the success of recent research in promoting macroeconomic stability. This year it pays tribute to the capacity of economists to predict the long-run movement of asset prices.

People with knowledge of financial economics may be further surprised that this year Eugene Fama and Robert Shiller are both recipients. Prof Fama made his name by developing the efficient market hypothesis, long the cornerstone of finance theory. Prof Shiller is the most prominent critic of that hypothesis. It is like awarding the physics prize jointly to Ptolemy for his theory that the Earth is the centre of the universe, and to Copernicus for showing it is not.

To me, much of the argument about whether or not markets are efficient misses the point. There are conditions, it seems, under which markets seem to do a great job of managing risk, keeping the cost of capital reasonable, and allocating capital to its most productive use, and there are times when clearly this does not happen. The interesting question, in that case, becomes what are the conditions under which the former seems to occur.

I wrote about this most recently in my most recent book about China, Avoiding the Fall, and I think it might be useful to recap that argument. I argued in the book (based on some articles I published in 2004-05) that an “efficient” market is one that has an efficient mix of investment strategies. Without this efficient mix, the market itself fails in its ability to allocate capital productively at reasonable costs.

Investors make buy and sell decisions for a wide variety of reasons, and when there is a good balance in the structure of their decision-making, financial markets are stable and efficient. But there are times in which investment is heavily tilted toward a particular type of decision, and this can undermine the functioning of the markets.

To see why this is so, it is necessary to understand how and why investors make decisions. An efficient and well-balanced market is composed primarily of three types of investment strategies—fundamental investment, relative value investment, and speculation—each of which plays an important role in creating and fostering an efficient market.

  • Fundamental investment, also called value investment, involves buying assets in order to earn the economic value generated over the life of the investment. When investors attempt to project and assess the long-term cash flows generated by an asset, to discount those cash flows at some rate that acknowledges the riskiness of those projections, and to determine what an appropriate price is, they are acting as fundamental investors. 
  • Relative value investing, which includes arbitrage, involves exploiting pricing inefficiencies to make low-risk profits. Relative value investors may not have a clear idea of the fundamental value of an asset, but this doesn’t matter to them. They hope to compare assets and determine whether one asset is over- or underpriced relative to another, and if so, to profit from an eventual convergence in prices. 
  • Speculation is actually a group of related investment strategies that take advantage of information that will have an immediate effect on prices by causing short-term changes in supply or demand factors that may affect an asset’s price in the hours, days, or weeks to come. These changes may be only temporarily and may eventually reverse themselves, but by trading quickly, speculators can profit from short-term expected price changes.

Each of these investment strategies plays a different and necessary role in ensuring that a well-functioning market is able keep the cost of capital low, absorb financial risks, and allocate capital efficiently to its more productive use. A well-balanced market is relatively stable and allocates capital in an efficient way that maximizes long-term economic growth.

Each of the investment strategies also requires very different types of information, or interprets the same information in different ways. Speculators are often “trend” traders, or trade against information that can have a short-term impact on supply or demand factors. They typically look for many opportunities to make small profits. When speculators buy in rising markets or sell in falling ones—either because they are trend traders or because the types of leverage and the instruments they use force them to do so—their behavior, by reinforcing price movements, adds volatility to market prices.

Different Investors Make Markets Efficient

Value investors typically do the opposite. They tend to have fairly stable target price ranges based on their evaluations of long-term cash flows discounted at an appropriate rate. When an asset trades below the target price range, they buy; when it trades above the target price range, they sell.

This brings stability to market prices. For example, when higher-than-expected GDP growth rates are announced, a speculator may expect a subsequent rise in short-term interest rates. If a significant number of investors have borrowed money to purchase securities, the rise in short-term rates will raise the cost of their investment and so may induce them to sell, which would cause an immediate but temporary drop in the market. As speculators quickly sell stocks ahead of them to take advantage of this expected selling, their activity itself can force prices to drop. Declining prices put additional pressure on those investors who have borrowed money to purchase stocks, and they sell even more. In this way, the decline in prices can become self-reinforcing.

Value investors, however, play a stabilizing role. The announcement of good GDP growth rates may cause them to expect corporate profits to increase in the long term, and so they increase their target price range for stocks. As speculators push the price of stocks down, value investors become increasingly interested in buying until their net purchases begin to stabilize the market and eventually reverse the decline.

Relative value investors or traders play a different role. Like speculators, they tend not to have long-term views of prices. However, when any particular asset is trading too high (low) relative to other equivalent risks in the market, they sell (buy) the asset and hedge the risk by buying (selling) equivalent securities.

A well-functioning market requires all three types of investors for socially useful projects to have access to appropriately-priced capital.

  • Value investors allocate capital to its most productive use.
  • Speculators, because they trade frequently, provide the liquidity and trading volume that allows value investors and relative value traders to execute their trades cheaply. They also ensure that information is disseminated quickly.
  • Relative value trading forces pricing consistency and improves the information value of market prices, which allows value investors to judge and interpret market information with confidence. It also increases market liquidity by combining several different, related assets into a single market. When buying of one asset forces its price to rise relative to that of other related assets, for example, relative value traders will sell that asset and buy the related assets, thus spreading the buying throughout the market to related assets. It is because of relative value strategies that we can speak of a unified market for different assets.

Without a good balance of all three types of investment strategies, financial systems lose their flexibility, the cost of capital is likely to be distorted, and the markets become inefficient at allocating capital. This is the case, for example, in a market dominated by speculators. Speculators focus largely on variables that may affect short-term demand or supply for the asset, such as changes in interest rates, political and regulatory announcements, or insider behavior.

They ignore information like growth expectations or new product development whose impact tends to reveal itself only over long periods of time. In a market dominated by speculators, prices can rise very high or drop very low on information that may have little to do with economic value and a lot to do with short-term, non-economic behavior.

Value investors keep markets stable and focused on profitability and growth. For value investors, short-term, non-economic variables are not an important or useful type of information. They are more confident of their ability to discount economic variables that develop and affect cash flows over the long term. Furthermore, because the present value of future cash flows is highly susceptible to the discount rate used, these investors tend to spend a lot of effort on developing appropriate discount rates. However, a market consisting of only value investors is likely to be illiquid and pricing-inconsistent. This would cause an increase in the required discount rate, thus raising the cost of capital for borrowers.

Because each type of investor is looking at different information, and sometimes analyzing the same information differently, investors pass different types of risk back and forth among themselves, and their interaction ensures that a market functions smoothly and provides its main social benefits. Value investors channel capital to the most productive areas by seeking long-term earning potential, and speculators and arbitrage traders keep the cost of capital low by providing liquidity and clear pricing signals.

Where Are the Value Investors?

Not all markets have an optimal mix of investment strategies. China, for example, does not have a well-balanced investor base. There is almost no arbitrage trading because this requires low transaction costs, credible data, and the legal ability to short securities. None of these is easily available in China.

There are also very few value investors in China because most of the tools they require, including good macro data, good financial statements, a clear corporate governance framework, and predictable government behavior, are missing. As a result, the vast majority of investors in China tend to be speculators. One consequence of this is that local markets often do a poor job of rewarding companies for decisions that add economic value over the medium or long term. Another consequence is that Chinese markets are very volatile.

Why are there so few value investors in China and so many speculators? Some experts argue that this is because of the lack of investors with long-term investment horizons, such as pension funds, that need to invest money today for cash flow needs far off in the future. Others argue that very few Chinese investors have the credit skills or the sophisticated analytical and risk-management techniques necessary to make long-term investment decisions. If these arguments are true, increasing the participation of experienced foreign pension funds, insurance companies, and long-term investment funds in the domestic markets, as Beijing has done with its QFII program, is certainly seems like a good way to make capital markets more efficient.

But the issue is more complex than that. China, after all, already has natural long-term investors. These include insurance companies, pension funds, and, most important, a very large and remarkably patient potential investor base in its tens of millions of individual and family savers, most of whom save for the long term. China also has a lot of professionals who have trained at the leading U.S. and UK universities and financial institutions, and they are more than qualified to understand credit risk and portfolio techniques. So why aren’t Chinese investors stepping in to fill the role provided by their counterparts in the United States and other rich countries?

The answer lies in what kind of information can be gathered in the Chinese markets and how the discount rates used by investors to value this information are determined. If we broadly divide information into “fundamental” information, which is useful for making long-term value decisions, and “technical” information, which refers to short-term supply and demand factors, it is easy to see that the Chinese markets provide a lot of the latter and almost none of the former. The ability to make fundamental value decisions requires a great deal of confidence in the quality of economic data and in the predictability of corporate behavior, but in China today there is little such confidence.

How to develop the investor base

Furthermore, regulated interest rates and pricing inefficiencies make it nearly impossible to develop good discount rates. Finally, a very weak corporate governance framework makes it extremely difficult for investors to understand the incentive structure for managers and to be confident that managers are working to optimize enterprise or market value.

And yet, when it comes to technical information useful to speculators, China is too well endowed. Insider activity is very common in China, even when it is illegal. Corporate governance and ownership structures are opaque, which can cause sharp and unexpected fluctuations in corporate behavior. Markets are illiquid and fragmented, so determined traders can easily cause large price movements. In addition, the single most important player in the market, the government, is able—and very likely—to behave in ways that are not subject to economic analysis.

This has a very damaging effect on undermining value investment and strengthening speculation. In the first place, unpredictable government intervention causes discount rates to rise, because value investors must incorporate additional uncertainty of a type they have difficulty evaluating.

Second, it puts a high value on research directed at predicting and exploiting short-term government behavior, and thereby increases the profitability of speculators at the expense of other types of investors. Even credit decisions must become speculative, because when bankruptcy is a political decision and not an economic outcome, lending decisions are driven not by considerations of economic value but by political calculations.

China is attempting to improve the quality of financial information in order to encourage long-term investing, and it is trying to make markets less fragmented and more liquid. But although these are important steps, they are not enough. Value investors need not just good economic and financial information, but also a predictable framework in which to derive reasonable discount rates. And here China has a problem.

There are several factors, besides the poor quality of information, that cause discount rates to be very high. These include market manipulation, insider behavior, opaque ownership and control structures, and the lack of a clear regulatory framework that limits the ability of the government to affect economic decisions in the long run. This forces investors to incorporate too much additional uncertainty into their discount rates.

Chinese value investors, consequently, use high discount rates to account for high levels of uncertainty. Some of this uncertainty represents normal business uncertainty. This is a necessary component of an economically efficient discount rate, since all projects have to be judged not just on their expected return but also on the riskiness of the outcome. But Chinese investors must incorporate two other, economically inefficient, sources of uncertainty. The first is the uncertainty surrounding the quality of economic and financial statement information. The second is the large variety of non-economic factors that can influence prices.

This is the crucial point. It is not just that it is hard to get good economic and financial information in China. The problem is that even when information is available, the variety of non-economic factors that affect value force the appropriate discount rate so high that value investors are priced out of the market.

Speculators, however, are much more confident about the value of the information they use. Furthermore, because their investment horizon tends to be very short, they can largely ignore the impact of high implicit discount rates. As a result, it is their behavior that drives the whole market. One consequence is that capital markets in China tend to respond to a very large variety of non-economic information and rarely, if ever, respond to estimates of economic value.

During the past decade, Beijing was betting that increasing foreign participation in the domestic markets would improve the functioning of the capital markets by reducing the bad habits of speculation and increasing the good habits of value investing and arbitrage. But it has become pretty clear that this faith was misplaced: the market is as speculative and inefficient as ever. This should not have been a surprise. The combination of very weak fundamental information and structural tendencies in the market—such as heavy-handed government interventions and market manipulation—reward speculative trading and undermine value investing. This forces all investors to focus on short-term technical information and to behave speculatively. In China even Warren Buffett would speculate.

Investors in Chinese markets must be speculators if they expect to be profitable. As long as this is the case, investors will not behave in a way that promotes the most productive capital allocation mechanism in the market, and such efforts as bringing in foreigners will have no meaningful impact.

What China must do is something radically different. It must downgrade the importance of speculative trading by reducing the impact of non-economic behavior from government agencies, manipulators, and insiders. It must improve corporate transparency. It must continue efforts to raise the quality of both corporate reporting and national economic data. Finally, it must deregulate interest rates and open up local markets to permit arbitragers to enforce pricing consistency and to allow better estimates of appropriate discount rates.

If done correctly, these changes would be enough to spur a major transformation in the way Chinese investors behave by permitting them to make long-term investment decisions. It would reduce the profitability of speculative trading and increase the profitability of arbitrage and value investing, and so encourage a better mix of investors. If China follows this path, it would spontaneously develop the domestic investors that channel capital to the most productive enterprise. Until then, China’s capital markets, like those of many countries in Latin America and Asia, will be poor at allocating capital.

When efficient markets become inefficient

But this is not just an issue for China. In the US there have been times when markets seemed efficient and rational, and times when they clearly were not. Of course this cannot be explained by the disappearance of the tools needed by value investors – for example the market for internet stocks seemed rational in the early 1990s and clearly became irrational by the late 1990s, but this did not occur, I would argue, because fundamental investors were suddenly deprived of their analytical tools.

What happened instead, I would argue, is that conditions that led to a too-rapid expansion of liquidity at excessively low interest rates changed the environment in which fundamental investors could operate. As excess liquidity forced up asset prices, the likes of Warren Buffet found themselves unable to justify buying assets and so they dropped out of the market. As they did, the mix of investment strategies shifted until the market became dominated by speculators, and when this happened what drove prices was no longer the capital allocation decision of value investors but rather than short-term expectations of changes in demand and supply factors that characterize a highly speculative market.

This, I would argue, made the US stock market of the late 1990s (and perhaps today, too) “irrational”, not because they are fundamentally irrational or inefficient but rather because they can only function efficiently with the right mix of investment strategies. When the mix was altered – and this can happen when liquidity is too abundant, or when a sudden shock undermines the confidence value investors have in their ability to analyze data, or when a political event cause uncertainty to rise so high that value investors are priced out of the market, or for a number of other reasons – the markets stopped functioning as they should.

Perhaps what I am saying is intuitively obvious to most traders or investors, but it seems to me that it suggests that the argument about whether markets are efficient or not misses the point. There are certain conditions under which markets are efficient because the tools needed for each of the various investment strategies are widely available and are credible. When those conditions are not met, because the tools are not available, or when they are temporarily overwhelmed by exogenous events, perhaps because the credibility of those tools are temporarily undermined, or when excess liquidity causes fundamental investors to drop out, markets cannot be efficient.

 

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53 Comments

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  1. Great post. Very much in line with Andrew lo’s adaptive ( evolutionary) market hypothesis which to me is exactly how the markets work.

    Specifically related to China I would also point out the role of feedback loops and Soros’ reflexivity theory. I think feedback loops explain a lot about China’s real estate market, why else have so many empty apartments and local gov’t salivating over building more. Liquidity explains a lot too as u mentioned.

    Lastly I would point out that fundamental investors, especially those with a value / cheap bent are very poor allocators of capital in environments with lots of change. They are often playing by the rules of the lastregime and dontdon’t rerealize the game has changed until far to late. They do well when there are opportunities ( lack of liquidity) but otherwise don’t create so much economic value.

  2. Excellent post. Markets consist of different traders/speculators/investors working on different time frames off different information. Crazy stuff like bubbles, crashes, cascades, etc occur when the underlying structure of the market is messed up. It usually happens, as you noted, when longer term “value investors” drop out of the market.

    It’s always funny when people blame speculators for creating bubbles when bubbles are almost always driven by factors like excess liquidity or some other form of breakdown in the market’s normal structure.

  3. Great post, professor. So far since its inauguration this new administration has really shown a lot of willingness in opening up and liberalizing the Chinese capital markets… putting a freely convertible currency and a market oriented interest rate regime on the agenda are steps in the right direction… not that things will happen overnight but at least we have something to hope for in the next five to ten years … on a side note, I would suspect that your suggestions should really be heard by Mr. Xiao of the CSRC – why wouldn’t he? I thought he is one of those in the current administration who really understand the markets and appreciate its risks and rewards.

  4. I think the importance of liquidity in driving market bubbles doesn’t get nearly enough attention, I’m glad you mentioned it. The Feds policies of accommodating speculative excess with artificially low interest rates and liquidity injections have proven to be extremely damaging. Each bubble has been bigger than the one before as more stimulus has been applied to “mop up” the last bubble. Currently the world is in the midst of a historic credit bubble, leading to absurd market valuations, when this one will burst no one knows.

    I do however have one partially related question. In the 1970’s the Federal Reserves debt monetization caused major inflation. With QE, particularly QE3, we don’t see CPI inflation, instead we see major asset inflation. Why? Is it because the financial system is more flexible today than it was 40 years ago?

    • Mabey because in the early stage of consumer price inflation, inflation take the form of reduced portion and material substitution rather than explicit price inflation. There are hidden signs of inflation, like McDonald ending the dollar menu http://www.theatlantic.com/business/archive/2013/10/why-mcdonalds-killed-the-dollar-menu-in-1-chart/280778/

      • I don’t think you understand what the words “hidden inflation” mean. Ending the dollar menu would probably be evidence of “outright” inflation in one very specific sector of the economy (i.e., fast food prices). It is not a sign of general price inflation. It is one, incredibly small, data point.

        As for the comment from “illumined” (oh, the irony), if one thinks the liquidity injections have “proven” to be extremely damaging, one has an almost unbelievably low standard of proof. First, cause and effect has not even been established. Second, it is usually impossible to judge “extremely damaging” without knowing the probability distribution of other outcomes, many of which may have in fact have been worse (with no certainty that *any* would have been better). Yikes.

        • First, are you suggesting that excess liquidity DOESN’T cause bubbles? Second, bubbles lead to a lot of severe distortions in the economy and if the bubble is followed up by another bubble then those distortions aren’t allowed to work themselves out, perpetuating and worsening the problem. Huge shocks like this can cause a lot of social disruption as millions of people have the rug pulled out from under them, a recent example being the collapse of the Suharto regime in the Asian Financial Crisis.

    • manufactures in Europe substituting horse meat and pork for beef my also be caused by inflation.

      https://en.wikipedia.org/wiki/2013_meat_adulteration_scandal

    • CPI in the US underweights a number of items — healthcare costs, energy costs, and education (secondary and university) to name three. CPI also does hedonic adjustments that lower the reported rate, but the official formula ignores needed adjustments that would make the reported rate higher — e.g. the shift toward self service from gasoline stations to home depot.

      Also, CPI is not a measure of cost of living

    • I think it depends on where this monetary expansion is likely to show up, Illumined. If it shows up as higher consumption it is likely to be inflationary for consumer prices. If it shows up as higher production it is likely to be inflationary for asset prices. My guess is that when there is a significant rise in income inequality, whether income share accrues to the rich or to the state, monetary expansion is more likely to be of the latter kind, and this certainly seems to be the story of the past two decades.

      • What if instead of going into production or consumption it instead goes towards leveraged market speculation and investment? Or is that what you were saying (sorry if it was)? I suspect that a published bulletproof explanation of the effects of central bank policy in the serial bubbles of the past 20 years will lead to a Nobel prize in the future….

        • Illumined, asset prices go up when central banks print money because no bank can create equity in the system. So when the central bank expands one side of its balance sheet to buy long term debt; the liabilities must expand by the same amount. What are the liabilities of a central bank? Currency in the system. That currency in the system has to show up as an asset for the banking system, which means the same corresponding increase has to show up in the liabilities side of the banking system, which is someone else’s asset. So central bank money creation has to drive up asset prices because it drives up the money supply. Monetary policy always works through financial assets; don’t use IS/LM to think about monetary policy. IS/LM sucks.

          • I’m oversimpifying a bit. You can think of QE as an asset swap where the Fed effectively creates short-term debt to buy long-term debt. QE basically just floods the entire market with liquidity and it’s not really very inflationary. In this environment, QE is basically a currency war. Currency depreciation is always good for stocks.

      • Great article again Michael.

        I would also present an alternative explanation for the asset inflation as opposed to the CPI. I would perhaps argue that the Keynesian assumption that government bonds are classed (consciously or subconsciously) by the market as financial assets is correct. (Opposed to the Monetarist notion that government bond yields are also substitutable for goods and services). In this case a Liquidity Trap and the zero-bound interest rates will not lead to CPI inflation as people rush away from bonds (because they now have lower yields) and in turn buy goods and services. Instead the exodus from treasuries would fund financially classed objects such as equity and in a modern financial system even mortgages.

        Thanks,
        Flint

        • The substitutability with financial assets and cash rather than goods of course becoming stronger as the interest rate reaches the zero bound. Explaining why very low interest rates have different effects to moderately low interest rates

  5. Excellent, the clearest, most coherent explanation of the market I’ve read.

  6. Thanks for a fabulous discussion on the degree to which investment themes can ‘balance’ the market. I am of the mind that it is the dynamics of the market that is required, the ‘flux of energy’ that ‘creates’ the circumstances for efficiency. Not unlike a natural ecological system, the financial systems also benefits from heterogeneity (different investing strategies), and becomes imbalanced just an a monotypic forest is less productive that a highly diverse rainforest under natural conditions. Since heterogeneity is in constant flux, so is the ‘efficiency’ of the market.

  7. Great article. Beautiful logic. Learned a lot. Thanks.

    Agree with all the key drivers you mentioned which have caused high % of speculators in China. However, the fact that my 80-y mom and her sisters are trading stocks makes me wonder whether the Chinese population might be a ted more speculative than most other countries. :) High saving rate may not be an indication of conservativeness but rather ignorance of risk factors and lack of alternative options.

    Every single aspect (government non-economic behavior, corporate transparancy, interest rate deregulation) in your prescription to fix Chinese financial market seems so reasonable. But how I wish there’s an alternative given how daunting each of them is…

  8. Hi Professor Pettis,

    Off topic from your most recent post but I wanted to know if you had any comment with regards to a recent Zerohedge article that calculates a $15 trillion increase over 5 years in Chinese banking assets. This seems to be in line with your previous comments about 40-50% of China’s GDP being based on investment, most of which is likely debt financed (8 trillion GDP –> 40% debt financing over 5 years is about $15 trillion of new banking assets).

    http://www.zerohedge.com/news/2013-11-25/chart-day-how-chinas-stunning-15-trillion-new-liquidity-blew-bernankes-qe-out-water

    Do you have any insight into what the term structure is like of these new bank assets and who the debtors are?

    • Debt continues to be a huge problem in China, Davis, and we will just have to wait and see if the reforms really do reduce credit creation. So far nothing has changed.

  9. illumined;

    If you would have read Prof Pettis books and thought for one minute, I am 100 % sure, you would not have to ask why CPI is not increasing in USA.

    • I haven’t had the chance to read his publications, as much as I would like to, because right now there’s no money in my budget to purchase them. I looked at the library but they don’t carry his work unfortunately. Hopefully next year will be a little kinder in that regard.

  10. I would point out that your analysis is valid for most emerging markets. And, from time to time, to developed markets too.

  11. Great post. While I cannot comment about markets in China, I can easily explain the apparent failings of markets in the USA: Ben Bernanke is not a market.

  12. @HaiHao mentioned “80-y mom and her sisters are trading stocks”

    When I was in Shanghai, the old joke was that there were 3 casinos in China, Macau. Shenzhen Stock exchange and Shanghai Stock Exchange. As the lack of reliable macro data and often opaque nature of SOEs (not to mentioned their enforced role as social piggy bank), there is little advantage value and arbitrage investors can do. On the other hand, there is a good point that value investors who assume long-term gains may miss market inflection points during a transition to a different technology trajectory (MS has been noticeably absent in the mobile space). On the other hand, Michael’s comment that speculators ignore the high implicit discount rates is a worry. If such speculators borrow money, even at high interest, to punt whether IPO or property, then a sudden correction can leave a lot of people walking away from their debts. Given that the outcome is a state bailout or (if convertible) currency flight (already happening on smallscale with bitcoin, apparently a chinese exchange overtook Mt Grox in Japan as biggest trader) both outcomes leave egg on face of chinese economic “miracle” which can only destabalise popular legitimacy. It is a worry for anyone with adjacent borders (historically economic disruptions like droughts led to mass emigration).

  13. Is it Michael Mauboussin in his excellent book “More Than You Know” that talks about the wisdom and madness of the crowd? I’m not 100% sure. I think the basic idea is that when there is a diversity of opinion, the collective tends give a more correct answer than the individual players. However, when opinion becomes uniform (non diverse), as might happen in times of “exuberance”, or conversely at times of depression or recession, the collective tends to be wrong.

    So a market, under normal conditions, involves players with diverse opnions. This is intellectually satisfying, to me, and perhaps even intuitive. I suspect this is the key, rather than whether the market includes value investors, speculators and arbitragers. Though no doubt, without the speculators, markets would not get to the same dizzy highs or extreme lows.

    Lets not forget, that even in the value investing world, no two players will have the same opnion about value. They say the best value investors are contrarian in nature. Well if the market is most wrong, and hence offers the most value, when most players have the same opinion, then being contrarian will no doubt be a useful attribute.

    • I hadn’t really thought about the wisdom and madness of crowds, Mars, but it makes intuitive sense to me too that a diversity of opinion creates a more robust system. When opinions converge the system imbeds a lot of positive feedback, which automatically increases volatility.

  14. So, in essence, this entire theory is useless. The canonical versions are imaginary, and the balances required by this modification are equally implausible.

    But keep trying. It would be awful if the entire economics profession had to think of something new instead of trying to tweak the old garbage into something they can sell to their neoliberal billionaire funders.

    • My God, you have caught me. George Soros just paid me $200 to say all of this.

      • The problem, of course, is that there are so few actual ideas in economics that when one of them blows up the economy, the drones rush to reassemble it into something marginally useful, instead of thinking up some new idea.

        • Most of economics has failed, but the stuff Prof. Pettis is saying is spot on. Very little of what I’ve learned from Prof. Pettis through his blog posts, books, and other works is taught in undergrad economics. Instead, I see these old ideas being flushed around to be “heterodox” economics when they’re really just free-lunch economics. I see old Marxist ideas and old Chartalist ideas that have no bearing in how the real world works. I see ideas that say government debts don’t matter for God’s sake by people like Krugman and I see reincarnations of old Chartalist ideas that base everything off this idea (MMT). These ideas are dangerous; it’s a complete joke. What we witnessed wasn’t a “failure of the market”. We live in a world where 3 out of the top 4 largest economies follow a mercantilist economic growth model and you’re telling me that our world is showing us a failure of free markets?! That doesn’t make any sense.

  15. So, in essence, this entire theory is useless. The canonical versions are imaginary, and the balances required by this modification are equally implausible.

    But keep trying. It would be awful if the entire economics profession had to think of something new instead of trying to tweak the old garbage into something they can sell to their neoliberal billionaire funders.

    • I’m not so sure you understand what neoliberal is. What Prof. Pettis says isn’t really neoliberal and I’d argue that a very large part of a country’s development is due to strong financial markets. Ironically, a country like China with corrupt financial markets that aren’t developed that has much larger income inequality than a country like the US. Strong capital and financial markets are a necessary requirement for a country to become rich and I can’t think of a single country that’s gotten rich without those necessary institutions to allocate capital efficiently.

      • As Professor Mirowski explains in his recent book on the subject, Never Let A Serious Crisis Go To Waste: How Neoliberalism Survived The Financial Meltdown, the central idea of neoliberalism is that markets are smarter than people. Markets know all, see all, and can do all. Markets are the only solution to whatever the problem is. If we have a meltdown, more markets, if we have full employment, it’s the market. Government interference in the mysterious workings of these markets can only destroy their efficacy, and must be stopped.

        The EMH was a central part of the theory. It was totally discredited by the Great Crash. This is just another effort to revive the silly idea. The plain fact is that markets are artificial constructs, subject to cheating, lying, fraud, asymmetric information, and gamesmanship. Do you think High Frequency Trading is neutral? Do you think the market in Credit Default Swaps meets any definition of a competitive market? Do you buy real estate mortgage-backed securities like you would wheat?

        There is nothing useful in the EMH, nothing useful in using words like “market” to describe politics, CDSs, RMBSs, pay structures for CEOs of gigantic corporations, or pretty much anything happening in the real world.

        • So I always hear from super leftists that securitization and CDS were the cause of the financial crisis, which has very little bearing in reality. Securitization has existed for centuries and was even used to finance productive activity in the US (ex. railroads, loans for merchants, etc.). Financial instruments don’t drive bubbles, liquidity does. What, sir, are the primary drivers of liquidity? I believe it comes down to the world’s central banks.

          Let’s just blame the super rich for all the world’s problems. There is no need to be any other sort of accountability either. It’s all someone else’s fault, now isn’t it. Let’s continue running our societies based on this ridiculous premise too. Gimme a break. This stuff that’s said by super leftists doesn’t make any sort of sense.

          The primary problem isn’t financial instruments; the primary problem is too big to fail. The financial institutions have been too big to fail since the 80s. If we wouldn’t have kept with the ridiculous policy of bailing out financial institutions since the 80s, we’d have a much less fragile financial system today. I do believe that bailouts are a government policy too.

          • No the primary (fundamental causative) problem is the power vacuum of democracy that enables the control over creation of debt money and taxation that enables government to grow from 10% to 70% of the economy and the corruption that comes with that. See my other comment of this page for a cited reference.

        • But government has never stopped interfering in the market by setting interest rate and control the money supply. So your version of neoliberalism is imaginary.

        • “As Professor Mirowski explains in his recent book on the subject, Never Let A Serious Crisis Go To Waste: How Neoliberalism Survived The Financial Meltdown, the central idea of neoliberalism is that markets are smarter than people. Markets know all, see all, and can do all. Markets are the only solution to whatever the problem is.”

          The reason neoliberalism came about in the first place was because central planning failed so spectacularly in the 70’s and 80’s. At best it lead to stagnation, at worst it lead to tremendous hyperinflation. As it turned out governments aren’t too bright.

  16. The minanarchist perspective. Markets are inefficient due to a power vacuum that enables privatizing profits and charging losses to the collective as explained in Mancur Olsen’s The Logic of Collective Action.

    I could say more about this w.r.t. to hard money and the 3% power-law versus 97% gas-diffusion distribution of money [1] if anyone is interested?

    [1] Dragulescu and Yakovenko, “Exponential and power-law probability distributions of wealth and income in the United Kingdom and the United States”.

  17. Out of curiosity Professor Pettis, what do you make of the research of Daniel Ellsberg? If you’re thinking: “Wait – isn’t that the guy who released the Pentagon Papers?” – no, I’m not kidding. He also wrote a seminal article that was published in the November 1961 issue of the Quarterly Journal of Economics.

    http://qje.oxfordjournals.org/content/75/4/643.abstract

    Yes. The Daniel Ellsberg who released the Pentagon Papers and the Daniel Ellsberg who published that article are one and the same.

    His article deserves its acclaim as a classic. Although it was originally a thought experiment, the findings of the Ellsberg Paradox have been verified over and over again by numerous researchers over the past five decades. I think you ought to consider Daniel Ellsberg’s scholarship as support for your observations on financial markets in East Asia.

  18. Following Krugman’s advise, Ben Bernanke has replaced the housing bubble with a stock bubble. And all of Krugman’s followers rejoiced.

  19. Prof. Pettis,

    1. Can a mostly efficient market exist without a good rule of law? Are there any examples where it exists without rule of law?

    2. Can any economy be successful in the long term without mostly efficient markets when other countries have mostly efficient markets?

    Thanks.

    • 1. Probably not, and I say this mainly because I cannot think of exceptions, which doesn’t prove it one way or the other however.
      2. As I see it long term success doesn’t need stock or capital markets. It mainly needs a more or less efficient way to allocate capital, and this in the past has been done by capital markets, by banks, and by governments.

  20. “What happened instead, I would argue, is that conditions that led to a too-rapid expansion of liquidity at excessively low interest rates changed the environment in which fundamental investors could operate. As excess liquidity forced up asset prices, the likes of Warren Buffet found themselves unable to justify buying assets and so they dropped out of the market.”

    What did they move their money into? Bonds? It seems strange to me that lowering interest rates would cause investors to move into the very assets whose return has been lowered. It also seems plausible that a fall in the interest rate could correspond to an increase in asset prices quite apart from a rise in speculation. I’m not familiar with the empirical evidence, but could it be the other way around–that is, the movement of investors from stocks to bonds caused the interest rate to fall and stock prices to rise?

  21. Professor Pettis,

    I am wondering if you think your classification of the fundamental investor applies to currency and commodity markets. I’ve often run a thought experiment about what would happen should the RMB go to a free float in overnight. Almost certainly the USD/RMB would fall, but how does one assign a price target? Of course fundamental factors such as interest rates, inflation and current account balances could feed into a model, but there is not to my knowledge an established model such as DCF that one can use to price fiat money.

    If the yuan went to free float, i’d imagine primarily speculators would pile in. And maybe fundamental investors investing piling into a fully open open A shares market or private equity would push up the RMB as well but hard to imagine the futures curve would be set by fundamental investors. So here’s the crux of my thought experiment: if the currency opened tomorrow and USD/RMB hypothetically fell 25% to about 4.7. What would the hypothetical fall have been if the government had never let the RMB appreciate from USD/RMB 8 to USD/RMB 6.3. If today’s USD/RMB were 8 and full liberalization occurred would it still only lead to hypothetical a 25% drop? It seems unlikely it would equilibrate to the same fully liberalized exchange rate if the starting point was different, thus meaning currency prices aren’t efficiently established by information.

    Disregarding the gross oversimplification that if the USD/RMB were still 8 today then many of the fundamentals that effect currency prices would be wildly different, it seems currency exchanges have arbitrary starting points and fundamentals only push exchange rates around at the margin. For instance we’ve seen the EUR/USD rise significantly from 1.33 to 1.37 in the past month or so. However what if there had never been a Greek default fear that took the EUR/USD to 1.20 — that tail risk that never panned out and should no longer be effecting price, but it set a wildly different starting point for the EUR/USD. If the EUR/USD had never seen such lows, would recent improvements in fundamentals have led to a similar magnitude move to the upside but from a much higher starting point? Is there really no such thing as fundamental valuation of currencies?

    I imagine the same argument could apply to gold and oil etc. where fundamentals push prices around but speculative shocks such as Iran booby trapping the straits of hormuz wind up pushing prices to extremes and there’s no intrinsic value models that can bring prices back to normalcy.

  22. Dear Prof. Pettis,

    Thank you for the article. It makes a lot of sense and I learned something.

    May I suggest that you get someone to be your editor? I find your articles well thought out and clearly explained, while their copy-editing is less good: there are sometimes one or two typos in an article. I suppose you prefer spending time on thinking about economics rather than tracing each word’s spelling. So getting someone to do that for you may be the solution.

    In this article, “investment strategies are widely available and ate credible” should have been
    “investment strategies are widely available and are credible”.

    • Thnaks, Gerald, but this is a free website and it is hard to justify paying someone to edit it (or to find someone who will do it quickly and for free).

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