By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB
The efficient market hypothesis – in various forms – is at the heart of modern finance and macroeconomics. Roger Farmer argues in a recent VOXEU communique (Jan. 22nd) that market efficiency is extremely unlikely even without frictions or irrationality. Why? Because there are multiple equilibria, only one of which is Pareto efficient. For all other equilibria, the whims of market participants cause the welfare of the young to vary substantially in a way they would prefer to avoid, if given the choice. This invalidates the first welfare theorem and the idea of financial market efficiency. Central banks should thus dampen excessive market fluctuations.
Richard Thaler has drawn attention to two dimensions of the efficient markets hypothesis, what he refers to as: ‘no free lunch’, what economists refer to as ‘informational efficiency’; and ‘the price is right’, what economists refer to as ‘Pareto efficiency’.
Farmer argues that while there are strong reasons for believing there are no free lunches left uneaten by bonus-hungry market participants, there are no reasons for believing this will lead to Pareto efficiency, except, by chance. There are policy implications of this, showing that the Pareto inefficiency of financial markets provides strong grounds to support central bank intervention to dampen excessive market fluctuations.
Some economists believe that financial markets experience substantial frictions. For example, agents are irrational, households are borrowing constrained or prices are sticky. Although there may be some truth to all of these claims, direct central bank intervention in the financial markets does not rest on any of these alleged market imperfections.
A number of economists suggest competitive financial markets will not function properly by government intervention. This assertion has been formalized in the first welfare theorem of economics. The theorem provides conditions under which free trade in competitive markets leads to a Pareto efficient outcome, a situation where there is no way of reallocating resources that makes one person better off without making someone else worse off. Farmer indicates why the conditions that are necessary for the theorem to hold do not characterize the real world.
The standard assumptions include: households are rational and plan for the future; they have rational expectations of all future prices; there are complete financial markets in which agents are free to make trades contingent on future observable events; and no agent can influence prices. In this approach, there are two types of people who discount the future at different rates; patient and impatient agents. Both types share common beliefs, which can independently influence what occurs. This follows an important idea called ‘sunspots’, or a ‘self-fulfilling prophecy’.
What can go wrong when agents are rational, hold rational expectations, there are no frictions, and markets are complete? Well, the first welfare theorem does not account for the fact that people die and new people are born. In our world: patient and impatient agents each recognize that the financial markets are fickle and equity markets can be volatile; if the markets boom then the patient savers will lend more to the impatient borrowers; and if the markets crash, then the savers will recall their loans.
Financial booms and crashes occur as a consequence of the animal spirits of market participants. Why should we care if there are big movements in the asset markets? After all, the borrowers and lenders are rational and they have made bets with each other in full knowledge that these large asset movements might occur. The problem is that the next generation is unable to insure against swings in wealth that have a big influence on their lives.
Recent research indicates that the present value of lifetime income of new entrants to the labor market can differ substantially depending on whether their first job occurs in a boom or a recession. As a result, the lifetime income of the young can differ markedly. Young agents prefer to avoid the risk of a sharp variation in lifetime wealth. There is a feasible way of allocating resources that would insure them against this risk, but financial markets cannot achieve this allocation, except by chance. The inability of our children to trade in prenatal financial markets is sufficient to invalidate the first welfare theorem of economics. In short, sunspots matter.
Farmer notes financial markets cannot work well in the real world except by chance because: there are many equilibria; only one of them is Pareto efficient; for all other equilibria, the whims of market participants cause the welfare of the young to vary substantially. Agents are rational, they have rational expectations and there are no financial frictions. Even when agents are rational, markets are not.
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