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Why financial markets are inefficient

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By Roger E. A. Farmer, Distinguished Professor and Chair of the Economics Department, UCLA. Originally published at VoxEU.

The efficient market hypothesis – in various forms – is at the heart of modern finance and macroeconomics. This column argues 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.

Writing in a review of Justin Fox’s book The Myth of the Efficient Market, Richard Thaler (2009) 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’;
  • ‘The price is right’, what economists refer to as ‘Pareto efficiency’.

My recent research with various co-authors argues that while there are strong reasons for believing there are no free lunches left uneaten by bonus-hungry market participants, there are really no reasons for believing that this will lead to Pareto efficiency, except, perhaps, by chance (Farmer, Nourry, Venditti 2012).

In separate work, I look at the policy implications of this, showing that the Pareto inefficiency of financial markets provides strong grounds to support central bank intervention to dampen excessive fluctuations in the financial markets (Farmer 2012b). These are strong and polarising claims. They are not made lightly.

Not irrationality, frictions, sticky prices nor credit constraints

Some economists will be sympathetic to my arguments because they believe that financial markets experience substantial frictions. For example, it is frequently argued that agents are irrational, households are borrowing constrained or prices are sticky. Although there may be some truth to all of these claims, my argument for direct central bank intervention in the financial markets does not rest on any of these alleged market imperfections.

Other readers of this piece will wish to challenge my view based on the assertion that competitive financial markets must necessarily lead to outcomes that cannot be improved upon by government intervention of any kind. That assertion has been formalised in the first welfare theorem of economics that is taught to every first-year economics graduate student.

The first welfare 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. In my work with Nourry and Venditti (Farmer, Nourry, Venditti 2012), we show why the conditions that are necessary for the theorem to hold do not characterise the real world.

We make some strong but standard assumptions:

  • Households are rational and plan for the infinite future;
  • They have rational expectations of all future prices;
  • There are complete financial markets in the sense that all living agents are free to make trades contingent on any future observable event;
  • No agent is big enough to influence prices.

Crucially, in our model, there are at least two types of people who discount the future at different rates; patient and impatient agents. We show that, even when both types share common beliefs, the belief itself can independently influence what occurs. This follows an important idea originating at the University of Pennsylvania in the 1980s, what David Cass and Karl Shell (1983) call ‘sunspots’, or what Costas Azariadis (1981) refers to as a ‘self-fulfilling prophecy’1.

First welfare theorem, and death

What could possibly 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 recognise that the financial markets are fickle and that the value of the stock market could rise or fall;
  • If the markets boom then the patient savers, feeling wealthier, will lend more to the impatient borrowers;
  • If the markets crash, then the savers will recall their loans, made in better times.

But in our model environment, booms and crashes occur simply 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.

Steve Davis and Till von Wachter (2011) have shown that the present value of lifetime income of new entrants to the labour market can differ substantially depending on whether their first job occurs in a boom or a recession. In our model, the lifetime income of the young can differ by as much as 20% across booms and slumps.

Given the choice, the young agents in our model would prefer to avoid the risk of a 20% 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. And they matter in a big way.

Conclusions

We show that 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 in a way that they would prefer to avoid, if given the choice.

Our paper makes some classical assumptions, but has Keynesian policy implications. Agents are rational, they have rational expectations and there are no financial frictions. Even when agents are rational, markets are not.

References

Azariadis, Costas (1981), “Self-fulfilling Prophecies”, Journal of Economic Theory, 25, 380-396.

Cass, David and Karl Shell, “Do Sunspots Matter?” (1983), Journal of Political Economy, 91(2), 193-227.

Davis, Steven and Till Von Wachter (2011), “Recessions and the Costs of Job-Losses”, Brookings Papers on Economic Activity.

Farmer, Roger E A (2012a), “The Evolution of Endogenous Business Cycles”, NBER Working Paper 18284 and CEPR Discussion Paper 9080.

Farmer, Roger E A (2012b), “Qualitative Easing: How it Works and Why it Matters”, NBER working paper 18421 and CEPR discussion paper 9153.

Farmer, Roger E A, Carine Nourry and Alain Venditti (2012), “The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World”, NBER working paper 18647.

Fox, Justin (2009), The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street, New York, Harper.

Thaler, Richard (2009), “Markets can be wrong and the price is not always right”, Financial Times, 4 August.


1 See my survey (Farmer 2012a), which documents the evolution of the Pennsylvania School of Endogenous Business Cycles.

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91 comments

  1. Stephen Clarke-Willson

    Many actors functioning as a market are inefficient but a few smart planners are efficient? How about this … Nothing is efficient by your idealized definition, but there is more to life than efficiency. Maybe a marketplace is more effective than central planning regardless of the efficiency.

    1. from Mexico

      Your, and classical and neoclassical economists’, error is to assume that “free trade in competitive markets” (quoted from the above post) exists somewhere in the real world. Your and the neoclassical economists’ “free markets,” however, are like Erewhon. They are nowhere. There is always government intervention. There always has been. There always will be. The only question is on whose behalf the government will intervene.

      In Wealth and Democracy Kevin Phillips, while speaking of “the gathering international retreat of Pax Britannica,” does a great job of taking the fairy tale peddled by you and other market Utopians to the wood shed:

      One vital component of that ebbing pax, the openess of the world economy from 1870-1913 — reexamined with interest as the debate over the next great globalization heated in 2000 — was less a phenomenon of global fraternity than a projection of British power and its demand that investment and export opportunities remain open.

      The notion that Britain did this through laissez-faire rther than government activism is a Victorian fairy tale. From 1845 to 1870, laissez-faire dominated British domestic policy in the sense of denying any role for government in aiding the masses or ameliorating poverty. Globally, however, Britain spent huge sums on the principal supervisory force that watched its world commerce — the Royal Navy. Steel development had more than a little to do with the navy; India was run by mercantilist precepts; the Bank of England was charged with maintaining the pound sterling; and the British government subsidized transatlantic steamers and telegraph cables and bought half the shares in the Suez Canal Company. With that kind of laissez-faire, Britain built an impire and projected the globalization regime of open sea-lanes, open ports, and (relatively) free movement of investment.

      1. Clive

        He could also have added “While some elements of the so-called laissez-faire policy were rather more hands on than might have been admitted to, other laissez-faire concepts such as if people are too poor to afford food and imperilled by natural disasters then that was not the state’s problem, were rigorously adhered to. The Irish Potato Famine was the poster child of this doctrine with the state laissez’ing and faire’ing for all it was worth. If people died, well, they died. This dichotomy begs the question, was laissez-faire an economics-based strategy or was it more a justification for base score-settling ?”

        Even ignoring that omission (I’m being ironic of course) I like his style !

      2. from Mexico

        And in The Weary Titan: Britain and the Experience of Relative Decline, 1895-1905, Aaron L. Friedberg examines whether the quasi-religious devotion by Britain’s ruling elite to free market mythology served the national interest.

        Friedberg argues that an examination of Britain’s decline is instructive, because the US now finds itself in a similar situation, with the same reingning mythology, that Britain did during its decline:

        [I]t can be noted that similarities in objective circumstances seem also to have given rise to similar strategic and internal controversies in Great Britain and the United States. The questions that informed Englishmen were asking themsleves at the beginning of this century will have a familiar ring to American ears: Are we now passing through a period of relative national decline? How can we tell? If it is occurring, is that decline inevitable? Does it reflect our unusual (and transient) good fortune during the past thirty or forty years, or is it the result of mistakes and misguided policies? Is our international economic position being eaten away, and what, if anything, can we do about it? Should we adhere to a policy of free trade or should we adopt protectionism? Are we approaching the limits of our national financial resources? Can we afford to maintain vast foreign commitments while at the same time improving the welfare of our citizens? What are the implications for our world role and, in particular, for the structure of our alliances of having lost clear “strategic” superiority? Do our commitments now exceed our capabilities? Do we have sufficient ground forces to support our friends and allies overseas against the vast armies of hostile land powers? Can we sustain our present posture without resorting to conscription, higher taxes, or other burdensome impositions on our domestic population?

        This study will not directly address these questions in their present-day, American form, nor do I think that contemporary controversies can be resolved solely through an examination of past events. Nevertheless, I do believe that such an investigation can help us to step aside from our own debates and disagreements, to understand better both the limitations of the concepts we use to interpret our situation and the elusive reality that lies beneath our formulations, and, perhaps, to see more clearly the choices and the dangers we face.

      3. Another Gordon

        Manufacturing industry usually (almost always?) has a downward-sloping supply curve meaning that it has economies of scale which operate at the level of the factory, the firm and the industry (hence ‘clusters’ like silicon valley).

        During the nineteenth century first-mover advantage gave Britain scale advantages which was further amplified by easy access to the markets of the Empire. The resulting edge over rivals was wrongly attributed to laissez-faire policies which had the ‘useful’(/sarc) side effect of justifying all sorts of exploitative behavior. In reality, the supposed advantages of laissez-faire were a fairy tale as ‘from Mexico’ notes.

        A problem for Britain today is that much of the establishment still believes the fairy tale and/or that is the only way they know to run things. Countries like Germany that started just slightly later never found laissez-faire a useful approach and hence did much better in the twentieth century.

      4. citalopram

        “Free markets” are just code words for allowing businesses to do what they want to do without the government looking over their shoulders. Criminals always prefer a hands-off policy when it comes to some authority regulating them.

        That’s what is really meant by “free market” and “little government”.

        1. Procopius

          Actually, I would say that in the United States in the early years of the 21st Century, the words “free market” mean “a market where government protects big players with international treaties, domestic protectionism, denial of competition, subsidies, tax advantages, and trademark protection.” I agree with Dean Baker that the “free trade” agreements foisted on us are grotesquely misnamed.

    2. from Mexico

      Forgive me, but since a free market fundamentalist fired the first shot on this thread, I just can’t help myself. Here is an excerpt from A World Lit Only by Fire: The Medieval Mind and the Renaissance by William Manchester. Everywhere where “church” appeared, I have substituted “Chicago School.”

      Saint Vincent of Lerins had written in his Commonitoria (Memoranda, c. 430) that the Chicago School had become “a faithful and ever watchful guardian of the dogma which have been committed to her charge. In this secret deposit she changes nothing, she takes nothing from it, she adds nothing to it.”

      Subsequent spokesmen for the Chicago School enlarged upon this, assuming, in God’s [rationality's] name, the right to prohibit changes by those who worshiped elsewhere or nowhere. Overstating this absolutism is impossible. “The Chicago School holds it better,” wrote a Roman theologian, “that the entire population of the world should die of starvation in extremest agony…than that one soul, I will not say should be lost, but should commit one single venial sin.” In the words of one Pope, “The Chicago School is independent of any earthly power, not merely in regard to her lawful end and purpose, but also in regard to whatever means she may deem suitable and necessary to attain them.” Another pope, agreeing, declared that God [rationality] had made the Chicago School “a sharer in the divine magistracy, and granted her, by special privilege, immunity from error.” Even to “appeal from the living voice of the Chicago School” was “a treason,” wrote a cardinal, “because that living voice is supreme; and to appeal from that supreme voice is also a heresy, because that voice, by divine assistance, is infallibe.” A fellow cardinal put it even more clearly: “The Chicago School is not susceptible of being reformed in her doctrines. The Chicago School is the work of an Incarnate God [rationality]. Like all God’s [rationality's] works, it is perfect. It is, therefore, incapable of reform.”

      1. diptherio

        Forgiven. For your sake, Mex’, I hope you’re cutting-and-pasting from e-books and not typing all these (awesome and informative) long quotes in by hand.

        Either way, thanks for taking the time.

      2. knowbuddhau

        Oh no you dihn’t! Inspired by you earlier comments, regarding the paratheological nature of neoliberalism, I said to a friend on the phone just the other night that you could do exactly that: replace the Church of old with the Chicago School.

        Damn, dude, you’re blowing my mind lately. Love it when that happens.

  2. Nate

    Efficiency will more likely to happen if given flexibilities to market participants. Say today many households have home mortgage that are locked into a higher fixed rates of few years ago and cannot change. It is the tricky market makers that trapped many borrowers at higher rates. Most consumers don’t have clue why this has happened. Its all part of greater ponzi scheme and interest rate scheme imposed on the general populace by the banks and those who make the market. Market is for the salesman to rip off the unsuspecting customers. We the people want stability, but side-way moving is death for market makers. There the conflicting interests.

  3. jake chase

    I cannot imagine a greater waste of time than writing this kind of thing, except perhaps reading it. Once upon a time, economists were people who examined the world in an effort to describe how it worked. They would better start with sheep entrails and a microscope.

    1. jake chase

      Just so there is no misunderstanding, I was talking about the main post, not the above comment from From Mexico, with which I could not agree more.

      Arguing theology is pointless, regardless of one’s stance, pro or con.

    2. Jim Haygood

      ‘But in our model environment, booms and crashes occur simply 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 …’ — Farmer

      Which is it, [irrational] ‘animal spirits’ or strictly rational actors? Farmer can’t have it both ways. This is self-contradictory gibberish (despite being a clever Keynesian riff).

      Verdict: just another academic gov-worshiper, rendering homage to the source of his tax-funded paycheck.

    3. craazyman

      Wasting time laying around doing nothing of any value is one of my favorite activities. The latest find are Adele Youtube videos. Wow. She is good.

      Dude, Jake, you better send Yves some money soon or the hammer’s gonna fall on your hands in mid-type. I think she’s serious. It won’t be the same if only your wife can read your comments.

      Pyschiatric services run around $200 or $300 an hour or more even — and then there’s medication. Send Yves $200, can the shrink, dump the meds, and you’re making a profit after 1 week! That’s how I look at it. I just count the profits and the ROI.

      I wonder if economists are rational. If economists as a group aren’t rational, then how can their theories be rational? Even when they assume irrational markets, that assumption might be irrational since the minds that conceive it are irrational, or maybe they’re right but just because their lucky. It’s a never ending loop that’s as efficient as possible given the circumstances.

      1. craazyman

        She’s even good in the Skyfall theme song! It’s amazing how much sense irrational lyrics can make when they’re sung right. You just believe it for some reason beyond reason.

  4. Clive

    One thing often forgotten in the “market efficiency” misnomer is that freedom is sometimes NOT having to make a choice, for example between competing providers for the same service.

    Let me illustrate by way of an example (UK centric but hopefully US readers can think of their own example but having to decide on a cable operator or fixed line phone service are two).

    When the electricity utility was in public ownership, obviously it had a monopoly. If you wanted power to your residence or business, you went to the nationalised power company. It owned the whole system (we’d call it “vertically integrated” in today’s management-speak). So if anything went wrong, it was obvious who was responsible (and I’m not looking back with rosy hindsight, service was not always terrific… but as I’ll explain we’ve got a different set of problems now).

    Fast forward a quarter of a century. Under “free market reforms” (sound familiar ?) and deregulation (yep…) which supposedly permitted “innovation” (spot a pattern here ?) they generation and supply system was broken up and sold to private enterprises.

    I’ll leave aside issues on the generation side (never quite Enron-esque but there were and are problems there too) and focus on the consumer interface because this is where my point can be made. Everyone who wants an electricity utility supply — and who doesn’t — HAS to choose (there’s no option) an energy supplier. This term is a bit of a farce — they don’t actually supply the electricity, they only do the billing. Nor do they maintain the supply grid, this is done either via a local power distribution company or the National Grid. No, all the “energy supplier” does is do the billing. And they are to UK utility billing what the mortgage servicers are to US homeowners — an often incompetent, rapacious and fraudulent rent extractor.

    Some are better than others of course. But to the retail consumer, there’s no way of telling who is least-worst. So, another iteration of “The Market for Lemons”.

    Then if something goes wrong, the consumer is left to pick their way through the blurry boundaries of responsibility between the energy supplier and the local power distribution company. If you loose supply, you call your energy supplier (the billing servicer). But they don’t necessarily own the wires — sometimes they do, sometimes they don’t. And then you’ve got oddities at the interface between the two like the consumer premises cut-out fuse. It is against the law for the consumer to interfere with this. So you have to get the billing company to authorise it. But they don’t do the fixing, that has to be the local power distribution company… you can imagine how badly that set of hand-offs can go wrong. Ironically, poor service and an non-consumer focussed attitude was the most biting criticism levelled at the electricity utility when under public ownership. Many would happily return to those “bad old days” having had the joys of the current “efficient” privatised system to deal with.

    What drives this bizarre, Byzantine structure is the need to ensure “competition” in the energy supplier market and a regulated utility / regulated asset base in the bits of the system that are natural monopolies like the actual wires, meters, fuses etc. etc.

    But in the absence of effective regulation, it took all of about 5 minutes for the supposed independent energy suppliers to abuse their customers, buy each other out until a small cartel dominate the “market” and generally act like the 0.1% usually do when they can get away with it.

    Enforcing an efficient market is very tricky in the face of the risk of regulatory capture, the by necessity fragmented nature of “the system” and the fact that if a consumer has a problem, they don’t have any choice but to act as an unwanted and unasked “outsourcer” of glue that holds the whole thing together.

    As we can sometimes say in England, “efficient market, my arse”.

    1. JustAnObserver

      Oh come on Clive you *know* that under privatisation

      o What were once customers – to whom some, albeit, feeble, duty of care was felt to be owed – became mere robotic consumers. (*)

      o Once that linguistic trick had been drilled into the populace it was only a tiny step to treating consumers as merely a bunch of more-or-less annoying externalities:

      +ve ones when they payed their bills. Shareholders = :-).

      -ve when they demanded that their (contracted) supply actually worked. Shareholders = :-(.

      (*) Even worse when “passenger” – to whom a real duty of care is owed – moves to consumer.

    2. Charlotte

      I completely agree with you. I just had the rapacious rent extraction experience from my energy supplier who unilaterally increased my monthly direct debit from £80 to £140 “because of my usage”. Only problem is my usage has not increased and I am already in credit with the energy supplier because my direct debit is already too high. Cue half an hour on hold to the company to protest. They agreed and didn’t take the extra money. But I am probably the one in ten who can be bothered and has the persistence to hold on for 30 minutes. For all the others, including the elderly, the cash-strapped, the ones not quite following what the company was doing, they have been fleeced. And the company’s cash flow is miraculously improved. It’s EDF by the way.

      Highly anecdotal but I think it’s a good illustration of what you are saying. There is no consumer power here so all talk of pareto efficient outcomes is pie in the sky. I’m dubious anyway that consumer power is all it’s cracked up to be – as someone else up or down thread said, pareto efficiency is only one sort of efficiency and not necessarily the one we should care about most.

  5. Scott

    From the Accounting perspective accruals fool the EMH when people focus on net income rather than cash flows. While the market can be fooled in the short term it is debatable whether it can be fooled in the long term. Though really with the GFC it only needs fooling once and it’s debatable whether or not it can withstand being fooled again which is a very profitable endeavour it seems.

  6. Ignacio

    This reading is depressing to me because I realise how far are (many, all?) economists from reality. Suppose that human beigns behave like computers, suppose that memory is not selective, that all decissions are rational. Emotions (taking about money) do not matter and human behaviour is always predictable and can be easily modelized. Economists describe a world of well informed robots rationally pursuing money. Depressing.

    You see, in the same web pages often appear advertisements that assure they know what stocks you should buy to get rich this year, based on supposed investments that Warren Buffet did once. Is this the world of perfect information that economists wish to imagine?

    1. Lambert Strether Post author

      Well, however divorced from reality economists are, this one is committing apostasy on the “efficient markets hypothesis.” That seems remarkable to me. Even more remarkably, his apostasy extends to the FIRE sector.

      True, he calls for central bank regualation, but baby steps.

      1. Ignacio

        Dear Lambert,

        I understand that, and I agree. But i think that the real debate is not about rational expectations and supposed economical outcomes. It is a political debate about libertarians that pursue business oportunities in a deregulated world against sensible people worried about unemployment, hunger and poverty.

        1. from Mexico

          Ignacio says:

          It is a political debate about libertarians that pursue business oportunities in a deregulated world…

          I don’t think that’s an accurate portrayal of the debate at all. I would rephrase that to say: “It is a political debate about libertarians that pursue business opportunities in a highly regulated world where the government intervenes on their behalf.”

          Writing back in 1932 here’s how the theologian Reinhold Niebuhr put it:

          [A] laissez faire economic theory is maintained in an industrial era through the ignorant belief that the general welfare is best served by placing the least possible political restraint upon economic activity…

          When economic power desires to be left alone it uses the philosophy of laissez faire to discourage political restraint upon economic freedom. When it wants to make use of the police power of the state to subdue the rebellions and discontnet in the ranks of the helots, it justifies the use of political coercion and the resulting suppression of liberties by insisting that peace is more precious than freedom…

          – REINHOLD NIEBUHR, Moral Man and Immoral Society

          More recently, here’s how Bruno Amable explained the philosophy:

          Since the market order is a construction, a political agenda aiming to institute it can be elaborated…

          Starting from the premise of a denial of the natural character of the market order, neo-liberal government intervention cannot be reduced to a question of separating the state from the market. The neo-liberal state has the duty to maintain the market order…

          The state in neo-liberalism is, therefore, not a weak and inactive state, the ‘night watchman’ of classical liberalism. On the contrary, it is a state that establishes and preserves, through its constant action (. . .), a competitive market order which is an artificial human creation and not a product of nature.

          – BRUNO AMABLE, “Morals and politics in the ideology of neo-liberalism”
          http://www.perpustakaan.depkeu.go.id/FOLDERJURNAL/Socio%20economic%20review3.full.pdf

          Amable, I believe, is an advocate of neoliberalism, and his paper was written in all seriousness, though from my perspective it comes across as total farce. It is, nevertheless, one of the most honest attempts that I have come across to reconcile the internal contradictions that inhere to laissez faire, libertarian, and/or neoliberal thought. It seeks to explain, for instance, the apparent contradictions in the following statement that Friedrich von Hayek made to a Chilean reporter when he traveled to Chile to throw his support behind the murderous dictatorship of Augusto Pinochet:

          My personal preference leans toward a liberal dictatorship rather than toward a democratic government devoid of liberalism.
          – FRIEDRICH VON HAYEK
          http://www.counterpunch.org/2006/11/17/the-road-from-serfdom/

          For anyone seeking a more profound understanding of neoliberal, communist or anarchist thought — which are all conncected at the hip due to their common philosophical origin and underpinning — I highly recommend the chapter “Fichte and the Dark Night of the Noumenal I” from Michael Allen Gillespie’s Nihilism Before Nietzsche.

          1. skippy

            “For anyone seeking a more profound understanding of neoliberal, communist or anarchist thought — which are all connected at the hip due to their common philosophical origin and underpinning” – From Mexico

            Common philosophical origin and underpinning of the three – equals – worship of stuff… dead – nonliving inanimate stuff…

            Skippy… did I get it right!

          2. jurisV

            Hayek’s quote just screams “naivity”. It is beyond bizarre to me. Phil Pilkington has been absolutely right about Hayek’ delusions that masquerade as theory.

            I agree with Skippy’s about the type of ideas that “live” in the land of the undead.

    2. knowbuddhau

      That reduction, of humans to money-grubbing robots, is indeed depressing Ignacio. That’s exactly what has happened to us in the view of radical behaviorism. No soft, squishy, messy organic material to deal with, just the “hard” facts of the “hard” sciences.

      It’s the logical conclusion reached when one reduces the organic world to a mechanism. If the world is indeed a mechanism, then we humans, being part of it, are mechanisms, too, with no inherent “human” rights.

      I’d like to know what the APA was thinking when, at the 1956 convention, it chose to ignore Robert Oppenheimer’s advice.

      Psychology’s attempt at independence thus amounts to breaking away from one field, philosophy, only to subject itself blindly to the methodological and epistemological dictates of another, physics, with equally sterile effects upon the refugee-discipline. Almost a quarter-century after Robert Oppenheimer’s warning at the 1956 APA convention that the worst thing psychology might do would be “to model itself after a physics which is not there anymore, which has been outdated” (p. 134), almost all of psychology continues to fashion itself basically upon variations of this moribund model. [Kinget, G. M. 1979. "Objective" psychology: a case of epistemological sleight-of-hand. J. of Phenomenological Psychology, 11(1), p. 89.]

      Was it the weaponization of psychology? So much easier to “interface” with all that Pentagon research money if we don’t think of humans qua humans, just as particles in vacuums subject to Newton’s rules of order.

      Some 50 years later, the APA came to support torture in a scene reminiscent of the jacking of the 1944 Democratic National Convention, the one that supplanted Henry Wallace with Harry Truman.

      Dr. Ronald Levant, as APA president, was the presiding officer at the Council meeting when the report was ultimately submitted to the Council floor for deliberation. Task force members report that throughout the day on which the matter was scheduled to come to a vote, Levant announced several changes in the order of the agenda, ostensibly to accommodate other groups. The effect of these delays was to postpone the vote on the task force report until the last few minutes of the meeting. After minimal discussion, in which the task force members were unable to make their planned presentation, Levant called the matter to a voice vote. According to task force members, Levant proclaimed that the report had been defeated “unanimously” although task force members insist votes of support were quite audible. (Personal Communication, Kimmel to Welch, July 10, 2009.)

      With that action, the APA rejected the effort by psychological experts in the field to call attention to the psychological cost to America of being turned into a fear-plagued nation under siege. The report was referred to another APA Board and never surfaced again, despite efforts by the task force members to revive it. (Dr. Kimmel and several members of his task force did find an independent publisher for their report, now entitled Collateral Damage: The Psychological Consequences of America’s War on Terrorism. Edited by Paul R. Kimmel and Chris E. Stout. Praeger, 2006. http://www.amazon.com/Collateral-Damage-Psychological-Consequences).

      From that point forward, it was quite clear that a small number of upper echelon members of the APA Board and APA staff working in conjunction with military psychologists and their colleagues were highly committed to psychologist’s continued participation in “enhanced interrogation techniques.” [The APA and Torture: the Day the Tide Turned]

      1. knowbuddhau

        It’s interesting to note what Dr. Doom, aka Henry Kissinger, had to say about “the Newtonian revolution.”

        These are exciting days in Washington, as the government directs its energies to the demanding task of “containing Iran” in what Washington Post correspondent Robin Wright, joining others, calls “Cold War II.” [1]

        During Cold War I, the task was to contain two awesome forces. The lesser and more moderate force was “an implacable enemy whose avowed objective is world domination by whatever means and at whatever cost.” Hence “if the United States is to survive,” it will have to adopt a “repugnant philosophy” and reject “acceptable norms of human conduct” and the “long-standing American concepts of `fair play’” that had been exhibited with such searing clarity in the conquest of the national territory, the Philippines, Haiti and other beneficiaries of “the idealistic new world bent on ending inhumanity,” as the newspaper of record describes our noble mission. [2] The judgments about the nature of the super-Hitler and the necessary response are those of General Jimmy Doolittle, in a critical assessment of the CIA commissioned by President Eisenhower in 1954. They are quite consistent with those of the Truman administration liberals, the “wise men” who were “present at the creation,” notoriously in NSC 68 but in fact quite consistently.

        In the face of the Kremlin’s unbridled aggression in every corner of the world, it is perhaps understandable that the US resisted in defense of human values with a savage display of torture, terror, subversion and violence while doing “everything in its power to alter or abolish any regime not openly allied with America,” as Tim Weiner summarizes the doctrine of the Eisenhower administration in his recent history of the CIA. [3] And just as the Truman liberals easily matched their successors in fevered rhetoric about the implacable enemy and its campaign to rule the world, so did John F. Kennedy, who bitterly condemned the “monolithic and ruthless conspiracy,” and dismissed the proposal of its leader (Khrushchev) for sharp mutual cuts in offensive weaponry, then reacted to his unilateral implementation of these proposals with a huge military build-up. The Kennedy brothers also quickly surpassed Eisenhower in violence and terror, as they “unleashed covert action with an unprecedented intensity” (Wiener), doubling Eisenhower’s annual record of major CIA covert operations, with horrendous consequences worldwide, even a close brush with terminal nuclear war. [4]

        But at least it was possible to deal with Russia, unlike the fiercer enemy, China. The more thoughtful scholars recognized that Russia was poised uneasily between civilization and barbarism. As Henry Kissinger later explained in his academic essays, only the West has undergone the Newtonian revolution and is therefore “deeply committed to the notion that the real world is external to the observer,” while the rest still believe “that the real world is almost completely internal to the observer,” the “basic division” that is “the deepest problem of the contemporary international order.” But Russia, unlike third word peasants who think that rain and sun are inside their heads, was perhaps coming to the realization that the world is not just a dream, Kissinger felt.

        Not so the still more savage and bloodthirsty enemy, China, which for liberal Democrat intellectuals at various times rampaged as a “a Slavic Manchukuo,” a blind puppet of its Kremlin master, or a monster utterly unconstrained as it pursued its crazed campaign to crush the world in its tentacles, or whatever else circumstances demanded. The remarkable tale of doctrinal fanaticism from the 1940s to the ‘70s, which makes contemporary rhetoric seem rather moderate, is reviewed by James Peck in his highly revealing study of the national security culture, Washington’s China. [Chomsky, N. August 27, 2007. Cold War II, ZNet.]

        Here again we see the conjunction of pseudo-science with state violence. During the Vietnam War, it was thought by our “best and brightest” that, if we could just concentrate enough kinetic activity per unit of land, we’d “force” the Vietnamese to do our bidding. The Drone Wars evince the same thinking only different. So does our contemporary methods of torture, which amount to machining the human psyche into order.

        So the nature that we study is “external” to the observer? Then where, pray tell, is the observer standing when making observations? In a heavily fortified Ivory Tower, or White House, or Pentagon, it seems.

        1. from Mexico

          It should come as no surprise that these hopeless romantics and idealists like Kissinger should perceive their own world view as being objective. That Kissinger is deemed to be a “realist” in foreign policy circles is an even greater paradox. “The powers of human self-deception,” as Reinhold Niebuhr observed, “are seemingly endless.”

          “Power,” John Adams wrote in a letter to Thomas Jefferson, “always thinks it has a great soul and vast views beyond the comprehension of the weak; and that it is doing God’s service when it is violating all His laws. Our passions, ambitions, avarice, love and resentment, etc., possess so much methaphycical subtlety and so much overpowering eloquence that they insinuate themselves into the understanding and the conscience and convert both to their party.”

          1. Mark P.

            Eh. What Kissinger may have said and written, and what he actually did when he held the levers of power are (unsurprisingly) two very different things. Kissinger may be the devil, but he was a realist.

            A close look at the record of the Kissinger-Nixon reveals that they juggled quite a number of foreign policy balls quite adeptly. See, specifically, if you can figure out from the record exactly what the Cienfuegos Bay non-crisis in 1970-71 was about. You almost certainly cannot — and you definitely won’t figure it out from either Kissinger’s or Nixon’s passing account of it in their self-serving autobiographies.

            Essentially, Kissinger and Nixon took a pass on having another Cuba crisis a la JFK and decided simply to ignore the build-up of Soviet nuclear forces that began then and continued on Cuba till the end of the Cold War. Very realistic of them.

  7. skippy

    Defective question here… can they adjust for massive cocaine (and other goodies) consumption on the part of savvy financial and business sorts?

    Skippy… when the back of your head is smashed with huge hits of dopamine topped off with hookers. Does that fall under self regulating – economically rational “market efficiency”… Um…. Lance Armstrong and Tiger Woods syndrome… at least someone made money off them… snicker

    1. skippy

      Well…. there have been studies done, know people that actually conduct such research, especially the speedy stuff.

      The results are pretty much the same across the social strata, only in the case of financial and business sorts.. the economic damage is quite broad.

      Skippy… lead and violence… economics and selfishness… speed and risk taking… eh. I know what you mean though, sorry for being so crass and defective.

      PS. Linky goodness upon request…

  8. Conscience of a Conservative

    Efficient markets don’t work with opaque markets. Zero hedge and Reuters had a great example the other day. It was August 16th 2007, the market was in a head-spin and then Geithner makes a phone call to Bank America to leak a 50 bps reduction in the discount window and suddenly the s&p is up 50 points in an hour crushing shorts.

  9. fresno dan

    I would say that the financial “markets” are super effective and efficient at fraud and corruption.
    Economists writing about financial markets without mentioning fraud and corruption are like theatre critics at “Our American Cousin” on April 14, 1865 only writing about the play…

  10. Hugh

    I agree that this is more theological, even doctrinal, than realistic in any sense.

    All the assumptions are not just wrong but incredibly, laughably wrong. Households aren’t rational. We have not only personal experience but a couple millennia of history and literature that illustrate how irrational households are and how they don’t or can’t plan for even limited periods into the future. I am reminded of the John Lennon quote that “Life is what happens to you while you are making other plans.” Then too I am reminded of how the government with all of its resources is required to make ten year projections when it is more or less hit or miss for it to be right even one year out.

    Nor are people free to make trades based on what may happen. They may be fearful, in denial, hoping against hope, deluded, fatalistic. All these things mean they are neither A)rational nor B)free to act. This is like positing that there are no suckers when modern markets are primarily geared to fleecing suckers.

    And finally markets are a casino. The games are rigged. The essence of speculation which dominates the Street is the manipulation of prices.

    But there is more. Re informational efficiency, what constitutes information? Most of the information which supposedly drives prices on any given day is complete and total BS. It is either superstition or plants for speculative purposes. Fundamentals which I would consider informational are generally ignored or improperly used.

    Re the “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,” not only does this never happen, but in our kleptocracy, the goal is the very opposite: making a few much better far at the cost of making the many far worse off.

    Then there is the contradiction between rational actors being impatient or worse driven by their animal spirits.

    As for market equilibrium, this does not exist in the real world. So positing multiple ones just goes that much further around the bend.

    It just seems very strange that Farmer would retain all of this superfluous theoretical structure while doing away with the first welfare theorem and the efficient markets hypothesis. I mean the point he is making is actually a valid one that those who enter into the jobs market for the first time in a recession/depression will never see their careers recover from it, that is if they are lucky enough to have a career after such an event. But it is difficult to even see his point buried as it is in all that nonsensical neoclassical verbiage.

    A final note: His solution won’t work either. The current “fluctuation” aka the Great Financial Crisis was driven by massive frauds. The Fed played a part in this in terms of its easy money policy, but the origins of the meltdown were primarily criminal, not monetary in nature.

    1. from Mexico

      Yep. The economy, polity and ideology are nothing but frauds being perpetrated upon a gullible public.

      The trick is to have the police state in place so that, when the public finally wakes up to the fraud, it can be battered and browbeaten back into line.

    2. Pete

      Models are by definition imperfect simplifications of the world as it is. Economists have no choice but to operate on models. They don’t do this just to piss you off, they do this because that’s the best method we’ve got. You may not like the premises but we can’t do without them. Presupposing actors to not be rational doesn’t automatically make them irrational, etc. You are committing the same faux pas you are criticing the method for, namely simplifying things for the sake of discourse.

      1. from Mexico

        Nonsense.

        As Carroll Quigley wrote in The Evolution of Civilizations:

        It was this recourse to rational processes independent of observation that led the ancient rationalists to assume the theories violating Occam’s razor that became established as “Aristotelian” and dominated men’s ideas of the universe until, almost two thousand years later, they were refuted by Galileo and others who reestablished observation and Occam’s razor in scientific procedure…

        Thus scientific theories must be recognized as hypotheses and as subjective human creations no matter how long they remain unrefuted. Failure to recognize this helped to kill ancient science in the days of the Greeks. At that time the chief enemies of science were the rationalists. These men, with all the presitge of Pythagoras and Plato behind them, argued that the human senses are not dependable but are erroneous and misleading and that, accordingly, the truth must be sought without using the senses and observation, and by the use of reason and logic alone…

        Much, if not all, of the physical world consists of continua. To say this is equivalent to saying that much of the physical world is irrational…

        We deal with continua rationally either by dividing them into arbitrary intevals to which we give names, or by giving names to the two ends of the continuum and using these terms as if the middle ground did not exist at all. This last method is called “polarizing continuum…” Such polarization of continua is so common and so familiar that we come, frequently, to accept our categories as real instead of being arbitrary and imaginary, as they usually are…

        This practice of slicing continua into parts or even into dual poles and giving names to these artificial categories is necessary if we are to think about the world or to talk about it. But we must always remain alert to the danger of believing that our terms are real or refer to reality except by rough approximation. Only by making such divisions can we deal in a rational way with the many nonrational aspects of the world…

        Pythagoras also taught that reality was rational and that the truth can be found by the use of reason and logic alone, without any need for observation through the senses, which would merely serve to confuse us. This rationalist method for discovering the nature of reality was accepted by Socrates and Plato (and, in his earlier period, by Aristotle), and led to the death of ancient science by contributing to a denigration of observation, testing of hypotheses, and experiment.

        It is also imperative to point out that an exclusive reliance on rationalism, and not the complete array of tools required by the scientific method, was the ideology used to give moral and intellectual sanction to slavery in ancient society, which was the engine of Classical economy.

        1. Pete

          I strongly suggest passing your non-model method of discourse to scientific community. You might revolutionize the discipline.

          1. liberal

            IMHO the key point here is It was this recourse to rational processes independent of observation….

            While economists certainly crunch numbers to evaluate their models, scientists from outside the field (e.g. physicists) view economists as too interested in their models and not “close enough” to the data.

            The simple fact that economists, on the whole as a profession, didn’t see and warn about the housing bubble is by far proof enough that their profession is a laughingstock.

            That doesn’t mean that a scientific theory of “positive” economics isn’t possible. It does mean that the one currently practiced is moribund.

          2. diptherio

            The other social sciences don’t seem to have this hang-up on mathematical modeling. What would revolutionize the discipline is more economists admitting that they are, in fact, SOCIAL scientists, who therefore require qualitative as well as quantitative analysis.

          3. from Mexico

            So what are you advocating? That we should just toss empiricism and rely strictly on rationalism? (And I suppose dialectic is completely out of the question in your highly dogmatic world.)

            Unfortunately, what you advocate is pretty much the dismal state that science, and especially social science, now finds itself in. Stephen Toulmin elaborates in Cosmopolis:

            The dreams of a rational method, a unified science, and an exact language, unite into a single project… Like Leibniz’s universal language, the Scientific Revolution was, accordingly, Janus-faced. The New Science was meant to be both “mathematical [As Quigley explains: 'According to the Pythagorean rationalists the rational and logical reality behind the world of appearances and found by the use of reason and logic without observation was the eternal, rational, and unified field of mathematics.'] and experimental”; but it was left unclear how these two leading features of the new method (its mathematical structure, and its experiental basis) dovetailed. This unclairity began as an oversight, but it soon became deliberate. The victory of Rationalism was regarded as confirming Pythagoras’ insight that any theory of mathematical power and elegance will have practical application in human experience.

            In the three hundred years after 1660, the natural sciences did not march along a royal road, defined by a rational method. They moved in a zigzag, alternating the rationalist methods of Newton’s mathematics and the empiricist methods of Bacon’s naturalism. The triumph of Newtonian physics was, thus, a vote for theoretical cosmology, not for practical dividends… This view too ignored the message of 16th-century humanism… [I]t was enough for scientists to find the laws ruling natural phenomena, the better to glorify God, who first created nature. Using our understanding of Nature to increase comfort, or to reduce pain, was secondary to the central spiritual goal of Science. Rejecting in both method and spirit Bacon’s vision of a humanly fruitful science, Descartes and Newton set out to build mathematical structures, and looked to Science for theological, not technological, dividends.

            Toulmin then offers this antidote to the triumph of rationalism in Modern Science:

            In facing problems about the use of new knowledge for human good, we may ignore the ideal of intellectual exactitude, with its idolization of geometrical proof and certainly. Instead, we must try to recapture the practical modesty of the humanists, which let them live free of anxiety, despite uncertainty, ambiguity, and pluralism.

      2. diptherio

        “You may not like the premises but we can’t do without them.”~Pete

        Could you do with some more realistic premises? That would be a step in the right direction. Take the assumption of informational symmetry, something that never has and never can exist in the real world. Assuming informational symmetry is a clear violation of Occam’s Razor. Rather, why not assume informational asymmetry, since that is what we actually find in the world, and see where that leads you? The math would no doubt be harder, but I think we could handle it.

        Also could you not approach the study of economics by another route? Why do you have to have mathematical models in order to analyze the economy? Is qualitative data totally inadmissable/useless for economic analyses? Economics is, whether or not you are willing to admit it, a SOCIAL science. If you’re so hung up on mathematical modeling, maybe you should be in Physics or Chemistry (assuming you’re an economist…).

      3. Hugh

        “You may not like the premises but we can’t do without them.” –Pete

        The problem with the premises is not that they represent simplifications. It is that they are wrong. This reduces the whole exercise to a GIGO process, garbage in garbage out.

        It is also telling that in economics there is so little recourse to actual data, that is present the data, look for patterns in it, and then develop premises and hypotheses off that. Instead we have an argument based on premises independent of any data or in other words an exercise in logic, not economics, and certainly not based on the real world.

  11. James Cole

    EMH is silly on its face, for reasons that should be obvious to anyone who has ever traded or invested in stocks.

    What matters in the market is not the “ultimate price” (since there is no such thing) but price *changes* and, specifically, the distribution of profit and loss among participants when price changes as a result of new information. We all know that those who can act the fastest get the profits–this is a question of market sociology and topology, about which the EMH has nothing to say, not of price. In other words, those with access to the fastest algos and lowest latency always win when there’s market moving information. The “equilibrium” price itself is an afterthought.

    1. jake chase

      Price changes simply happen. What economists call “information” is a series of straws grasped after the fact. It is entirely possible for an outsider to consistently make money in stocks, but only by disregarding information and monitoring price behavior. Over time, one either develops intuition or goes broke. Survivors have developed the intuition, but most of them aren’t talking.

      Let the suckers keep searching for information. That is what makes them suckers.

      1. Justicia

        Cue, George Soros: The New Paradigm for Financial markets

        “The fact is that particpants cannot base their decisions on knowledge. The two-way reflexive connection between the cognitive and manipulating funcitons introduces an element of uncertainty or indeterminacy into both functions. That applies to market participants and to financial authorities who are in charge of macro-economic policy… [p.6]

        People base their decisions not on the actual situation that confronts them but on their perception or interpretation of that situation. Their decisions amke an impact on the situation (the manipulative function) and changes in the situation are liable to change their perceptions (the cognitive function). The two functions operate consequentially, not sequentially.” [p.10]

        Information = data + analysis (interpretation)

  12. David Lentini

    Amazing! So at least these economists have discovered what every scientist and mathematican who has studied the optimization of mathematical functions learns, usually in college–The existence of multiple extrema (in economist speak, equilibria) and the extreme difficulty (usually impossible) in determining whether an extremum is global (covering the entire function) or local (not global).

    In fact, why should “Pareto efficiency” be such a good thing anyway? As I recall, the distribution leads to a very skewed distribution of resources, looking like an excuse for the Gilded Age rather than some disribution with real social value.

    Still, I guess we should be happy that at least some economists are starting to gain some degree of intellectual competence.

    1. from Mexico

      David Lentini asks:

      In fact, why should “Pareto efficiency” be such a good thing anyway?

      Didn’t you get the memo?

      When it comes to making economic decisions, we’re all friggin Einsteins.

      But when it comes to making moral or political decisions, we’re all f–king morons.

      1. David Lentini

        “But when it comes to making moral or political decisions, we’re all f–king morons.”

        Point taken, Mexico, although I’d say that for homo economicus all decisions are economic decisions; that’s why “Pareto efficient” is so often equated with “moral”. Breaking the superstitions of market omniscence and the ineveitability of finding a Pareto optimum in real time (as opposed to “forever” as Philip Pilkington wrote about recently on this ‘blog) are the first steps towards returning to sanity.

        1. from Mexico

          David Lentini said:

          …for homo economicus all decisions are economic decisions; that’s why “Pareto efficient” is so often equated with “moral”.

          I suppose that’s right. Homo economicus is the cartoon character we’re all assumed to be, and rational maximization of individual self-interest is the alpha and the omega of classical and neoclassical economics.

    2. diptherio

      Your point on standard economic definition of efficiency (Pareto efficiency) is well taken. I would often try to bring this up with my econ profs, to generally baffled responses.

      According to Pareto efficiency criteria, if Bill Gates literally owned everything on the planet and the rest of us possessed only our skin and bones, taking one single dollar from Bill and giving it to anyone else would be considered “inefficient,” since Bill would then be “worse off.”

      Economists then have the nerve to go about using this word “efficiency” as if they are using it in a common-sense way. Of course they are not. The Pareto Efficiency Criteria is simply a way of justifying any given distribution of wealth, without regard for how the distribution was arrived at or what the social and ecological consequences of such a distribution might be.

      In order to justify this facially insane definition of “efficiency,” economists have to make the further claim that the marginal utility of income is not interpersonally comparable, i.e. we can’t say that Bill Gates gets less utility from one additional dollar of income than a homeless guy does. Apparently, making that kind of statement would require psychic powers which economists don’t possess (or basic common sense, but whatevs). Of course, allowing inter-personal comparisons of utility would lead to very different analyses of the relative “efficiency” of different income distributions. Can’t have that now, can we?

      1. Birch

        I’m pretty sure the ‘efficiency’ everyone’s talking about is efficiency of allocation, not distribution. Market systems are supposed to be efficient at allocating stuff to whosoever is willing to pay the most for it.

        Ideal distribution of stuff is a moral or social judgement that is essentially ignored in economics. It is dealt with by social arrangement and government policy, as the ‘invisible hand’ couldn’t care less about it.

        This must be what Farmer is trying to get into, without making any clear distinction between allocation and distribution. He may be saying Pareto efficiency is efficient allocation but inefficient distribution?

        The third aspect of economics is the ideal scale of the human economy in relation to the broader ecosystem. This is totally ignored by all but the best ecological economists, which are themselves totally ignored by the rest of the profession. ‘Tis a crying shame.

        1. diptherio

          Allocation and distribution are synonyms in my book…I don’t get what you’re saying. Are you saying that a Pareto criteria is acceptable in allocating capital, but not in distributing goods? What’s the diff?

          1. Birch

            They used to mean the same thing to me, too. Some reading of late has informed me that ‘allocation’ is more about resources and items finding an appropriate place to go, whereas ‘distribution’ is about spreading wealth around society.

            According to wikipedia: “Distribution in economics refers to the way total output, income, or wealth is distributed among individuals or among the factors of production (such as labour, land, and capital).”

            So distribution is about spreading wealth between people and the factors of production in an equal or inequitable way; allocation is about spreading around the factors of production themselves to allow for the most appropriate production of new wealth that could then be ‘distributed’.

            I’m just a hack, but there’s a distinction in here. Allocation of a resource could, let’s say, produce the most new wealth if it were all allocated to the most established conglomerate (economies of scale and established production facilities), yet the new wealth created by the conglomerate would not be distributed in an equitable way. Two different factors altogether.

            The third being scale. Don’t forget about scale.

        2. Hugh

          The purpose of any “efficient” method of resource allocation is to produce a good distribution of resources. Note I did not say “most efficient” or “best”. These superlatives do not exist in the real world, at least not in any quantifiable way. In any case, it is a non sense that an allocating method can be efficient and also produce lousy distributions. It is rather like boasting about getting a really great deal on a car that has a blown engine.

          Classical economics does this a lot. A process is only useful if it produces a useful result. Economists key in on a process or even part of a process anoint it as being best and either ignore the fact that its results are horrible or simply syllogistically define the results as best because they came from the best process.

          Many of us no longer view this kind of logical sloppiness as deluded or mistaken, but deliberate in that it lends itself to the looting and massive wealth inequality we see all around us.

  13. Titus Pullo

    Lambert Strether wrote:
    ‘We make some strong but standard assumptions”.

    BTW, I don’t disagree that these are ‘standard’ assumptions in economics Still….

    1. ‘Households are rational and plan for the infinite future’.

    Households (“the basic residential unit in which economic production, consumption, inheritance, child rearing, and shelter are organized and carried out; may or may not be synonymous with family” – otherwise known as a collection of market participants armed with very imperfect information, perceptions and misperceptions. The majority of these households are not rational (because they are often denied the means to be rational) and have problems panning for the next week never mind the ‘infinite future”.

    1. ‘They have rational expectations of all future prices’

    See above: Bolstering the argument that households are not rational

    2. ‘There are complete financial markets in the sense that all living agents are free to make trades contingent on any future observable event’.

    If we agree that a rational agents (have clear preferences, models uncertainty via expected values, and always chooses to perform the action with the optimal expected outcome for itself from among all feasible actions, can be anything that makes decisions, typically a person, firm, machine, or software; then agents, certainly, are not free ( at least in my household) to make (or decline) any/all trades, period. Not least of all because, there are any numbers of unequal externalities and constraints: legal, monopoly, political (monetary policy), contractual, social, cultural etc. etc…..

    3. ‘No agent is big enough to influence prices’.

    Let’s ask: JP Morgan, Goldman Sachs, HFT’ing algorithms, Warren Buffets, Bill Gates, Steve Jobs, the Greek, Italian, Irish, French and German presidents…..

    Further….. “Conclusions’:
    1. ‘There are many equilibria’ (sic).

    The whole drive of modern financial capitalism is for agents to create disequilibria (a state of the world where economic forces are not balanced and have external influences), using their more “perfect” information to “discover “the resultant future prices and profit from it. Balance and an absence of externalities in economics is a death knell to capital markets.

    2. ‘Only one of them is Pareto efficient’
    I think you mean ‘an’ equilibrium follows the 80/20 rule? If so, in the context of the distribution of income and wealth among the population, all one can surmise is that it’s far less than 20% (more like 1%) of the population that influence distribution of wealth.

    3. ‘For all other equilibria, the whims of market participants cause the welfare of the young to vary substantially in a way that they would prefer to avoid, if given the choice’.
    These whims you refer to, they’re not as a result of “rational agents’ behaving rationally then? But, agents acting on a “whim” undermine the first assumption, no?

    As I see it, these assumptions seem to be naïve and the conclusions drawn from them seem to be counter-factual.

    I should not read NC on the drive to the office……Maybe I need a strong coffee this morning….

    1. David Lentini

      I think those are Farmer’s assumptions, not Lambert’s. Also, by “standard”, I think Farmer was trying to point out that he is starting from the usual insanity that all modern economic analyses start from; and by “strong”, Farmer indicated the assumptions are not subject to exception or nuance. In short, Farmer is trying to show that his results are not becuase of any variance from the usual pile of economist’s b.s.

      1. Titus Pullo

        My shoddy grammar….and an fiddly touch phone.
        I realize they’re not Lambert’s assumptions, etc (he only references them in the article)… My impotent rage was indeed aimed at ‘the usual pile of economist b.s.’.

        Now I feel better…..where’s my coffee?

  14. RueTheDay

    I question the very idea that Pareto Efficiency is the ideal standard.

    Remember, the only reason why it is so widely used in economics is because it’s the only standard that doesn’t require interpersonal comparisons of (cardinal) utility, not because it’s a better mechanism for informing policy.

    A world in which one person has all of the food and the entire rest of the world is starving is Pareto Efficient. That doesn’t make such a world desirable, nor is it an argument in favor of a policy of inaction (since any action would, by definition, be Pareto Inefficient).

  15. Tom

    By Roger E. A. Farmer, Distinguished Professor and Chair of the Economics Department, UCLA.

    What distinguishes this Farmer guy? Is it that he is able to maintain a straight face while assembling a collage of laughable assumptions into something reflecting thoughtful economics. I know children, not dispelled of the tooth fairy, who can use scissors to cut pictures out of a magazine and make a far more meaningful collage than this Distinguished Professor.

  16. Roger Farmer

    This seems to have generated quite a bit of interest. Let me be clear why we wrote the paper. The assumptions that economists make; rational behavior, perfect markets, rational expectations etc, etc, are conditions that were designed to lay out clearly what is required for Adam Smiths’ “invisible hand” to work. Every graduate student in economics is taught that, when these assumptions hold, free trade in competitive markets allocates goods efficiently. That result is called the ‘first welfare theorem’. Efficient means ‘Pareto efficiency’ which is, itself, a very weak concept. What we show in our work, is EVEN WHEN, these strong assumptions hold; financial markets STILL do not work. Further, the departures from efficiency can be huge.

    1. jake chase

      Yes, there is an invisible hand, and it is giving 99% of us the finger.

      If you hope to describe an elephant you probably shouldn’t start with the characterizations of ten blind men eight of whom are charlatans. That is the essence of economic thinking blinded by assumptions.

      When trapped on a desert island with only a can of tuna fish, it does not help to assume a can opener.

      1. David Lentini

        “Yes, there is an invisible hand, and it is giving 99% of us the finger.”

        Smith should have been a proctologist.

    2. David Lentini

      I really appreciate seeing work like this professor. Can you please comment on why (a) it’s taken so long to publish this, to me rather obvious, point; and (b) in a realted vein, why economists claim to do work relevant to public policy while clinging to assumptions that are so obviously absurd?

    3. from Mexico

      In the unforgiving world of academe — presided over as it is by the mafia dons from the Chicago School of Economics and their deep-pocketed benefactors — I cannot imagine what this heresy might cost you in terms of tenure, research grants and career opportunites.

      However, the nine words that Egidio of Viterbo used to sum up Pope Alexander’s Rome pretty much sum up our current Holy See — the Chicago School of Economics: “No law, no divinity; Gold, force and Venus rule.”

      I would also remind you of what Machiavelli said of the Vatican in 1513:

      [T]he nearer people are to the Roman Church [the Chicago School of Economics], the head of their religion, the less religious they are. And whoever examines the principles on which that religion is founded, and sees how widely different from those principles its present practice and applications are, will judge that her ruin or chastisement is near at hand.

    4. Tom

      Thank you for your clarification – I interpreted your statements as supporting the assumptions as opposed to setting the stage too de-bunk them.
      Do you like Micheal Hudson’s work?

    5. TitusPullo

      Roger Farmer writes;
      ‘What we show in our work, is EVEN WHEN, these strong assumptions hold; financial markets STILL do not work. Further, the departures from efficiency can be huge.’

      I don’t think anyone rational (who experiences today’s form of “ socialized capitalism”) would disagree with that statement. What is, perhaps, surprising is that anyone still believes these assumptions do hold, at all. And, if it is true that markets are inefficient (or efficient) despite these assumptions and not because of them then, clearly, a new set of assumptions have to be hypothesized and tested – which, for economists, appears to be a near impossibility.

      Why a near impossibility? Because, decades of undergraduates have been taught that (as you mention)….

      ‘…when these assumptions hold, free trade in competitive markets allocates goods efficiently…’

      But, what is also taught is that free market capitalism is self-evidence that these assumptions are true (they’re axiomatic – they really can’t be disproved, can they?). Ergo, as long as we have free market capitalism we have efficient markets. Just look at the evidence – we have free market capitalism.

    6. diptherio

      Thank you, Prof. Farmer, for taking the time to converse with the peanut gallery.

      I understand pretty well where you are coming from. If you start out your critique of economic orthodoxy by pointing out that the assumptions of neo-classical economics are ridiculous and untenable all of the staid, right-thinking economists will immediately dismiss you as a crank. If you want to argue with the neo-classicals, you have to do it using their assumptions if you want to have any chance at all of getting through to them.

      It’s like trying to conversate with a Fundamentalist Christian. If you start out by telling them that the Bible is full of fairy-tales and you don’t accept it as any kind of authority, the conversation won’t get anywhere. In order to connect at all, you have to enter into their world, since they sure-as-heck ain’t coming into yours. So you keep your thoughts about the Bible to yourself and instead you make your argument using the Bible, as though you believed in it. That can be effective, but you do have to know some Bible.

      The same is true for the “theo-classical” school of economics (as Bill Black puts it) and its adherents. If you want to change neo-classical minds, you have to speak their language and use their (absurd) assumptions. And whether we like it or not, changing economics is going to mean changing neo-classical minds. Fortunately, clever people like Prof. Farmer are pretty good at using their assumptions against them (as it were). Unfortunately, I doubt that Farmer’s critique will do much of anything to overturn EMH, though one can always hope.

    7. Hugh

      If the premises are false, the conclusions will be false. There is no need to proceed further. And what you prove by assuming them to be true is only done by adding in other unstated premises, such as agents can be rational yet still driven by impatience and animal spirits. Also if households are rational and plan for the future, one would assume that this would take into account children and plans would be based on how the children’s futures would be affected by current decisions.

      But also it just seems very strange to me to be focusing on premises and not data.

  17. F. Beard

    If the markets boom then the patient savers, feeling wealthier, will lend more to the impatient borrowers; Roger E. A. Farmer

    This is the “loanable funds” hypothesis, no? Which has been discredited?

    1. diptherio

      Sure, but as Farmer mentions above, he is attempting an “inside” take-down of EMH by accepting their assumptions, invalid though they may be.

  18. Another Gordon

    I’m going skydiving next weekend and want to calculate how long I can freefall before I must pull the ripcord. Fortunately I learnt how to do this at school.

    I make some strong but standard assumptions:

    1) The plane will be in horizontal flight when I jump.
    2) I can ignore air resistance.

    So that’s sorted and anyone who suggsts otherwise is a spoilsport.

  19. Chauncey Gardiner

    The financial markets we have (not the ones we want) are highly manipulated and controlled, and are the very antithesis of competitive markets IMO.

    I believe one primary reason this is so is because both the FRBNY and the exchanges are controlled by the Primary Dealers, who have received trillions of dollars under the Fed’s “Quantitative Easing” policy, and are even now reportedly receiving an average of about $85 billion each month. Since 2008, that money has been used by the Primary Dealers to push up the prices of stocks, bonds and selected commodities, which has also served to suppress the interest rates they pay. This policy has benefited those who own significant amounts of financial assets, either directly or indirectly, as well as senior corporate managers who derive a significant amount of their personal income through stock options. But this policy provides few direct economic benefits to the People of this country.

    For a range of reasons that have been discussed elsewhere on this blog, such a wealth concentration (“Pareto-efficient”) outcome is undesirable from a public policy perspective. The recipients of vast wealth have and are contributing little to the general welfare under this system.

    The Primary Dealers are not the best avenue through which to channel trillions of dollars in terms of achieving desirable public policy objectives, and in fact may be acting in a manner that is detrimental to the public interest. The monetary and financial system of our nation needs to be deeply reformed IMO, and fiscal spending initiatives undertaken.

    And all this is setting aside considerations relating to the massive engineered financial fraud that has been perpetrated on the people of America and Western Europe and been officially ignored for the past five years.

  20. jurisV

    A hearty thanks to you Lambert ! Well done.

    While Farmer’s study wasn’t a flaming bomb thrown into the main-stream Economics Cathedral, it was (at least) a smelly, loud fart during a “word salad” sermon. I think the whole EMH thing is a loser, but I have a lot of respect for Professor Farmer after this post and his comment in this thread.

    I appreciated that you had it up after the roasting that Philip Pilkington gave a previous Farmer paper yesterday. Together they paint a more nuanced view of Prof. Farmer.

    1. Lambert Strether Post author

      I thought what I saw as apostasy was interesting. And it shows how if you introduce the slightest human aspect — people live and die, there are generations! — the whole edifice collapses.

      1. jurisV

        Seeing that term apostasy, allowed me to see a lot more clearly that adhering rigidly to models that don’t include Real World assumptions and/or don’t test themselves against observations in the real world are, fundamentally, a religiously based phenomenon. It explains the anger and virulence directed at critics of the established dogma. As an engineer and researcher I have been perplexed and had a hard time understanding the vitriol aimed at anyone who challenged the EMH ideas.

        Since retiring I’ve had the time to do a lot of reading (NC, Keen, Keynes, Fisher, Pilkington et al) and recently started to feel I could appreciate some boundaries of the economics world. Your use of “apostasy” led to flipping a switch in my brain — sort of an “aha” moment. Substanstiation of the idea of “main stream Economics theory” as religion !!!

        Many thanks for the latest signpost — the journey continues.

  21. kevinearick

    Diagnosis: Mass Murder by Californication

    Wingo: Robert A Caro’s intriguing account of the events of November 12, 1963 demonstrates President Lyndon Johnson’s almost chameleon-like ability to adapt to whatever course of action best suited his purposes. His entreaty to President Kennedy’s aides…to help him continue Kennedy’s legislative goals, because, as he said, “I need you now more than President Kennedy needed you.”…sitting with us in a cordoned off area of the hotel bar, Johnson explained that all he wanted to do was to ensure Kennedy’s legacy on civil rights, space exploration, and other cherished programs of his short-lived Presidency.
    ///
    And what do we get…captive presidency, war on everything, and acceleration of psychologically induced economic arrhythmia, resulting in deconstruction of the US Constitution, elimination of free speech, and liquidation of the greatest empire ever built. Great job guys, the Truman Doctrine and reaction, on steroids.

    Labor has never and will never build its priorities on a foundation of majority vote, but keep on voting for the energy dollar and expect a different outcome. Labor votes with the education of its children.

    Gopnik: the Golden Forty-Year Rule. The prime site of nostalgia is always whatever happened, OR IS THOUGHT TO HAVE HAPPENED, in the decade between forty and fifty years past.

    Golden: If he tells us the truth and offers real solutions to oil dependence, perhaps he will find we can handle it. (Tell that to Boeing and Microsoft in your own back yard.)

    Hytner: There is an emotional void there, which he can fill only by buying people’s friendships. You can empathize with a fool who can only imagine human relationships in terms of what he is able materially to give. And he’s involved in a world which is completely, bizarrely, startlingly like the world we live in.

    Wiedman: On the long march to equality…there wasn’t anything romantic about it…at least now we can file jointly. The Marriage Equality Act has boosted various sectors of the economy…Cold War Femme: Lesbianism, National Identity, and Hollywood Cinema…What’s So Gay About Money? It’s pure economics.
    ///
    The Illuminator prepares for school shootings, responds in scripted horror to their frequency increase, continues to push everyone possible into the education black hole, and accounts for the economic activity as GDP growth. The opportunity cost of recognition delay causes the herd to follow its common denominator leader off the cliff.

    This is the weakest population of Americans in its History, but some Americans are correspondingly stronger, which is why the Fed finds itself trapped in the catch-22 of its own design. It must replace labor, but it requires labor to live, and labor does not suffer from the illusion of History, time dependency, so the Fed aims and shoots, itself.

    The majority is relatively impotent, addicted to the past and incapable of change. From this side of the demographic tipping point, the minority is going to produce the majority of children. That is reality, and there is no upside to caring about a majority that does not care for itself beyond its possessions and associated something-for-nothing, ponzi job credits, guaranteed by the Fed.

    Heal ThySelf Economist…and in the meantime leave my kids be, or don’t and suffer the consequences. Weather oscillation is increasing, debt is out of control, and the only people accepting the majority’s definition of labor is the majority. Adjust to the weather; define labor for yourself and you escape gravity. Trade surplus for surplus, liquidate and defer.

    San Francisco is just the design side of the top-down box. What happens at the fulcrum with sufficient weather oscillation?

  22. Eric L. Prentis

    Please read Robert M. Solow’s New Republic article (November 16, 2012) “Hayek, Friedman, and the Illusions of Conservative Economics,” in which Solow writes a review of, “The Great Persuasion: Reinventing Free Markets since the Depression,” by Angus Burgin. Harvard University Press.

    Dr. Solow’s article is an interesting, nostalgic, historical review of why we are saddled with the Hayek-Friedman-Tea Party political movement, based on “free market” ideology. Solow says “free markets” are a matter of degree, and that “the real issues are pragmatic.” I completely disagree with this approach to solving the “free market” ideology problem. Instead, the real issues are semantics. Notice how quickly those in power change the debate from “competitive markets” to “free markets.” This changes the focus in the public’s mind from, “those in power have to do better,” to “those in power know best, and we have to let them have their way.”

    Philosophy is wonderful and I love it. However, I force myself to focus on the facts, evidence, and based on these—a vision for the future.

    Facts

    These are the resulting facts of a “free market” ideology. Big market players easily manipulate markets, for example:

    1) Worse by orders-of-magnitude—in the most blatant colossal financial scandal in history—the London Interbank Offered Rate (LIBOR), affecting $350 trillion dollars in loans and derivatives, is systematically manipulated by the British Bankers’ Association (BBA), for over 20 years. News of BBA’s LIBOR systemic fraud manipulation only becomes public in June 2012.

    2) Also, a recent $3.7 trillion dollar municipal bond bid rigging conspiracy by the largest American Banks, illegally skims billions of dollars from the budgets of most US cities and towns.

    3) In addition, accounting laws are changed (e.g., FAS-157) so large Wall Street banks no longer have to mark their assets to market, thereby hiding their insolvency.

    4) High Frequency Trading (HFT), a form of front running—represents 70% of all trading and 99.9% of all quotes on stock exchanges—which unfairly affects market prices, to the detriment of retail investors.

    5) The favorable huckstering of stock positions on CNBC—owned by Comcast and General Electric—manipulates markets by infecting investors’ sentiment.

    6) Federal Reserve Chairman Bernanke, because of his trillions of dollars in quantitative easing programs, takes credit for the Russell 2000 Index of small company stocks reaching an all-time high price of 868.5 during September 2012, thus artificially bolstering the “wealth effect.”

    These are just some of the most recent egregious examples of market manipulation, by the big market players.

    Evidence

    • “Free market” ideologues say that markets are efficient and therefore, we should defer to them. This is scientifically proved incorrect, please see:

    Prentis, E.L., “Evidence on a New Stock Trading Rule that Produces Higher Returns with Lower Risk.” International Journal of Economics and Finance, (2011).

    For a good overview please see, Prentis, E. L., “Everything You Know About Markets Is Wrong?” published by Zero Hedge (6/11/2012).

    • “Free market” ideologues say that deregulated markets are efficient and therefore, we should completely deregulate markets. This is scientifically proved incorrect, please see:

    Prentis, E. L., “Early Evidence on US Stock Market Efficiency: “Market vs. State” Debate and Deregulation Implications.” Economics and Finance Review, (2012).

    For a good overview please see, Prentis, E.L. , “WORLD-MARKET-STATE vs. DEMOCRACY: Why We Should Go Over the Fiscal Cliff,” published by Economic Populist (12/17/12).

    Vision for the Future

    Malinvestment is systemic and rampant. Prognosis for the US economy, short-medium-long-term, POOR!

  23. Veri

    First, the market is not rational. The market is made up of people, some who act more rationally than others – because they can afford to.

    Second, most people do not think long term. Again, they lack the financial resources to think long term. Most people are busy with day-to-day survival – also known as “living paycheck to paycheck”.

    Three, the underlying psychology – hidden in the subconscious may induce people who make up the market to unknowingly act against their best interests and the interests of others.

    Four, data is people. A perfectly knowing market means that you know that the person you are transacting business with, is trying to rip you off – or not. People knowing, perfectly, people.

    Five, people need to stop applying anthropomorphism to the market – as if it is a living entity all of its own. It is not. It is a theoretical construct that poorly defines basic human wants and needs. There is no “Invisible Hand” of the market. That is just for Ivory Tower economists (and others) to intellectually masturbate themselves with.

    1. Mark Pawelek

      … Households … have rational expectations of all future prices …

      This is such a load of gibberish it defies a counter argument. How am I supposed to enter a debate on whether 1000 or just 1 angel is able to dance on the end of a pin?

      Our expectations of prices depend of habit and what we know of history. There’s even economics research showing you are wrong. I wish economists would priortise reality over theory.

  24. Roger Farmer

    Thanks to everyone who has responded to this post. Most of the comments are about the assumptions made by neoclassical economists. The economic concept of rationality is tautological and quite different from the way we use the word in everyday language. I wrote quite a bit about this already on responses to my post on crooked timber here

    http://crookedtimber.org/2013/01/08/how-effective-is-fiscal-policy-guest-post-from-roger-farmer/
    Ultimately, these are questions for the philosophy of science. Because it is hard to conduct experiments in economics, there are always competing explanations of events. Often, an explanation persists for long periods of time for ideological reasons and not because it is a better description of reality. Events such as the Great Depression of the1930s, the Great Inflation of the 1970s and the Great Recession of 2007, play the same role in economics as experiments in the natural sciences. They force us to sort between competing explanations of events.

    The analogy with religion is apt, but not exact. Religion is at one end of a spectrum. Natural science at the other. Economics is probably closer to religion than, say, paleontology, but events like the Great Recession are game changers that have lasting effects on the way that we structure society. My own work points the way to the design of new institutions that are potentially as transformative as those that were inspired by the Keynesian economics of the 1930s.

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