Monday, September 14, 2009

Economic Theory: Efficient Markets, Leverage, and Rational Market Participants

It seems that it is in vogue to question the fundamentals of market economies these days. Understandable. While driving back from breakfast this morning, I was listening to Marc Faber being interviewed by Tom Keene on Bloomberg. They were discussing the idea of leverage in efficient markets with the innuendo being that efficient markets shouldn't need leverage (Faber flatly denied this saying, correctly, that efficient market theory says nothing of leverage). It was a great interview and it brought me to the conclusion that we need to redefine certain axioms in the market economy such as:

-The idea that market participants always act in a rational manner

This is clearly not true. Simply put, few are educated well enough to make such rational decisions. Consider my post from a few days ago regarding a simple profit and loss word problem. The vast majority of those that I polled failed to answer it properly. So where does this leave us? The assumption of rational participants is very convenient for modeling purposes and for logic experiments. What we can assume, safely, is that market participants will always act in a manner that they THINK maximizes their own economic condition. It is obvious that this has large implications. Greater discussion on this point will follow in later posts.

-The idea that markets are efficient

It has always truly stunned me that when people refer to efficient market theory they speak of "perfect markets" as in 100% efficient. The typical attack for academics on the left is to point out that if markets are not "perfect" then the idea of efficient markets is busted. From there they go on to reason that a greater role should be played by the government. What these academic fail to realize is that there are degrees of efficiency. It is lunacy to think that beings as imperfect as humans could ever price goods perfectly. Further, it is also lunacy to think that a government composed of imperfect humans could ever price goods perfectly. The market is an engine. Instead of saying that the engine is doomed because it is inefficient and it broke down we should try to better understand why it broke down and how it can be made more efficient.

Edit: one more
-The idea of an ever growing economic pie

For the foreseeable past and future and for our purposes here, we will consider the idea of an ever growing economic pie to be a reality. Will it grow forever? That gets into the idea of the sustainable-growth contradiction which we will avoid here but visit in a later post.

Over the long term, we have managed to steadily increase our production of goods and services. Every year, we are capable of manufacturing more steel, building more buildings, cars, appliances, televisions, computers, cell phones, clothes, etc. Our agricultural system manages to produce more and more food. People are willing and able to work. Even in this recession, the deepest and most dire since the Great Depression, our capacity to produce probably rose. Ours is not a plague of locusts. It is not a problem of actually working, of actually producing, and of actually consuming. We are very good at all three and become better as each year passes. We are just not very good at paying for things.

While the theory of an ever growing economic pie is a reality, there is a substantial disconnect in that the monetary pie is not ever growing (our ability to pay for things). Our fiat currency system is very fickle and very vulnerable to swings in investor sentiment and human emotions. Animal spirits as Keynes would say. This isn't the appropriate place to detail the mechanisms behind money, debt, and changes in the supply of the two (that will be a later post). Instead, I'll just say that in times of investor panic, a sudden contraction in the money supply will halt commerce and trigger bankruptcies (see this post for a visual representation of the money/debt cycle). Therefore, when economists, investors, or financiers speak of an ever-growing economic pie they should make sure that they delineate this from the idea of an ever-growing monetary pie.

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