Much of the disagreement about the truth or falsity of the efficient market hypothesis seems to stem from a disagreement about what constitutes identifiable. Scott Sumner, and a lot of other EMH proponents, define bubbles as identifiable only if the method of identification can reliably be profited from. Ryan Avent, Andrei Shleifer, and other EMH critics, argue that because of the risk in betting against a bubble, and the lack of perfect capital markets, one could have a relatively certain belief that a bubble exists but not be able to profit from it.A third route is to agree with Sumner that are identifiable and the fact that you profit from them reliably proves it, thus EMH is false.
I think this is part of the reason Sumner is frustrated by the anti-EMH crowd: he isn’t distinguishing between those that identify profitability as sufficient proof from those who don’t, so he is faced with some people arguing that “people reliably profit off of bubbles, therefore EMH is false!” and others arguing that “market irrationality prevents reliably profiting off of bubbles, and EMH is still false”. There may be people who hold both of these contradictory points at the same time, and they are wrong. But the existence of two separate arguments against EMH that happen to contradict each other is not evidence against either theory or for EMH.
Aside from the insistence of profitability, the other problem I have with Sumner’s definition of identification is the claim that identifying one bubble is not enough, you must also able to identify them. This is a very econometrician-centric way of thinking of identification: you get a particular model of asset prices and estimate a set of parameters, which you can then use to forecast. If your forecast is not reliable, then your model or your parameters are wrong, and your identification is false. But why should a model that can identify a housing market bubble be capable of identifying a tulip bubble or a tech bubble? For that matter, why should an individual with a particular set of knowledge that has allowed him to idenfity a bubble in one market be held to the burden of proof of identifying the next bubble, which will likely be in a completely different market of which he has no knowledge? Take Calculated Risk, for instance. He clearly and specifically identified the housing bubble using his extensive knowledge of the entire housing industry- from realtors to securitizers. Are we really going to demand that he identify the next bubble in gold, oil, Beanie Babies, or some other market he knows nothing about until we accept that he identified the housing bubble? I see no reason to expect this to be true. Nor do I see any reason to expect that all bubbles be equally identifiable. Using Sumner’s criteria, I’m not sure how you tell the difference between a world in which 1/5 bubbles are identifiable and a world in which 0/5 bubbles are identifiable.
Look, I’m not coming down strongly on one side of this debate- my instinct actually tends to be that, in general, you can’t beat market prices, and we should have humility about disagreeing with them. I also understand why a definition of bubble identification that does not include a higher burden of proof is unsatisfactory; it lends itself to people like Dean Baker claiming they identified the current housing bubble in, I think, 1948. Nonetheless, I’ve obviously got disagreements with the way Sumner and other EMH proponents define bubble identification. I’m still open to persuasion on this.
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Friday ~ February 5th, 2010 at 2:54 pm
teageegeepea
I think we could just look at bubbles within a certain sector. The question then would be does Calculated Risk call bubbles that then fail to occur? When Sumner was making fun of the Economist he restricted his mockery to their analysis of housing (because that’s what they were preening themselves on). American real estate values kept going up over the period when the Economist said they’d go down, and Australian values never fell at all even after that period. So let’s say Calculated Risk uses the following heuristic: if a value is not in housing, assume the market price is correct. If it is in housing, don’t assume that but use your own knowledge of the industry. In that case Calculated Risk should on average beat the market consistently over time. Identifying 1/5 bubbles is no worse than identifying 1/1 small bubbles. Since Sumner doesn’t seem to really believe in “bubbles” (he thinks prices go up and down, but none of that can be considered a bubble or antibubble), Calculated Risk could hardly be penalized for missing any.
Friday ~ February 5th, 2010 at 8:30 pm
TheMoneyIllusion » The EMH; reply to my critics
[...] for them! That’s been my answer in several comment sections. This relates to a post by Adam Ozimek: I think this is part of the reason Sumner is frustrated by the anti-EMH crowd: he isn’t [...]
Saturday ~ February 6th, 2010 at 9:08 am
Dean Baker
Um, I suppose being right is worthy of ridicule in your world. They year was 2002 [http://www.cepr.net/index.php/publications/reports/the-run-up-in-home-prices-is-it-real-or-is-it-another-bubble/] and any competent economist should have been able to recognize the housing bubble at that point.
The point from a policy perspective is that the housing bubble was driving the economy, which meant that its collapse would have the sort of consequences we are now seeing. There isn’t generally a need from a policy standpoint to worry about bubbles in barley, zinc, or most other commodities. There is a need to worry about a bubble in the largest market in the world.
Yeah, so you missed it — no big deal. We have 15 million people out of work and are going to lose on the order of $5 trillion in output in the U.S. alone. It’s not like the mistake had serious consequences. Let’s go play more with EMH.
Saturday ~ February 6th, 2010 at 12:37 pm
I Called The Housing Bubble In 1948 « Modeled Behavior
[...] 6th, 2010 in Economics | by Adam Ozimek In previous post on the efficient market hypothesis, I sympathized with Scott Sumner’s overly demanding definition of identifying a bubble, because his [...]