The stock market as viewed by realists


It’s so adorable, the way economists try to rehabilitate the hypothesis that financial markets are good at something besides making some people rich at the expense of others. Here’s an example from the relatively sensible Michael Pettis who writes about China’s financial markets from his post as a professor at Peking University’s Guanghua School of Management. Pettis notes the laughter generated by the fake Nobel Economics prize committee, which awarded vast sums to Eugene Fama of the U. Chi. for creating the Efficient Markets Hypothesis, and to Robert Schiller for his criticism of the EMF.

Pettis explains that this misses the point.

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

Pettis says financial markets require three kinds of investors, value investors, relative value investors, and speculators. Value investors make purchasing decisions based on their assessment of the cash they expect to generate over their holding period. Relative value investors are essentially arbitrageurs between two different investments. Speculators look to make short term profits from temporary fluctuations. When we have the right balance of these forces, we get good results: “…socially useful projects … have access to appropriately-priced capital.”

He applies these principles to China, where financial markets are dominated by speculators, and explains what they need to do to create markets that fit his definition. Then he applies them to the US, saying that we need the right mix of investment strategies, and that this can be disrupted by, say, too much liquidity, or sudden events that make value investors unsure of their ability to analyze financial data. In other words, he replaces one fairy tale, the neoliberal all-knowing market, with another, the balanced forces market.

This, of course, is standard economic practice. The good market is defined, and the economist explains how to bring it into existence. Pettis explains how China can be more like the US, which is also standard. Perhaps it isn’t fair to point out that as far as I know, China hasn’t evidenced any intention of letting financial markets set its development agenda, and has done pretty well anyway, at least so far, and if you ignore the horrible pollution and social disruption and corruption. But there is a deeper criticism.

The blogger Unlearned Economics wrote a post titled “How ‘Conservative’ is Mainstream Economics, which is well worth reading. One of his excellent points is that economists do not ask certain questions:

It is not unfair to say that in many economic models, economic phenomena are just presumed to ‘exist’, with market relations and institutions the norm.

For Unlearned Economics, Pettis’ view that China should be like the US is a normative decision, one based on Pettis’ view of the right way to do things.

Let’s take another look at Pettis’ list of market participants. Are any groups missing? What about manipulators, insider traders, the London Whale traders, people trying to corner the market, churning stock brokers, prospectus writers who lie, distort and smear, front-runners, short sellers against the box, pump and dumpers, and a vast number of other frauds, cheats and liars.

Then there are the middlemen taking cuts out of everything, touts, and investment advisers and TV shouters who get paid for doing nothing but jabbering, mutual funds sellers who push people into high-fee high expense deals, and a rafter of other cheats.

Then there are the markets themselves, all private ventures with proprietary top secret computer codes that you have to trust, but who lavish special love on High Frequency Traders, dark pools where trades happen away from market exposure, and a other connected thieves. In all my years of trading, I never got the daily high when I sold, or the daily low when I bought. Coincidence?

Then there are the cops: FINRA which is run by the stockbrokers; and the SEC, the captive regulator; neither of which found a single criminal executive on Wall Street in the wake of the Great Crash. There is the OCC, which loves banks and doesn’t care about a few cut corners; the Fed, which has never bothered to regulate; the FDIC, which has no enforcement power, and which was viewed by Timothy Geithner as a well of money to support his buddies on Wall Street; a court system devoted to crushing efforts at regulation and denying protection to investors; a Congress that loves its cuts of the profits generated by Wall Street liars and cheats; and a President who agrees that these guys are greedy but not evil. Then there is the Chief Keystone Kop, Preet Bharara, who thinks that if we could just get rid of the insider traders, the world would be perfect.

Finally, there are the investors, old people forced into the market in search of some minimal return on a lifetime of savings, younger people pushed into the market to save for retirement, people convinced that they have inside information, people who believe what they hear on CNBC (!), people influenced by crazies like Glenn Beck, people who get their investments from fortune cookies, people who think they can beat HFT traders from their home computers, and plenty of other marks, gulls, fools, clowns, ideologues, trend traders, market timers, trend analysts, systems players and true believers.

Where’s your model for that market?

Economists started with simple-minded markets, and built structures that ignore reality. It isn’t as if there wasn’t a history of crooked markets, but modeling them was too much trouble; the math was beyond that of college juniors. Then they claimed that based on their models, the existing financial markets were the best of all possible ways to allocate capital to socially valuable purposes, with perhaps a couple of minor tweaks. The neoliberals who dominate public discourse claim that these markets are the best way to do everything. They claim that this cacophony of stupid will produce the best of all possible worlds.

Pettis is a tweaker: he wants to rescue the EMH from the infamy it rightly deserves by limiting its claims to suit his values. I suggest that we need to start over with models that resemble the circus that is the reality-based market. If that’s too hard, the least we can do is to be very circumspect about the claims we make for our simple models.