Saturday 26 March 2011

Inefficient Markets Hypothesis

It strikes me that the language of proper free market capitalism has been completely hijacked by what we might loosely refer to as 'rent seekers'. Having free markets is a splendid idea, because clearly a free market works better than state planning or monopolies. But the fact that something is a 'market' does automatically means that is in any way 'efficient'.

There is a sliding scale of markets, which we can broadly categorise into two extreme cases and an intermediate case:

1. Very efficient

At one end - notwithstanding that most businesses are regulated and taxed to the n-th degree, and incumbents always try to erect barriers to entry - are markets in things we are constantly producing and using, stuff like food, entertainment, cars, consumer electrics, clothes etc. I'd say that these are efficient in terms of

a) Pricing, in so far as you can go to the shop and compare all the different features and prices, talk to friends, look at product reviews, keep going back to the same shop, restaurant or make of car if you are happy and going somewhere else if you are not, and

b) In terms of the pure mechanics of how stuff is produced, like the African farmers who produce food which is eaten thousands of miles away in the west, which requires an intricate web of farmers, transporters, packers, ships and aircraft, ports and airports, lorry drivers, shelf stackers and check out girls to get from field to plate.

Similarly, all businesses have to employ people, and those that do better can pay better wages and people make a trade off between how long it takes to qualify for the job (where relevant), working conditions, wages, career opportunities, job satisfaction etc when deciding what sort of job to do.

You seldom see rapid price swings or speculation in these things. Nobody buys hundreds of loaves of bread even if they think bread prices are going to go up because they'd all just dry out or go mouldy by the time you want to eat them; no employer takes on dozens of extra staff because he thinks that wages are going to rise (or indeed sack loads of people because he thinks wages will fall); likewise people who rent tend to live in the 'right size' property and so on.

And the market value of these things is a reasonable measure of 'wealth'. A second hand car worth £5,000 is an asset or wealth which is actually worth £5,000. A year later that car has depreciated to £4,000 and £1,000 in wealth has been lost for ever. Or maybe somebody repairs an old banger and its value goes up by £1,000, that is new wealth that has been created.

2. Woefully inefficient

At the other end are 'meta-markets', which is mainly things like land and buildings or shares in companies, where you are not buying the thing itself, you are buying a right to future income which has not yet been created.

The price of land has nothing to do with the cost of producing land (which is more or less nil), the price depends on people's estimates of the future rental stream; the value of shares in a company has little to do with its net asset value and all to with people's estimates of future profits, whereby profits are a fairly small balancing figure between selling prices and input costs (which are both largely outside the company's control).

Estimates of future rental income or future profits are just that, estimates, and this has to be divided by another estimate, being a discount rate or the interest rate you could earn by sticking your money in the bank (adjusted for higher risk). So if your estimate of earnings per share is 5p, and you could earn 3% interest by putting your money in the bank, you might expect a return of 5% by buying the riskier shares, so you value them at £1 each (5p divided by 0.05).

If interest rates go up to 5%, you now apply a discount rate of 7% to the company's shares, so even if it is just as profitable as before, the price of each share falls from £1 to 71p (5p divided by 0.07).

There are then a myriad of other things to take into account - earnings growth, inflation, political risk (which is why shares in tobacco companies have such a high yield, at the back of everybody's mind is that governments around the world love to give smokers a good kicking), how successful that company will be in maintaining barriers to entry or persuading the government to do so; how good the directors will be at wringing concessions or contracts from the government; if you're buying a house you want to know that the local council will raise barriers to entry (i.e. prevent any more construction in that area) to maintain the selling price etc etc.

As we well know, share prices and house prices can fluctuate wildly, and it seldom happens the price you pay is a fair reflection of the true wealth represented by that house or that company, i.e. there are very few places in the UK where you can buy a house for its rebuild cost, and very few companies whose shares are trading at the net asset value per share.

Usually you pay vastly over the odds for these things - but this excess can melt away very quickly, or if a bubble is in progress, it can increase very quickly as well, people buy it simply because it is getting more expensive (which is the exact opposite of the bread example above).

So it strikes me that house prices (more correctly, land prices) and share prices are not a measure of wealth at all, this is not real wealth, it is merely a wild estimate of the share of future income that other people will generate using real wealth which will accrue to you as landowner or shareholder. If house prices or share prices change without any underlying change in that house or the company's business, then real wealth has been neither created nor destroyed, people as a whole have become neither richer nor poorer (it is merely a relative shift between those that own the house or share and those that don't).

There is also a massive amount of fraud and skullduggery going on in these 'financial markets', and there is no particular reason to assume that they even 'allocate capital efficiently'. The 'efficient allocation of capital' is carried out by businesses making decisions about what machines to buy, what training courses to send their staff on; or by a student who decides to study something a bit dull because it will lead to a well-paying job etc.

Worst of all are 'markets in meta-markets'. If house prices or share prices are rising, then estate agents and stockbrokers will do well, and so the perceived value of the shares in these middlemen goes up, fuelled by the general bubble, but as these people produce absolutely nothing (they do provide a service, and unlike most people I don't do estate agent-bashing), there is no real underlying value to their businesses at all, so if house prices go down a bit or the stock market crashes (leading to much lower churn), all of a sudden, the price of the shares in the middleman's business simply evaporates to nothing.

3. Intermediate case

Examples of the intermediate case are things like oil or other commodities.

People do speculate in what the price of these things will be over the next twelve months or so, and speculators clearly push up or depress the price beyond what is rational (which does cause some damage to the efficient markets) but these bubbles tend to be short lived because these are all things which have to be consumed, i.e. you can keep buying wheat futures in the hope that the price of wheat goes up, but sooner or later those contracts come up for delivery.

No speculator in his right mind actually wants to take physical delivery of wheat because the storage costs would wipe you out, so all these contracts get reversed again within a few months at the latest, so any price surge the speculators may have caused quickly gets cancelled out again.

13 comments:

chefdave said...

"It strikes me that the language of proper free market capitalism has been completely hijacked by what we might loosely refer to as 'rent seekers'."

I agree, as a discipline economics has been mangled so badly that different schools of thought may as well be talking completely different languages.

Just a few examples, the financial markets are commonly mistaken for a free market, so defending the concept becomes nigh on impossible in certain circles. Private ownership has become synonymous with 'capitalism' even though it may act as a monopoly (i.e land). And silly things like attacking the claim that "we need more jobs" to recover, or my favourite "the collapse is due to the banking sector" make it look like you're either uncaring, or are unable to deal with objective reality.

There's some great stickers that have been put up around town by the some anarchist society, there's a few banking logos with the caption; "sod your loans, where's our pay?" I admire their commitment, going to the effort of designing and printing up stickers shows that they believe in their cause, but I absolutely no idea what the caption means.

This is problem, and it occurs whenever we debate economics. (I'm about to read The Corruption of Economics, and I think they talk about this stuff)

Lola said...

Yes, well. The efficiency of markets refers to the ability of the market to adjust quickly to new information. Whether or not that information is right or wrong is not the point.

Personally, my thinking (much shallower than yours Mr W) is that much of the problems you enumerate for financial markets boils down to unsound money, or rather the replacement of the exchange econmoy based on sound money by the exchange economy based on universal credit.

One would have thought that it should be right for those with surplus savings to provide risk capital for enterprise directly, and get rewarded for it, either by realising a capital gain and/or an income. But as you say lots of stuff gets in the way of this of this simple idea.

Lola said...

@ Chefdave - quite.

DNAse said...

So does the problem arise when the middle men become the market rather than simply servicing it? Thus speculation and bubble fuelling become the dominant force. And this was the case with the banks, who are the middle men between those with money to invest and those with a need of money to develop business (real wealth).

Mark Wadsworth said...

CD, L, I think that the Stock Exchange and houses are a free market, you can buy and sell at will. Whether shares and houses are accurately priced (lack of information) is doubtful, but more to the point, just because there is a free market in something does not mean that the underlying subject matter is a free market.

Maybe electricity or water companies have a monopoly/cartel position, and land & buildings is certain a monopoly/cartel, so the underlying subject matter is the rights to partake in the monopoly/cartel profits.

To take an extreme example, there used to be a free market in slaves (and in theory a slave could have saved up enough money to buy his own freedom), this does not excuse slavery - you are buying and selling the rights of a privileged class (whitey) over a disadvantaged class (darkies).

L, yes of course if you invest money in the actual business, or you are a bank which lends a business money you are entitled to a return, it is called 'interest' and you adjust the rate upwards to suit the risk.

But the people best placed to decide what to invest in are the people who work in the business itself and not the shareholders or stockbrokers, pension fund managers etc.

DNAse: "Banks... are the middle men between those with money to invest and those with a need of money to develop business"

If banks just stuck to that activity, then fair play to them, they take most of the risk and earn a margin on the interest charged/paid. The depositor gets a lower return but gets convenience and better security than lending to a third party business directly.

But in bubble conditions (esp. a house price bubble), the mortgages and corresponding deposits just create themselves out of thin air.

So banks are a sort of meta-meta-market*. They inflate the price of land vastly and then lend people money on which they have to pay interest. So the banks convert an entirely fictitious form of wealth (capitalised value of future land rents) into a very real source of wealth (the capitalised value of the future interest payments).

Remember: the land value is entirely spurious and at the whim of a thousand factors outside the landowners economic control (but unfortunately within the landowner's political control) but the mortgage debts are real.

* And then you can trade in shares in banks which is a meta-meta-meta market, or even become an investment bank which advises a high street bank on take overs and mergers (a meta-meta-meta-meta market) and the shares in the investment bank are meta-meta-meta-meta-meta market, i.e. the value thereof is completely divorced from and unrelated to any sort of wealth creating activities whatsoever, like taking deposits and lending them to a business to buy a new machine or develop a new product or something.

Anonymous said...

Just one little bit I don't agree with: "input costs (which are both largely outside the company's control)". Input costs are not outside a company's control at all, because a company can make itself more efficient and therefore use less inputs.

Quiet Guy said...

"I think that the Stock Exchange and houses are a free market, you can buy and sell at will."

There's one aspect of your market classification system that I don't feel comfortable with. The Stock Exchange and residential property are clearly markets of sorts but buying equities is voluntary whereas buying or renting a place to live is forced (except, perhaps, for living with your parents.) We all have to live somewhere.

I can choose to keep all my money in the banks instead of investing in equities and commodities; that might not be the best choice but it's unlikely to lead to my absolute doom. All of us have to pay to live somewhere unless we are willing/forced to be truly homeless with all of the problems that causes for everyday life. Apart from food, water and clothing, it's hard to think of any other market with such captive participants.

Lola said...

"(and in theory a slave could have saved up enough money to buy his own freedom" Ho Ho. He's a "slave" - by definition he doesn't get paid, so how's he going to save up any money to buy his own freedom?

Lola said...

"L, yes of course if you invest money in the actual business, or you are a bank which lends a business money you are entitled to a return, it is called 'interest' and you adjust the rate upwards to suit the risk.

But the people best placed to decide what to invest in are the people who work in the business itself and not the shareholders or stockbrokers, pension fund managers etc.
" Hence the putative 'risk premium' for equities.

Mark Wadsworth said...

AC, but what does a company do once it has removed every single inefficiency and honed every system to perfection? If the price of oil and gas go up and hence fuel and electricity prices, that its costs will go up.

QG, I quite agree, which is why I'm not too fussed about share price bubbles, you can manage your whole life perfectly happily without every owning a share (or even owning one indirectly via a pension fund or other savings scheme).

L, comment 1: some slaves did buy their own freedom, heck knows how.

L, comment 2: Don't forget the risk premium (which depresses share prices) is more than cancelled out by the 'rent' element (which boosts share prices), so most companies shares trade far above net asset value.

Which brings us back to the idealised example of the employee-owned partnership. There is neither risk premium nor rental element in the value of each employee-partner's capital account.

Lola said...

MW (response 2)...which might be why 'value' stocks (defined as a high book price to market price ratio) outperform the broad equity market?

James Higham said...

I'd say that these are efficient in terms of

a) Pricing, in so far as you can go to the shop and compare all the different features and prices,

I'd say they're efficient in terms of price fixing, certainly.

Mark Wadsworth said...

JH, yes, even in the free-market-capitalist sector, there is all manner of price-fixing, barriers to entry etc etc. But it's still only possible if you have The Government (or The EU) on your side.