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.