Posts Tagged ‘efficient market hypothesis’
Formation of the World Economics Association (WEA) a positive outcome from the Global Financial Crisis (GFC)
One positive aspect of the global financial crisis (GFC) is the clarity of the failure of neoclassical economics to predict the crisis and of its complicity in fermenting the crisis. This clarity of failure and complicity is positive because failure is a source of learning that is to take a new direction away from the neoclassical favoured by the American Economics Association and its journals and their hold on the profession. The newly formed World Economics Association (WEA) provides the economics profession such an avenue. An open letter to join the association is below. Read the rest of this entry »
Real Business Cycle (RBC) and Rational Expectations Hypothesis (REH) contributing to the Global Financial Crisis (GFC) and the Dynamite Prize
This article discusses how neoclassical economics has contributed to the Global Financial Crisis (GFC). In particular, how two neoclassical theories, the Real Business Cycle (RBC) and the Rational Expectations Hypothesis (REH) contributed to the GFC and how these theories are false and unscientific.
Edward C. Prescott and Finn E. Kydland were awarded the 2004 Nobel prize in economics for their work in developing the RBC and Robert E. Lucas Jr. was awarded the 1995 Nobel prize in economics for developing the REH. They have been nominated for The Dynamite Prize in Economics that is to be awarded to the three economists who contributed most to enabling the GFC. The Dynamite Prize in Economics nominates Prescott and Kydland ‘for jointly developing and popularizing “Real Business Cycle” theory, which by omitting the role of credit greatly diminished the economics profession’s understanding of dynamic macroeconomic processes’ and nominates Lucas for ‘his development of the rational expectations hypothesis, which defined rationality as the capacity to accurately predict the future, both served to maintain Friedman’s proposition that monetary factors do not affect the real economy and, in the name of “rigor”, distanced economics even further from reality than Friedman had thought possible.’ Read the rest of this entry »
Capital Asset Pricing Model (CAPM) and Efficient Market Hypothesis (EMH) Contributing to the Global Financial Crisis (GFC)
The Efficient Market Hypothesis (EMH) and Capital Asset Pricing Model (CAPM) are a framework and standard financial tool, respectively. Together, they provide a worldview for financiers and determine their decision-making in the financial markets.
Fama (1965; 1970) introduces the EMH in three market efficiency levels: a strong level where all relevant information regarding a stock is fully reflected in its price; a semi-strong level where all publicly available information is reflected in its price; and a weak level where current prices reflex all past history of the prices.
Fama and French (2004, p. 25) note that CAPM of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a Nobel Prize for Sharpe in 1990). Four decades later, the CAPM is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece of MBA investment courses. Indeed, it is often the only asset pricing model taught in these courses. Read the rest of this entry »
Hormonal Male Traders producing a Momentum Effect contrary to the Efficient Market Hypothesis and Rational Choice
Coates and Herbert (2008) study the role of the endocrine system in financial risk taking in a group of male traders in London. They find a positive relationship between a trader’s testosterone level and his daily Profit and Loss (P&L) and between his cortisol level and financial uncertainty, being measured by variance of economics returns and expected variance of the market. They note that rational choice is affected by the levels of the hormones. The more profits the trader made relative to his daily average the higher his testosterone became. Heightened testosterone increases a trader’s preference for risk. The process has a positive feedback, producing a financial variant of the “winner effect”. Additionally, short periods of high volatility increase a trader’s cortisol levels, which increase his motivation and his ability to focus, producing a euphoric feeling. However, prolonged period of elevated cortisol levels produce selective attention on mostly negative events and anxiety, reducing a trader’s preference for risk. Even if the number of traders is small, these hormonal effects could reinforce the momentum effect and cause markets to deviate from rational choice and the predictions of the Efficient Market Hypothesis (EMH). Read the rest of this entry »
Neoclassical economics is deductive, using a mathematical axiom-proof-theory format. Arnsperger and Varoufakis (2006) list the three basic axioms of neoclassical as methodological instrumentalism, methodological individualism and methodological equilibration. In such an approach the basic axioms have to be correct otherwise the whole framework becomes unsound. In contrast to the deductive approach, the scientific approach is inductive, forming theories from observation and using prediction to falsify the theories (Neuman 2003, p. 51). Neoclassical economists have become adept at avoiding empirical falsification by creating ad-hoc explanations as to why their theories fail to work when confronted with empirical evidence, for example the Efficient Market Hypothesis predicting dividend volatility in excess of price volatility but the converse is observed (Shiller 1981). Falsification avoidance is the sign of a degenerative research program (Lakatos 1976). So, rather than use empirical falsification, a more suitable approach to disprove deductive frameworks is to use a logical proof showing their axioms lead to an absurdity. The Sonnenschein–Mantel–Debreu Theorem (Debreu 1959) proves the basic axioms of neoclassical economics are logical inconsistent. The Sonnenschein–Mantel–Debreu Theorem (Debreu 1959) shows that starting with the first two axioms leads to a shapeless excess demand curve. The shapeless excess demand curve means that there are multiple equilibria and equilibrium are unstable making the third axiom untenable. To fix this problem, it is assumed that all goods have constant Engel curves. A good would have a constant Engel curve if somebody spends the same proportion of their income on the good as their income grew (Keen 2001). This is an unlikely scenario as when income grows then people consume more luxury goods and basic goods become a smaller fraction of their income. Can you think of a good with a constant Engel curve? Colander (2000, p. 3) equates neoclassical economics “to the celestial mechanics of a nonexistent universe” for using theory outside its domain assumption (Musgrave 1981). That is neoclassical economics as a pursuit in pure mathematics for intellectual exercise is fine but claiming applicability to the real world is misleading. Read the rest of this entry »