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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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But economists bury their mistakes quietly and quickly forget about themYet we are told that the free market provides the most efficient allocation of capital that is possible. How can that be? How can we look at our past 25 years of badly misallocated capital investment and conclude this represents the most efficient possible use of capital? Of course, there are models that “prove” free markets allocate capital with the greatest possible efficiency. But how can we take them seriously after even a brief glimpse of our recent past? It is easy to see why the free market is so inefficient in capital allocation. The psychology associated with cyclic performance guarantees that investors will be out of step. Investor optimism and enthusiasm are consistently the greatest at peaks of long-term cycles. Lack of interest, or even fear, is greatest at troughs. So people invest at the highest prices and disinvest at the lowest prices. (Market technicians commonly use measures of investor sentiment as a contrarian indicator, predicting market advances when investors are overly bearish and declines when investors are overly bullish.) This does not make for efficient use of capital. Paralleling this, corporations have the greatest return on investment — both actual and projected — and the greatest ability to raise additional funds at peaks of long-term cycles. They also have the greatest incentive to build new capacity at those times, at the peak of their projected returns. So corporations, which often bear an unsettling resemblance to lemmings, also invest in the wrong sectors at the wrong times — despite assurances of the maximal efficiency of free markets. In the late 1990s, telecommunications companies borrowed nearly half a trillion dollars to bury 39 million miles of fiber-optic cable across the U.S. In their manic phase, they built enormous excess capacity. When the mania wore off in early 2000, these companies laid off more than 100,000 workers. Several were unable to pay interest on their debt. They buried more than just fiber-optic cable. Undaunted, unfazed by such disasters, we still sanctify the free market and accept any argument that would minimize the role of government. And so we embrace monetarism, the theory that the sole cause of inflation is a too rapidly increasing money supply. Monetarism claims that merely by regulating money supply one can maintain economic growth while holding inflation in check. The use of a simple directive — maintain money supply growth at 2-3% per year — would diminish the power of the Federal Reserve and end government’s monetary meddling. For this reason monetarism has been especially popular with devotees of laissez faire. But historically the connection between money supply and inflation is tenuous. Between 1820 and 1860, U.S. money supply rose five-fold, but price levels declined. Other examples go back centuries: “These episodes have been closely examined in one of the most controlled historical tests of a monistic monetarist model. The results of that test are conceded to constitute a ‘contradiction of the basic hypothesis’ even by a monetarist as convinced as Anna Schwartz…. Similar difficulties also appear in other attempts to correlate the movement of prices with the stock of money.” (Fischer, The Great Wave, p. 337.) The factors underlying the historic irrelevance of money supply to inflation are equally present today. For one thing, the velocity of money (how quickly it gets spent) is an important factor independent of the quantity of money. Its increase can cause increases in both inflation and economic growth, even if there is no change in money supply. Independently, there are different measures of money supply growing at different rates, but few theoretical grounds to choose among them. From 1990 to 1992, annual M1 growth increased from 4% to 12% while growth in the broader measure M2 declined from 5% to 2%. Should the Federal Reserve have obeyed M1’s call for monetary restraint or M2’s call for monetary accommodation? From 1995 to 1998, M1 declined. M2 grew at more than 6% per year. M3 grew at more than 9% per year. Should the Fed have targeted M1, M2 or M3? Goodhart’s Law, tongue in cheek, claims that no matter what measure of money supply is targeted by the Federal Reserve, that measure will prove useless as a predictor of economic growth and inflation. In addition to this, as Lester Thurow pointed out (Dangerous Currents), there is irony in monetarists’ insistence that we use monetary policy to control inflation. For monetarism regards money as no more than an intermediary among goods. All that counts is the relative values of different goods. Changing the value of money, the intermediary, does not change those relative values. Inflation must be innocuous, so it should not be necessary to control it. These problems underlie the persistent failures of monetarism. Monetarists looked for a recession in 1984, double-digit inflation in 1986-7, and a recession in 1992-3. They were far off the mark in each case. Nor has monetarist policy worked. The Federal Reserve’s targeting of money supply in 1979-1982 produced severe economic dislocations. The congenital failures of monetarist predictions should not be dismissed lightly. Because it is easy to explain results that you already know, “successful” explanations of historical data are less significant than successful predictions of new events. The inability of monetarists to get the right answers when they did not know those answers beforehand is a serious flaw. In contrast to the poor predictive record of monetary aggregates, a simple, if elegant, algorithm developed by David Ranson, based solely on changes in short-term interest rates, has been remarkably accurate in predicting real GNP growth. On most accounts of causality, causal and predictive efficacy go hand in hand. That interest rates have had greater predictive power than money supply suggests a closer causal link between interest rates and economic growth than between money supply and economic growth. But economists bury their mistakes quietly and quickly forget about them. Many observers of the economic scene, even those who are well informed, are unaware of the extent to which free market predictions and policies have failed. These failures are only part of the problem. The most basic notions of free market economics, while they work well enough in theoretical models, hardly make sense in the real world. Free market economists insist on a flat playing field in foreign trade. This sounds good, at least in theory. But how in the world do you measure distortions caused by culture, for example, by the proclivity of the Japanese to distinguish between foreigners and fellow Japanese, the latter often regarded as almost extended family? This ethnocentrism is responsible for a variety of features: for $3 trillion in postal savings accounts that pay less than 1% per year, enabling Japanese industry to be more competitive by borrowing at low interest rates; for the tendency to prefer domestic to foreign goods; for the pre-occupation with market share as opposed to profits; for high levels of job security provided to direct employees, independent of performance. These distort any playing field. How do you treat the bumps caused by our own tilting of the playing field? Boeing achieved its dominance in commercial aviation thanks to a decades-old government subsidy. An Air Force order for 29 KC-135 jet tankers to provide airto-air refueling for its fleet of B-47s and B-52s provided critical support to Boeing’s venture into commercial jet aviation. (The Boeing 707 is nearly the same as the KC-135.) The excellence of American agriculture is due to the development of agricultural colleges and experimental farms, the construction of dams, government crop insurance, the Rural Electrification Association, and the Farmers’ Home Administration, all funded by federal or state government. It does not matter that we have discontinued many of these supports. Dominance, once established, tends to perpetuate itself. Inferiority, once established, also tends to perpetuate itself. “A poor country is poor because it is poor.” (Ragnal Norske, Problems of Capital Formation in Underdeveloped Countries, p. 4.) It is impossible to measure, much less correct, the effects of historical distortions of the playing field. As yet another example of the virtual reality of classical economics, academic economists love to talk about the efficiency of financial markets. By this they mean that the price of any financial instrument at any time appropriately reflects all the information publicly available at that time. On their assumptions that investors are fully informed and completely rational, information that could change the price were public, the price would have changed already. The most remarkable feature of this theory is that, if it were true, then all investing should be illegal. For if the market price reflects all publicly available information, the only way one could hope to outperform the long and broad trends would be through information that is not public. But it is illegal to trade on the basis of inside information. (Alternatively, one might regard investing as gambling, with the cagnotte going to brokers. But gambling is illegal in most states.) There are other problems with the efficient market hypothesis. For one thing, closed end mutual funds often trade at a significant discount or premium to their underlying asset values. In an efficient market investors should arbitrage the difference. For example, if a fund were undervalued, one could buy the fund and sell the underlying stocks to the point that the fund would be appropriately priced. But this has not happened. The discounts or premiums in such funds have continued for months at a time. In addition, there are investors who have decisively outpaced the broad market averages for decades. Warren Buffet, Peter Lynch and George Soros are three of the best known, but there are others. Is this merely a matter of chance, with consistent superior performance explained entirely by luck, as opposed to careful research and insight into developing trends? To the contrary, the performance of these investors has been so consistent and so significant that the null hypothesis, that it is due to chance, is extremely unlikely. Yet Rational Expectations economists claim it is impossible to consistently outperform the market. Faced with the conflict between the theoretical notion of market efficiency and the reality that certain investors consistently do well, they discard reality. Warren Buffet has expressed his opinion about the efficient market hypothesis, noting that it is easier to excel when your competitors believe there can be no advantage gained from hard work and careful research. In an interview published by Fortune, he quipped: “I’d be a bum on the street with a tin cup if the market were efficient.” Peter Lynch, in the same vein, remarked: “Efficient market? That’s a bunch of junk, crazy stuff.” In addition to the efficacy of sound fundamental research, there are technical algorithms that have worked well over decades. (While academic economists have had a difficult time generating successful trading rules, professional traders have done rather better.) Norman Fosback notes a regularity in Stock Market Logic. He contrasts a seasonal investor, who owns stock (the market average) for only the two days preceding each holiday market closing, to the non-seasonal investor who owns stock the rest of the time: To summarize, if two hypothetical investors, the Seasonal and the NonSeasonal, each started with an initial capital of $10,000, they would have realized the following results (assuming no commissions) by using alternative strategies: If we combine this seasonality with favorable price tendencies over the last five trading days of every month, the results become even more dramatic: “The results of the various strategies are startlingly different. A seasonal strategy saw $10,000 grow to over $1.4 million while a $10,000 initial investment in the non-seasonal strategy shrank to a minuscule $357... . The seasonal strategy also provided a percentage return superior to the non-seasonal strategy’s portfolio in 40 of the 48 years despite the fact that the seasonal strategy was only invested in the generally uptrending market about one-fourth of each year.” (p. 159-163.) The probability that this is due to mere chance is vanishingly small. Random walks with small steps almost never lead to so great a divergence. A study of point-and-figure charts by Earl Davis at Purdue University showed that trading off standard patterns was profitable from 70% to 90% of the time, depending on the patterns. (An advantage of point-and-figure charts is that they leave no room for subjective interpretation. Buy and sell signals are objectively generated.) Even in Value Line, which appears to use simple momentum measures to rank stocks, the higher-ranked quintiles have consistently and significantly outperformed the lower-ranked quintiles. There are also technical algorithms that often fail but are so accurate when they do succeed that they preclude the null hypothesis that their success was just a matter of luck. The precision with which Fibonacci ratios (½(±1+?5) [1.618 or 0.618]) call turning points in both time and price cannot be reasonably explained as pure chance. Finally, there are examples of violent moves in the financial markets that cannot be explained, even in retrospect, in terms of efficient markets. Consider the 1987 stock market crash in which major averages lost one-third of their in just a few hours. What was the additional information that instantly made everything worth one-third less? What information came public on Black Monday in October 1929 that precipitated the sharp market decline that wiped out 90% of market value? It is remarkable that a theoretical construct such as the efficient market hypothesis has survived this. True believers in a widely accepted theory, be it physics or economics, maintain their beliefs no matter how overwhelming the contrary evidence. The very justification of laissez faire is problematic. The standard claim is that in the competition engendered by free markets consumers will shop to maximize the value they receive. Wares that don’t provide good value will not sell and their producers will soon be out of business. Producers making what the public wants and providing it at the lowest cost will be the survivors. The most efficient producers (even if that efficiency comes from using slave labor) will have the greatest profits and will be able to expand at the expense of less efficient producers. Consumers will receive the greatest value. It does not take a rocket scientist to find flaws. It may seem trivial, but consumers shop to maximize perceived value. There may be a wide gap between value and perceived value. One can add perceived value in ways that have nothing to do with real value. One can produce a product that is addictive. To an addict his favorite substance may have such perceived value that he will go without food and clothing to purchase it. That is why the unethical drug and cigarette industries are so profitable. Alternatively, one can advertise the product, adding perceived value to a product that may have little intrinsic value. It is often the effectiveness of the advertising, rather than the quality of the product, that determines competitive destiny. “But, there are many examples of products which are technologically inferior not just surviving, but driving out of existence competitors with distinctly superior qualities. The free market chooses not the best, but the worst.” (Ormerod, Butterfly Economics, p. 20.) |
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