Thursday, July 5, 2018

What guides intuition about efficient markets?

Scott Sumner has recently been making the case for the efficient market hypothesis.  I'm basically with him on this, especially when it comes to public policy.  If a committee decides that they know the correct price level of something is different than the market price, they will be wrong much more often than they will be right.  And, if that committee has the power to move prices to where they think they should be, the results will be disastrous.  Furthermore, if the committee decides that prices, or God forbid, quantities of something are too high, then they will be imposing scarcity on their constituents.

That's what happened in the housing bubble and the financial crisis.  The model was wrong, but we have given the federal government enough power to impose its model on the economy, and it took a crisis to move prices to the place that they were aiming for.  Though, it's not really an issue of a state-imposed crisis, because the crisis was popular.  It was demanded.  To the extent that people like Ben Bernanke and Timothy Geithner used discretionary power, they used it to moderate the crisis in ways that were widely unpopular.  They partially saved us from ourselves.  Their memoirs can be seen, to a certain extent, as extended apologies for protecting us from our worst impulses.

The public treatment of market efficiency is strange to me.  It seems random.  Some markets are clearly prevented from clearing in a functional way, but people seem to have an intuition for making excuses for them.  Take 100 random people who haven't thought about the issue and present to them the idea that there is a politically imposed shortage of housing in Los Angeles, and they will respond with: Well, there just isn't any land left to build on.  Well, there are just too many people.  Well, the Chinese keep buying up the properties and leaving them sit idle.  Well, with all this income inequality, the rich just keep bidding up the home prices.  Well, all that QE cash keeps pumping up the market.  Well, California is a nice place, so of course it is more expensive.

These are all plausible, yet not significant, reasons from high home prices in Los Angeles.  With a little digging, it becomes clear that these factors aren't definitive, and that the problem is supply.  Even without going into detail about each factor, simply look at the process of development in Los Angeles.  If all these other factors were the reasons for high prices, housing authorities in LA would be running new projects through the system as ferociously as they could to make up for it.  The opposite is the case.

Similarly, mortgage markets are tied up in knots because of extremely tight lending standards.  But, seeing the dislocations, people respond: Well, incomes have declined and people can't afford homes any more.  Well, young families have student loans.  Well, homebuilders only want to build high-dollar properties because they are more profitable.  Well, families don't want to own any more.

All of these are, again, plausible sounding enough if you don't check to see if they are true.

So much of the development of our opinions comes from what we give the benefit of the doubt.  In these cases, for some reason, intuition tends to be that there must be a good reason for what is happening, and our minds search for plausible reasons.  When we find one, we are satisfied.

Sometimes, this intuition leads to conclusions that are extremely supportive of very strong efficiency.  The idea that public schools become segregated because higher quality schools cause home prices to be bid out of the reach of poor families supposes a sophisticated and extreme amount of efficiency in housing markets.  This supposes that quality of a school district gets capitalized into the prices of homes with a high correlation coefficient.

The idea that the various forms of income tax benefits create much higher home prices also supposes a sophisticated level of efficiency, where many far future benefits - some of them imputed - are capitalized into present prices.

But, then, there are times when, for some reason, the intuition flips.  So, if one points to fundamental causes for high home prices in the 2000s, the response is usually to push back and to find plausible reasons why markets weren't efficient.  Well, bankers make bad loans in a shortsighted attempt at padding their numbers.  Well, naïve speculators hop in the market at the top and keep pushing prices higher.  Well, mortgage originators could just dump garbage on investors who were too dumb to know.  Well, the Fed just keeps pumping money in so that this fake bubble economy just gets more and more bloated.

Again, all plausible if you don't look hard enough.  It's amazing to me, in hindsight, how many facts that contradict these stories are just sitting in plain sight.

What causes that flip?  What causes the intuition to support efficiency in some ways while it contradicts it in others?  What convinces the average person at the end of the bar that there must be a natural reason for the median home price in San Francisco to approach a million dollars but that we had to suffer through a financial crisis because home prices in Topeka were up to $120,000, and when they fell back to $90,000, that was when we were back to normal.

There is definitely an important role for attribution error here.  We do things because of the context we are presented with.  Other people do things because they are greedy, ill-informed, and short-sighted.  That explains the nuts and bolts of what happens when consensus forms against something.  This is clear in the current anti-immigrant political machinations.  But, we have been dealing with this problem for years, across the political spectrum in the mental models that people have about what caused the housing bubble and the financial crisis.  There are a lot of villains and dupes in the various stories about what happened.

But, this isn't a compelling answer to the question of where this intuition falls.  The housing regulators and NIMBYs in Closed Access cities could easily serve as the villain in stories about expensive urban housing.  In the just-so stories about the current shortage of entry-level housing, attribution error leads to stories of homebuilders who aren't willing to supply low tier markets.

I'm not sure that I have an answer.

And, I'd like to say that I wish that the public tended to support EMH, but even that doesn't help much.  The excuses that seem to plausibly explain million dollar urban homes, in defense of an efficient market, aren't much better than the excuses that seem to explain inefficiency.  I mean, I guess complacency is better than aggressive, passionate sabotage.  But, still what is the mechanism that steers public intuition?

I think the intuition is to search for defenses of the status quo and to see things that change quickly as aberrations.  This is probably not a bad heuristic if it's the best we can do. But this is where the efficiency of modern markets gets them in trouble.  Changes in prices can move quickly when valuations change for any reason. The natural proclivity to distrust financiers leaves us all too eager to blame them and their perceived excesses when change happens.

Even this intuition is biased, though. Our intuition is to explain why there are reasons for financial markets to retract but to push back against financial markets that expand.


  1. Great post.

    I am not sure why, but there is a proclivity to designating some periods as being in a bubble, but no equal emphasis on reverse bubbles.

    As for housing scarcity, there is of course an alliance between property owners and lenders. Who wants to unzone property and place at risk property values and outstanding loans?

    The macroeconomic blogs today are in near-hysteria over dubious changes in import tariffs proposed by the Trump administration.

    There is no hue and cry on property zoning.

    Maybe what you said is true, that the status quo is always the defensible position.

  2. You should try and get on the Strong Towns podcast or publish something their site. I think your framing of overzealous land use regulation and meddling in things we don't really understand might be well received.

    1. Thanks for the tip.

      I'd love it if you put a word in for me there. Frequently, it helps to get a third-person recommendation.

  3. Great post. One quibble. I think Bernanke instituted IOR at literally the worst time possible in over 50 years.

    1. Yeah. Good point. That was a pretty big whiff.