All entries for Thursday 22 January 2015

January 22, 2015

Nothing orthodox about belief in efficient financial markets

We should not call the efficient markets theory economic orthodoxy. It is a theory that originated in the Chicago school of economics - a very particular instituion whose theories are often regarded as highly controversial by economists - that (at least s far as the pensions industry is concerned) has turned the minds of part of the actuarial profession. Some of them have discovered that it is a way of avoiding some of the problems that have befallen the profession in the past for which they have been criticised. Adopting a strict mark-to-market approach to valuation assuming markets are inherently efficient is a perfect route to a successful actuarial career if you can carry the trustees and stakeholders along with you (by telling them it is orthodoxy). You can then take all the credit for success while having a perfect cop-out for failure ('it wasn't due to my failure of judgement it was the market').

You don't have to be an anti-capitalist to criticise it. Here is what Warren Buffett thinks about it (this is just a flavour):

There is much criticism of it revealed by the merest googling. There are many articles in the financial press and also in the economics literature. Here is one in today's Telegraph online:

This article says: "So, increasingly few people still believe that markets are wholly efficient and that is a good thing. "

Unfortunately Bill Galvin i(USS chief executive) seems to be one of them. This is what he recently wrote in a letter: "...the RPI inflation assumption is derived relative to the implied market expectations for future inflation levels ... the trustee feels it is appropriate to use an objective measure such as this as a starting point rather than trying to otherwise predict future changes." (My emphasis)

He interprts the data according to his theory of how expectations are formed by market participants, hence they are 'implied' and the results he gets are 'objective' (they are actually the result of behaviour by human beings which is what a market is).

This is blind faith. Suppose the market is affected by 'irrational exuberance' or randomness of some form. By interpreting the data according to the theory to get so-called objective measures he will go badly astray.

Maybe we are witnessing this already in the high volatility of the valuation.

Worrying economics of the USS trustees and UCU negotiators

Today's Times Higher Education quotes Jimmy Donaghey, chair of the UCU superannuation working group, and 11 higher education committee members as saying in a letter, “the reality of us changing what is regarded as economic orthodoxy…is an immense task”. On that basis they are apparently willing to swallow the belief that the estimated deficit has suddenly increased to £20 billion without needing any explanation for this 66 percent increase in a few montths beyond 'market conditions'.

For trade unionists to argue thus is remarkable. First there is no such thing as economic orthodoxy. Economics is a very diverse field and it is unhelpful to refer to the market fundamentalism of the USS trustees as orthodox. And these ideas have been controversial for a long time and widely criticised ever since the financial crash of 2007/8.

Secondly their position is absurd because advocates of the orthodoxy they are referring to regard trade unions as a form of market imperfection and tend to argue in favour of 'flexible labour markets'. The whole point of trade unions is to challange laissez faire market orthodoxy. There is nothing unrealistic about that.

But there is a much more serious point here. That is that the economic ideas underpinning the approach to the USS valuation are deeply worrying in themselves because they are self-contradictory and will lead eventually to another crisis.

The trustess argue that the key assumptions about things like asset values and liabilities should be taken from market prices because thses are 'objective'. The idea is that the market price of an asset, say a company share, will inccorporate all the information about the future returns expected to come from owning that asset. The price of the share is taken to incorporate all the information about the whole future of the company. (In its purest form the theory even assumes that the share price also incorporates private information.) But for that to happen the other particpants in the market place must actively optimise their decisions about buying and selling all the time. Then an investor like the USS can free ride on their efforts.

But this is a self-contradictory theory. If the other participants all decide to take the same view of the market prices as being objective - and why not since that is the best thing to do according the trustees - then obviously the theory does not work. Market prices will be arbitrary because all market traders will be passively following rather than active participants.

Another example is in the way the USS forecasts inflation. It looks at the prices of government secutiries with different maturities and gets what it considers an objective estimate from that. But this only works if the rest of the market does not behave the same way. If all market participants do the same as the USS then this approach is pretty arbitrary and will result in volatile and incrreasingly arbitrary valuations. Maybe this is what is behind some of the volatility we are seeing in the valuation of liabilities.

This is a very serious point. It has been said many times that financial institutions have learnt nothing from the crash that cost us all so much and they are carrying on with 'business as usual' with inevitable consequences. Many economists have been saying this in the Finanical Times and elsewhere.

It is not simply a matter of "the reality of us changing what is regarded as economic orthodoxy…is an immense task”. The belief in this orthodoxy is not only a threat to the USS - because actually the orthodoxy does not have a place for defined benefit pension schemes at all, since they are another market imperfection in the way of perfect equlibrium - but actually a danger to the whole macroeconomy. It is simply creating the conditions for another crash.

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