In which we prove the efficient markets hypothesis with Willy Hutton\’s help

Now, as we all know, the efficient markets hypothesis does not say that all markets all the time markets is efficient.

It most certainly does not say that defence of the realm should be organised market stylee: nor does it exclude a welfare safety net (nor even a welfare state). Not even that justice sold in a market will be more efficient than justice not so.

What it actually says is that when trying to work out what prices should be in a market markets are efficient at processing the information about what prices should be in a market.

No more: the weak version says that a market will be efficient at processing the information everyone knows, the semi-strong that it\’ll be efficient at processing what is publicly available and the strong that it\’ll process all information, private, secret and little known as well.

That last is because those with private, secret and little known information will trade on it (yes, even to the point of insider trading) and thus the effects of that information will be reflected in market prices.

Which brings us to the markets\’ pretty much non-move in any direction following S&P\’s decision to list US Govt debt as possibly, maybe, about to get a downgrade. Perhaps, in a bit. And then Willy Hutton.

Maybe it\’s because Boston is different, a semi-detached city in one of the US\’s most liberal states. But the news that the world\’s biggest economy had had its creditworthiness challenged for the first time by the upstart rating agency Standard & Poor\’s (S&P) hardly seemed to register with the locals.

No one I met fulminated about loss of economic sovereignty or that S&P, whose purblind approval of junk mortgage debt as triple A was one of the causes of the financial crisis, had finally over-reached itself. Bostonians seemed unconcerned. Perhaps this was because it was just one more surreal moment in the pantomime that is American economic and political life.

That was how the markets judged the news. There was a momentary tremor in the Dow Jones. Some analysts shrugged it off; others thought it profoundly serious. But soon the markets were on the rise again as if nothing had happened.

Well, quite.

The information that S&P used to get to their reconsideration that might happen in the future of the US AAA rating is widely known. The government is spending like a fleet of drunken sailors on shore leave, no one really seems to want to do anything about it, over and above this in the longer term there\’s the dire necessity of getting a handle on entitlement spending and in the short there\’s a real fight going on about the appropriate level of taxation. Should the federal govt expand from its post WW-II roughly 18-19% of the economy up to 23-24% of the economy?

Erm, actually, should the federal taxation expand so so as to catch up with the federal spending already going on?

This is all well known and so, if markets are in fact efficient will already be in market prices. We only even need the weak version of the EMH to assume so.

Which is what leads to my amusement about those shouting about how the announcement hasn\’t moved markets. It\’s exactly those, Willy, the Krugster, who would adamantly insist that the Great Financial Crash proved the EMH wrong who are highlighting, right now, how the reaction to the S&P annoucement shows the EMH to be correct.

It\’s just that they won\’t admit that what they\’re saying is in fact proof of the EMH. Which is fun, no?

1 thought on “In which we prove the efficient markets hypothesis with Willy Hutton\’s help”

  1. The Efficient Markets Hypothesis is a tactic adopted by American academics to make the maths easier. They realised that they just couldn’t develop any new theories without simplifying assumptions as the maths was insoluble if there were more unknowns than equations.
    Everyone who pauses to think for two seconds knows that EMH is not true in the real world (e.g. I believe in the existence of death and taxes, either of which will invalidate the assumptions upon which the EMH rests) but some of the conclusions reached have some use.
    You cannot prove a hypothesis. A hypothesis is an assumption made as a preliminary to proving or disproving a theory. What you have shown is that the reaction to the news that S&P had belatedly recognised that the USA needs to pull its socks up is consistent with EMH.

    Tim adds: Fair enough…..although “prove ” has another meaning, “to test” which is what I’ll now claim I meant.

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