In honor of Donald Trump officially becoming the worst president of all time I thought I should post an R1 of a horrible article to lift spirits. The article I found to fit this desire was an egregious piece by the esteemed Robert “Krugman Slayer” Murphy talking about the Efficient Market Hypothesis( henceforth shortened to EMH). And it’s bad. Besides the obvious head scratching nature of an Austrian criticizing an economic theroy that states that the market is always right the article get’s a lot of stuff wrong on both sides of the argument.

Please Note: This R1 is not meant to be a particularly through defense or critique of the EMH. Rather I will be pointing out that the things that Murphy asserted about the EMH are insufficiently defended. That being said let the shit show begin

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Krugman Section

There isn't much of argumentative substance in this part of the article, which is odd coming from the ContraKrugman guy, but there was one paragraph that I thought showed Murphy has a tenuous grasp on what EMH is.

This same problem exists when it comes to the EMH. In its weakest form, it simply means that new information tends to get incorporated quickly into stock prices, meaning that there can't be any obvious arbitrage opportunities lying around (since someone would have exploited them already). However, the most fanatical EMH advocates come close to saying that financial bubbles are literally impossible.

Most of that is true. Murphy is absolutely correct when he talks about the differences between the strong and weak forms of EMH except for when he says that some argue “financial bubbles are literally impossible”. “Impossible” implies that in some sense the thing that we are talking about exists. When I say it is impossible to flap my arms and fly that makes sense because flying exists. What hard EMHers would argue is not that financial bubbles are impossible it is that they don’t exists. Here is an example of Fama making the claim.. In other words, to use the word impossible implies that there is some sense in which bubbles are a thing that could happen but hard EMH defenders would say that bubbles literally don’t exists not that they can’t happen. It’s possible this was a slip of the tongue by Murphy but else where he seems to not understand EMH several times in the article so I think this is a fair criticism.

Lucas Section

In reference to an article written by Robert Lucas, Murphy says

Lucas's arguments here are typical in this debate. He offers a seductive mixture of assertion and non sequitur to make his case. First, the EMH is itself under dispute, so it hardly helps to cite the EMH and its implications. (This is akin to a Christian quoting the Bible to an atheist to prove the authority of Scripture.)

Firstly, Lucas was not defending the EMH as Murphy claims. Instead he was arguing that the assertion that economic models should have predicted the financial crisis. He mentions the EMH only to point out that if we did have models that could “that forecasts sudden falls in the value of financial assets” that it wouldn't prevent the crash. The EMH implies that it would simply move whatever crash occurred backwards in time. You can disagree with Lucas's characterization of reality in that passage but Murphy instead disagreed with a non existent defense of the EMH. The EMH was an assumption in his passage; not the thing that was being defended.

Now, in what sense has it "been known for more than 40 years" that it's impossible to predict sudden falls in asset values? Didn't Mark Thornton and others warn us that the housing bubble was too good to be true several years before the crash? What more could an Austrian cynic do to disprove the EMH, than to predict that "the market" was all wrong when it came to housing prices, risk premiums, and so forth? Investors who heeded the warnings of Thornton and others got out of the stock market, didn't buy houses to flip in 2005, and, otherwise, managed to outperform other people who were caught up in the euphoric boom. If that's not "beating the market," what is?

And now it becomes clear why Murphy is criticizing the EMH. Because if it were true Austrians would have prevented the crisis! This passage is silly nonsense. Firstly the EMH says that “existing share prices change to incorporate and reflect all relevant and generally known information”. That Mark Thornton “predicted the crash” holds no relevance to whether EMH is true because an Austrian Economists predicting a crash is not “generally known or relevant information”. They do it all the damn time. Like when Murphy made bets about inflation that never came true.

Notice, there is a flaw in Lucas's argument. He is saying that if an economist could reliably predict a crash in a week, then everyone would know it now and the crash would happen immediately. There are two problems here. First, an economist can accurately predict a crash, but it doesn't follow that everyone else will automatically follow suit. In the real world, some economists are bullish and some are bearish at the same time. So, which way is the market supposed to move?

In content, I think Murphy is right here. There are people like Nobel laureate Robert Shiller who make claims about bubbles all the time and recently Yellen seems optimistic. Macro is hard and it’s easy to find people going in every direction at once. However Murphy’s point in particular is that Austrians have predicted crashes and not been listened to which is laughable for self evident reasons.

The EMH fan would probably say, "Aha! That just proves how right the EMH is. We don't have any reason to suspect the market will go up or down, because the current price reflects all available theories and information." Yet, the market price will go up or down, showing that at least one forecaster was wrong. (The other one might have just been lucky, so we can't say for sure that his prediction was really correct in the grand scheme.)

But the fact that two predictions necessitate that at least one is wrong doesn't mean anything. Stocks are unpredictable by nature. “Generally available” information does not mean all information and it does not mean that everyone is going to agree on the direction of a stock. Virtually every economists that the average investor is better off with an index fund. It is possible to make money without inside information but generally you can’t. That doesn't mean the EMH is wrong.

The second major flaw in Lucas's neat little demonstration, is that he assumes the formula for an impending crash must be very time specific. But what if someone like Mark Thornton says, "This situation is unsustainable. Housing prices cannot continue to rise at these rates"? That is still an accurate prediction. It is definitely useful to investors, especially if the forecaster gives a broad period, within which the move will occur.

Murphy seems to contradict himself in this paragraph. Both Murphy and Lucas agree that in order for a prediction to be useful there needs to be a time frame given.

In this situation, where some forecasters make qualitative predictions, Lucas's quick argument falls apart. We are back in the conventional world, where different forecasters rely on different theories to make different recommendations. The investors who listen to the bad ones lose money, while the investors who heed the more accurate theories make money. You can "beat the market" if you invest based on more accurate predictions. Is this really that strange a concept?

No one would argue that. However Murphy seems to be under the impression that there are theories more accurate or useful then EMH which there aren’t (unless there is some behavioral voodoo weirdness involved but that goes beyond the knowledge of the author).

Wait a second. Lucas has now considerably weakened his defense. Earlier he said that beating the market was an impossibility; moreover, an impossibility that had been known for 40 years. Yet in his discussion of the falsifiable tests, he admits that there are departures from the theory. So, now we have Lucas himself admitting that the EMH fails in the microscopic particulars. I still maintain that it failed spectacularly in the recent housing bubble, as well as the earlier dot-com bubble (which many Austrians also called, before it popped). What would it take for Lucas to admit that the EMH isn't true?

No he hasn’t. The existence of the CUBA fund is a relatively minor thing. That doesn’t weaken almost any of the practical knowledge that EMH gives investors. Is there any situation where an investor should assume that the market isn't efficient? Sure. But those situations are few and far between.

Also, Murphy, maybe the reason that no one listened to ABCT Austrians yelling about impending doom is that ABCT is wrong.

Let's put aside Lucas's funny defense of Mishkin and Bernanke, which says they're very good at predicting economic conditions, except for those pesky financial disasters. Beyond that side splitter, Lucas is simply making stuff up in the excerpt above. Ben Bernanke, most assuredly, did not convey that he had any inkling of what lay ahead for the US economy. Watch this incredible compilation of Bernanke's consistent errors from 2005 to 2007, where at every stage he either failed to see the coming storm, or predicted that the trouble would soon end. Again, I ask Mr. Lucas, What would Bernanke have to say for him to be guilty of what his critics accuse? Would we have to have Bernanke on tape saying, "I am 100 percent certain that no financial crash will occur"? It seems Lucas has set the bar really low for our Fed chairman.

Murphy has his time line wrong. Bernanke certainly did not see the crash coming. But he absolutely thought a crash would come after the fall of Lehman Brother’s if he didn't act. On Page 261 of Courage to Act Bernanke wrote

“You have a neighbor, who smokes in bed... Suppose he sets fire to his house... You might say to yourself ‘I’m not going to call the fire department. Let his house burn down. It’s fine with me’ But then, of course, what if your house is made of wood? And it’s right next door to his house? What if the whole town is made of wood?”

This is either a convenient misremembering or something more insidious. But it certainly isn't correct.

Levine Section

Anyone familiar with the incredible precision — and experimental confirmation — of the forecasts of quantum physics should recognize the absurdity of Levine's analogy. It's a bit like comparing a Euclidean proof to a closing argument by Johnny Cochrane. A better analogy for Levine would be a bunch of particle physicists inviting you over to look at their super collider, and then calling you the next week to say they exposed you accidentally to a lethal dose of radiation.

This is just stupid. I don’t even know what to say. Murphy is actually denying that economic models are statistical in nature and then got to far into the physical analogy Levine used. Not that surprising since Murphy is squarely in the Mises/Rothbard mold of economists but a priori reasoning is not very useful especially for sufficiently complex topics. See section 4 for more information.

Siegel Section

Siegel is to be congratulated for his masterful stroke here. During the bubble, when investment bankers were earning multimillion-dollar bonuses, the defender of the EMH would have said, "It's crazy for an average investor to try to beat the market. Some of the brightest minds in the world have enormous computers and an army of mathematicians at their service, squeezing every ounce of mispricing from the market. Don't bother trying to compete with those experts. Put your money in an index fund instead."

Yet, after many Austrians (and others from different schools of thought) predicted that the market would crash, and that investors should get into cash, Siegel points to the monumentally incompetent investment bankers as proof of the wisdom of "the market."

First, to again point out how silly listening to Austrians hand wave about the end of the world, I present Peter Schiff being wrong for two hours.

Second, this is just 20/20 hindsight. Murphy is right in that obviously someone would be better off if they sold off a lot of stuff before the crash happened. The problem is that no one should actually listen to Austrians when they talk about most things but especially about crashes. Someone would definitely be better if they just invested in index funds rather than get consulted by RPM even if one of the crazy predictions came right every once and while.

The efficient-markets hypothesis comes in various forms. There is, indeed, a large empirical literature, in which Fama and others conducted falsifiable tests. However, as I hope I've demonstrated with the quotations above, in practice the efficient-markets hypothesis is actually a tautology, or a way of viewing the world. There's nothing wrong with using a priori mental frameworks to parse economic reality; indeed that is one of the defining characteristics of Misesian praxeology . However, as the quotes show, many of the EMH apologists think they're independently confirming the EMH, when, in fact, their goggles simply force all evidence into conformity with their presuppositions.

As I have shown the EMH is not just a tautology. There are two main parts to it, the impossibility of beating the market consistently and whether prices are objectively “correct”. The second part is harder to really determine but the first part seems absolutely correct. Murphy's main argument seems to basically be that Austrians aren't listened to and ergo EMH is wrong which would be correct if Austrians were worth listening to.

Fama always get’s his pound of flesh. Murphy BTFO.