The Lehman Brothers fall almost caused the global financial system meltdown. For many decades Wall Street was being ruled by the Efficient Market Hypotheses (EMH). Risk management modelling was being done using EMH. These risk management models were underestimating the probability of black swan events. Are financial markets efficient and stable as stipulated by EMH or they are inherently unstable. In this post I am going to discuss in detail the Financial Instability Hypotheses by Hyman Minsky versus the Efficient Market Hypotheses by Eugene Fama. Does the financial system behave like a docile animal as described by the Efficient Market Hypothesis? Or the financial system inherently unstable and prone to destructive boom bust cycles? What is the role of the central bank in these boom bust cycles?
21st century started with a credit crisis popularly known as the Tech Bubble or the Internet Bubble. Tech stock prices skyrocketed and then crashed to zero. This was followed by the housing market bubble and the 2008 financial market crash. Many now think were these bubbles caused by the loose monetary policy of the Federal Reserve Bank. Federal Reserve low interest rate policy fuels excessive credit creation and asset price bubbles. In anticipation of an economic slowdown, interest rates get lowered. Efficient Market Hypothesis followers advocate this policy to smooth our bust cycle. But in reality this has only resulted in unsustainable level of debt which then results in a major financial crash like that happened in 2008.
Economics textbook teach when the demand of a good or service increase its price increases which entices people to supply more of it which results in the market reaching equilibrium when the supply and demand equal themselves. This means increase in demand causes the supply to increase. Market price rises and falls to make the supply and demand of a product or service balance. This ensures optimal allocation of resources. If price of a product or service is high it attracts more supply and this ensures that resources are diverted to those products and services where the allocation of capital brings the maximum return. This is the classical laissez faire theory of economics in which markets when left free without interference from the government will optimal equilibrium of resources on their own. This is in accordance with the EMH that stipulates that free markets reach equilibrium if not interfered with. A external shock will disturb this existing equilibrium and the market will then find a new equilibrium.
Then a bold assertion is made. What is true for the goods and services market is also true for the market for factors of production land, labor and capital. Is this bold assertion supported by facts? Let’s take the example of the painting market. Here painting get sold. Supply of these painting is always limited. Van Gogh Sunflowers painting sold for more than $200 million. Supply cannot be increased to make the market more efficient despite the fact that the price is quite high. Painting market is not economically important. But if we look at the oil market. Decrease in supply of oil in the global market forces the consumers to reduce their oil consumption but speculators increase their demand for oil. This illustrates that market for assets work different than market for goods and services. When the price of a stock increase, its demand also increases even though the supply is constrained and limited. In an asset market demand does not stimulates the supply rather lack of supply stimulates demand and oversupply or glut can cause fall of demand. Rate of price change also stimulates demand in the asset market. So keep this in mind asset markets don’t behave like goods and services market.
How Efficient Market Hypothesis is wrong?
According to the Efficient Market Hypothesis market prices are always correct. Stock price at the moment is correctly reflecting its true value. based on the current and future economic conditions. Stock price change is triggered by external events which most of the time will be news shocks. So whenever new information hits the market in the form of breaking news, stock price will change to the new correct level according to that new information. Efficient Market Hypothesis has no place for asset price bubbles or asset price crash as the market price is always correct it cannot be overvalued or undervalued. Now aren’t you amazed. EMH does not believe in asset price bubbles. So housing market was correctly priced at all the times before it crashed in 2007. As price is always correct, there is no bubble and the central bank does not need to take any action.
Efficient Market Hypothesis is the basis of all the statistical models and probability distribution models that are being used to forecast asset returns. Obviously these statistical models are based on false premise. Most of the time the predictions of these statistical models don’t tally with the real results. This discrepancy is called the fat tail problem. According to EMH statistical models the probability of a 25 standard deviation move in asset returns is almost zero. 25 standard deviation move cannot happen in millions of years. But in reality 25 standard deviation moves in asset returns happen on frequent basis and finance community still believes in the Efficient Market Hypothesis. Whatever EMH predicts has always been found to be not in accordance with the real observation.
Financial Instability Hypothesis by Hyman Minsky
Do we have a better financial theory that can explain the asset market bubbles and crashes and the erratic financial market behavior that we observe from time to time like that in 2008. Financial Instability Hypothesis FIH developed by American economist Hyman Minsky can explain all the things that are observing in the financial markets. Hyman Minsky says that he developed his Financial Instability Hypothesis after reading John Maynard Keynes book, The General Theory of Employment, Interest and Money. In his book John Maynard Kaynes totally refuted the idea of efficient markets.
What makes the asset price move. According to the Efficient Market Hypothesis, it is the external shock in the form of new information that disturbs the market equilibrium. When there is new information, the existing price equilibrium is disturbed and a new price equilibrium is established in accordance with the new information. If there is no external shock, asset price don’t change. Now in stark contrast to the efficient market hypothesis, the financial instability hypothesis says that there are internal forces in the financial market that generate waves of credit expansion and asset price inflation followed by waves of credit contraction and asset price deflation. So instead of external shocks everything is internal inbuilt in the financial system that makes is unstable. So this is what Financial Instability Hypothesis is saying: financial markets are inherently unstable and there is no mechanism in the market to find equilibrium.
What are the internal forces that make financial markets unstable? As pointed above, one is the supply which is driving demand and the other is asset price change as the driver of asset demand. Let’s discuss a few other internal forces that destabilize the financial markets. Money Market Funds are an important and big part of the US financial market. Money Market Funds allow investors to deposit money just like a bank and earn a high rate of return unlike a bank. An investor can deposit money in a money market fund and withdraw it anytime while at the same time earn good interest rate on the deposit.
Banks and Money Market Funds are Unstable
Money market funds are highly competitive. Investors usually choose those money market funds that offer high rate of return on their deposits. The deposits made by investors are loaned to commercial money markets are high rates of return for several months. By lending the money in the commercial money markets for longer periods, the manager of the money market fund can earn a high rate of return for the fund clients. The way to earn high interest rate is to make loans to the low quality least reliable investors for longer periods of time. This is a risky strategy. On one hand the money market fund wants to ensure safety of deposit and earn high interest on the deposits and on the other hand, there is a high risk that the loans made may not be returned. So investors enjoy the benefits of bank deposits and high interest rates of term deposits both while not recognizing the inherent risks involved in the money market fund business.
Now suppose the loan made by the money market fund manager defaults. The manager will subtract the interest rate on this loan and spread it over the whole fund deposit. Money market fund business is highly competitive. This reduction in the interest rate offered will force some investors to withdraw their money and deposit it with another money market fund. This will force the manager to allocate the negative interest rate to a smaller pool of deposits. As more investors withdraw their deposit, the fund pool of investment becomes smaller and smaller and the fund collapses. So you can see there is an inbuilt inherent instability in the money market fund business. The depositors objective and the funds business are in conflict which leads to an unstable business model.
Now banks also have this instability inherent in their business model. On one hand banks guarantee the safety of deposit and on other hand they are making loans for long periods like 20-30 years at high interest rates. If many depositors withdraw their deposit at the same time, it can lead to liquidity problems for the bank and can even result in a bank run. The basic conflict gets generated when you guarantee the safety of the capital deposited and at the same time risk that capital by making a loan at high interest rates for a long period of time. Banking business model is not in accordance with the efficient market hypothesis. But the financial community has never tried to integrate this inherent instability in the banking business models into their market behavior models.
This inherent instability in the banking business model is known to everyone for the last hundreds of years ever since banks got created. But the financial theory totally ignores this instability in their financial risk modeling. It is easy to model this instability using a positive feedback system.In a positive feedback system past events influence current and future events. Efficient market hypothesis says that asset prices are not influenced by past events. New events are random and are not at influenced by past events. This assumption of a random walk in asset prices allows financial modeling using normal probability distributions in predicting the future asset returns.
If the present events influence future events and the market behavior is memory driven than we have a problem with the financial risk models built using efficient market hypothesis. These financial risk models are underestimating the risk by ignoring the risk of bank runs.