Market Efficiency Hokum

Stephen Lendman

Posted Aug 24, 2007      •Permalink      • Printer-Friendly Version
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Market Efficiency Hokum

by Stephen Lendman

You know the story triumphantly heard in the West.
Markets work best when governments let them operate
freely - unconstrained by rules, regulations and taxes
about which noted economist Milton Friedman once said
in an interview he was “in favor of cutting….under
any circumstances and for any excuse, for any reason,
whenever it’s possible (because) the big problem is
not taxes (but government) spending.

Friedman is no longer with us, but by his reasoning,
the solution to curbing it is “to hold down the amount
of income (government) has (and presto) the way to do
it is to cut taxes.” He seemed to forget about
borrowing and the Federal Reserve’s ability to print
limitless amounts of ready cash the way it’s been
doing for years and during the current credit squeeze.
Friedman further added in the same interchange “If the
White House were under (GW) Bush, and House and
Senate….under the Democrats, I do not believe there
would be much spending.”

Clearly, either the Nobel laureate wasn’t paying
attention or age was taking its toll late in his life.
Since 2001, Democrats embraced tax cutting and
overspending policies as enthusiastically as
Republicans with both parties directing the benefits
hugely to the right pockets. They’re on Wall Street
and in corporate boardrooms where recipients know
“free markets” work great with a little creative
resource directing from Washington.

Financial Market Efficiency

In investment finance, Eugene Fama is generally
regarded as the father of efficient market theory,
also known as the “efficient market hypothesis (EMH).”
He wrote his 1964 doctoral dissertation on it titled
“The Behavior of Stock Market Prices” in which he
concluded stock (and by implication other financial
market) price movements are unpredictable and follow a
“random walk” reflecting all available information
known at the time. Thus, no one, in theory, has an
advantage over another as everyone has equal access to
everything publicly known (aside from “insiders” with
a huge advantage). That includes rumored and actual
financial, economic, political, social and all other
information, all of which is reflected in asset prices
at any given time.

Those buying this theory believe Milton Friedman knew
best. He became the modern-day godfather of “free
market” capitalism and leading exponent that markets
work efficiently and best when unfettered by
government intervention that generally gets things
wrong. In 1958, Friedman explained it in his famous
“I, Pencil” essay. In it, he illustrated the notion of
Adam Smith’s invisible hand and conservative economist
Friedrich Hayek’s teachings on the importance of
“dispersed knowledge” and how the price system
communicates information to “make (people) do
desirable things without anyone having to tell them
what to do.”

Friedman’s “pencil” story explained “a complex
combination of miracles: a tree, zinc, copper,
graphite, and so on.” Added to these ingredients from
nature is “an even more extraordinary miracle: the
configuration of creative human energies - millions of
tiny know-hows configuring naturally and spontaneously
(responding to) human necessity and desire and in the
absence of any human master-minding.” None of them
working independently was trying to make a pencil. No
one directed them from a central office. They didn’t
know each other, lived in many countries, spoke
different languages, practiced different religions,
and may have even hated each other. Yet, their
unrelated contributions produced a pencil.

By Friedman’s reasoning, this could never happen
through central planning. It sounds good in theory,
but how does it jibe with reality. The Soviets split
the atom, were first in space ahead of the US with
Sputnik 1, and developed many advanced technologies
even though they were outclassed and outspent by the
West overall with greater resources to do it.

In practical reality, governments, like individuals
operating freely in the marketplace, can succeed or
fail. It comes down to people skills and how well they
do their jobs. Top down or bottom up has little final
effect on the end result, but does direct what’s
undertaken and what isn’t. Top down in Canada, Western
Europe and Venezuela delivers excellent state-funded
health care to everyone. Bottom up in America offers
it to anyone who can pay, but if not, you’re out of
luck if your employer won’t provide it. Forty-seven
million and counting had their luck run out, and
Friedman’s pencil making miracle won’t treat them when
they’ll ill.

Put another way, if “free market” capitalism works
best and America is its lead exponent, why then:

—is poverty high and rising in the world’s richest

—incomes stagnating;

—higher education becoming unaffordable for the

—public education crumbling;

—jobs at all levels disappearing to low-wage

—the nation’s vital infrastructure in a deplorable

—3.5 million or more homeless and heading higher in
the wake of subprime defaults;

—the standard of living of most in the country
declining; and,

—the nation, in fact, bankrupt according to a 2006
study for the St. Louis Fed.

Clearly, something is wrong with the “pencil miracle”
working for some but not for most. Friedman no longer
can respond and his acolytes won’t.

The Myth that Markets Get It Right and Operate

Economist Hyman Minsky was mostly ignored while he
lived, but his star may be rising 11 years after his
death in 1996. Some described him as a radical
Keynesian based on the theories of economist John
Maynard Keynes who taught economies operate best when
mixed. He believed state and private sectors both play
important roles with government stepping in to
stimulate or constrain economic activity whenever
private sector forces aren’t able to do it best alone.

It’s the opposite of “supply-side” Reaganomics and its
illusory “trickle down” notion that economic growth
works best through stimulative tax cuts its proponents
claim promote investment that benefits everyone. It
was Reagan-baloney then and now, and so is the notion
markets are efficient and work best when left alone.

Minsky explained it, and people are now taking note in
the wake of current market turbulence. His work showed
financial market exuberance often becomes excessive,
especially if no regulatory constraints are in place
to curb it. He developed his theories in two books -
“John Maynard Keynes” and “Stabilizing an Unstable
Economy” as well as in numerous articles and essays.

In them, he constructed a “financial instability
hypothesis” building on the work of Keynes’ “General
Theory of Employment, Interest and Money.” He provided
a framework for distinguishing between stabilizing and
destabilizing free market debt structures he
summarized as follows:

“Three distinct income-debt relations for economic
units….labeled as hedge, speculative and Ponzi
finance, can be identified.”

—“Hedge financing units are those which can fulfill
all of their contractual payment obligations by their
cash flows: the greater the weight of equity financing
in the liability structure, the greater the likelihood
that the unit is a hedge financing unit.”

—“Speculative finance units are units that can meet
their payment commitments on ‘income account’ on their
liabilities, even as they cannot repay the principle
out of income cash flows. Such units need to ‘roll
over’ their liabilities - issue new debt to meet
commitments on maturing debt.”

—“For Ponzi units, the cash flows from operations
are (insufficient)....either (to repay)....principle
or interest on outstanding debts by their cash flows
from operations. Such units can sell assets or borrow.
Borrowing to pay interest….lowers the equity of a
unit, even as it increases liabilities and the prior
commitment of future incomes.”

“....if hedge financing dominates….the economy
may….be (in) equilibrium. In contrast, the greater
the weight of speculative (and/or) Ponzi finance, the
greater the likelihood that the economy is a
deviation-amplifying system….(based on) the
financial instability hypothesis (and) over periods of
prolonged prosperity, the economy transits from
financial relations (creating stability) to financial
relations (creating) an unstable system.”

“....over a protracted period of good times,
capitalist economies (trend toward) a large weight
(of) units engaged in speculative and Ponzi finance.
(If this happens when) an economy is (experiencing
inflation and the Federal Reserve tries) to exorcise
(it) by monetary constraint….speculative units will
become Ponzi (ones) and the net worth of previous
Ponzi units will quickly evaporate. Consequently,
units with cash flow shortfalls will be forced to
(sell out). This is likely to lead to a collapse of
asset values.”

Minsky developed a seven stage framework showing how
this works:

Stage One - Displacement

Disturbances of various kinds change investor
perceptions and disrupt markets. It may be a tightened
economic policy from higher interest rates or
investors and lenders retrenching in reaction to:

—a housing bubble, credit squeeze, and growing
subprime mortgage delinquencies and defaults with
spreading contagion affecting:

—other mortgages, and the toxic waste derivative
alchemy of:

—collateralized debt obligation (CDO) instruments
(packages of mostly risky junk and other debt),

—commercial and residential mortgage-backed
securities (CMBS and RBMS - asset backed by mortgage
principle and interest payments), and even

—commercial and AAA paper; plus

—home equity loans harder to service after mortgage
reset increases.

Stage Two - Prices start to rise

Following displacement, markets bottom and prices
begin rising as fundamentals improve. Investors start
noticing as it becomes evident and gains momentum.

Stage Three - Easy credit

Recovery needs help and plentiful easy credit provides
it. As conditions improve, it fuels speculation
enticing more investors to jump in for financial
opportunities or to borrow for a new home or other
consumer spending. The easier and more plentiful
credit gets, the more willing lenders are to give it
including to borrowers with questionable credit
ratings. Yale Economist Robert Shiller shares the view
that “booms….generate laxity in standards for loans
because there a general sense of optimism (like) what
we saw in the late 80s” preceding the 1987 crash that
doesn’t necessarily signal an imminent one now.

New type financial instruments and arrangements also
arise as lenders find creative and risky ways to make
more money. In recent years, sharply rising housing
prices enticed more buyers, and lenders got sloppy and
greedy by providing interest-only mortgages to
marginal buyers unable to make a down payment.

Stage Four - Overtrading

The cheaper and easier credit is, the greater the
incentive to overtrade to cash in. Trading volume
rises and shortages emerge. Prices begin accelerating
and easy profits are made creating more greed and
foolish behavior.

Stage Five - Euphoria

This is the most dangerous phase. Cooler heads are
worried but fraudsters prevail claiming this time is
different, and markets have a long way to go before
topping out. Greed trumps good sense and investors
foolishly think they’re safe and can get out in time.
Stories of easy riches abound, so why miss out. Into
the fire they go, often after the easy money was made,
and the outcome is predictable. The fraudsters sell at
the top to small investors mistakenly buying at the
wrong time and getting burned.

Stage Six - Insider profit taking

The pros have seen it before, understand things have
gone too far, and quietly sell to the greater fools
buying all they can. It’s the beginning of the end.

Stage Seven - Revulsion

When cheap credit ends, enough insiders sell, or an
unexpected piece of bad news roils markets, it becomes
infectious. It can happen quickly turning euphoria
into revulsion panicking investors to sell. They begin
outnumbering buyers and prices tumble. Downward
momentum is far greater and faster than when heading

Sound familiar? It’s a “Minsky Moment,” and the irony
is most investors know easy credit, overtrading and
euphoria create bubbles that always burst. The
internet and tech one did in March, 2000, and since
mid-July, reality caught up with excess speculation in
equity prices, the housing bubble, growing mortgage
delinquencies and subprime defaults. Goldilocks awoke
and sought shelter as lenders remembered how to say
“no.” This time, central banks rode to the rescue
(they hope) with huge cash infusions, the Fed cut its
discount rate a half point August 17, and it signaled
lower “fed funds” rates ahead if markets remain tight.

Intervention may reignite “animal spirits” and work
short-term but won’t easily band-aid over what noted
investor Jeremy Grantham calls “the broadest
overpricing of financial assets - equities, real
estate, and fixed income - ever recorded” with the
financial system dangerously “overstretched (and)
overleveraged.” His view is that current conditions
have “almost never been this dire,” and we’re
“watching a (too late to stop) very slow motion train
wreck.” Minsky would have noticed, too.

Grantham’s exhaustive research shows all markets
revert to their mean values, and all bubbles burst as
the greatest Fed-engineered equity one ever in US
history did in 2000 but didn’t complete its corrective
work. In Grantham’s view, lots more pain is coming and
before it’s over, it will be mean, nasty and long,
affecting everyone. Minsky saw it earlier, studied it,
and wrote about it exhaustively when no one noticed.
If he were living today, he’d say “I told you so.”

Federal Reserve Engineered Housing Bubble and
Resultant Financial Market Turmoil

Astute observers continue to speculate and comment
that the housing bubble and resultant current
financial market turmoil came from deliberate
widespread malfeasance aided by considerable cash
infusion help from the Federal Reserve in the lead on
the scheme.

Economist Paul Krugman is one of the latest with his
views expressed in an August 16 New York Times op ed
piece titled “Workouts, Not Bailouts.” He began by
debunking Wall Streeter Treasury Secretary Henry
Paulson’s ludicrous April claim that the housing
market was “at or near the bottom” followed by his
equally absurd August view that subprime mortgages
were “largely contained.” Krugman’s response: “the
time for denial is past….housing starts and
applications for building permits have fallen to their
lowest levels in a decade, showing that home
construction is still in free fall….home prices are
still way too high (at 70% above their long-term trend
values according to the Center for Economic and Policy
Research, and) the housing slump (will be around) for
years, not months” with all those empty unbought homes
needing hard to find buyers to fill them.

In addition, mortgage problems are “anything but
contained” and aren’t confined to the subprime
category.  Krugman believes current real estate
troubles and mortgage fallout bear similarity to the
late 1990s stock bubble. Like today, they were
accompanied by market manipulation and scandalous
fraud at companies like Enron and WorldCom. In his
view, “it is becoming increasingly clear that the
real-estate bubble of recent years (like the 1990s
stock bubble)....caused and was fed by widespread
malfeasance.” He left out the Fed but named
co-conspiratorial players like Moody’s Investors
Service and other rating agencies getting paid lots of
money to claim “dubious mortgage-backed securities to
be highest-quality, AAA assets.” In this role, they’re
no different than were “complaisant accountants” like
Arthur Andersen that lost its license to practice from
its role in the Enron fallout.

In the end, this scandal may be more far-reaching than
earlier ones because so many underwriters and other
firms are part of the fraud or are seeking to profit
from it. At this point, it’s hard separating villains
from victims as, in some cases, they may be one in the
same. They’re all involved in dispersing up to
trillions of dollars of risks through the derivative
alchemy of highly complex, hard to value, packages of
mostly subprime CDO and various other type debt
instruments that may even end up in so-called safe
money market funds unbeknownst to their unsuspecting

Before this scandal ends, they’ll be plenty of pain to
go around, but as always, small investors and low
income subprime and other mortgage homeowners will be
hurt most. Krugman says this is “a clear case for
government intervention,” but it won’t be the kind he
wants. He cites a “serious market failure (needing
fixing to) help (as many as) hundreds of thousands” of
Americans who otherwise may lose their homes and/or
financial nest eggs. Faced with this problem, “The
federal government shouldn’t be providing bailouts,
(it should) arrange workouts….we’ve done (it) before
(and it worked) - for third-world countries, not for
US citizens.” It helped both debtors escape default
and creditors get back most of their money.

By providing huge cash infusions to ease credit and
reignite “animal spirits,” the Fed and other central
banks showed they aren’t listening. It proves what
Ralph Nader said in his August 19 Countercurrents
article called “Corporate Capitalists: Government
Comes To The Rescue” that’s also on CounterPunch
titled “Greed and Folly on Wall Street.” With
“corporate capitalists’ knees” a bit shaky, Nader
recalled what his father once explained years ago when
he asked and then told his children: “Why will
capitalism always survive? Because socialism will
always be used to save it.” Put another way, the
American business ethic has always been socialism for
the rich, and, sink or swim, free market capitalism
for the rest of us.

As the housing slump deepens and many tens of
thousands of subprime and other mortgage holders
default, vulture investors will profit hugely buying
troubled assets at a fraction of their value as they
always do in troubled economic times. Writer Danny
Schechter calls the current subprime credit squeeze
debacle a “sub-crime ponzi scheme (in a) highly rigged
casino-like market system” targeting unsuspecting
victims. Schechter wants a “jailout” for
“criminal….financial institutions (posing) as
respectable players.” Krugman, on the other hand,
wants a “workout” for the victims. Neither will get
what he wants. In the end, as ordinary people lose
out, big government will again rescue “corporate
capitalism” (at least in the short-term) the way it
always does when it gets in trouble. It’s the
“American way.” It’ll be no different this time.

Stephen Lendman lives in Chicago and can be reached in
Chicago at .(JavaScript must be enabled to view this email address).

Also visit his blog site at and
listen to The Steve Lendman News and Information Hour
on Saturdays at noon US central