Efficient Markets and Innovation

good book

Today is going to be comment on Ezra Klein blog post day; From about 6 weeks ago, The Economist:

AS A believer in free markets I’m inclined to believe that whatever innovation our kinetic and energetic innovators come up with is, until proven otherwise, welfare enhancing…

But the case for the welfare enhancing benefits of financial innovation is tougher to prove. At first blush, there should be no difference. If financial engineers come up with a more effective way for a company to hedge the risk of its operations or a homeowner of limited means to buy a home, why should we accord that less respect than an iPod or a broadband system that enables big city surgeons to view the MRIs of patients in remote locations?

This is backwards. As a believer in efficient financial markets, your inclination should be that any innovation is not welfare enhancing until proven otherwise.

We need to be clear on what is meant by efficient markets. There’s a lot of pushback in thinking that financial markets are efficient: behavioral economics, “animal-spirit” financial economics, I expect next to see a Freudian financial economics where bull markets are from fantasizing about our mothers and bear markets are us experiencing acute castration anxiety. By efficient, all that I mean is that it is difficult to make more money or have less risk, especially in the long run, since the market should have already priced that at any given point.

This is a unique feature of financial markets. Let’s look at regular markets: Let’s say that everyone knows that the energy market is a big deal over the next 10 years. You could buy land where oil is buried very deep and innovate digging techniques, you could start an innovative research firm to get better solar energy going, you could try and make an innovative super-carburetor. All of these, if you pull them off, are going to be very profitable and welfare enhancing. Markets work, so you’ll probably find capital and labor more willing to work with you.

Now what about financial markets. Let’s say that everyone knows that the energy market is going to be a big deal over the next 10 year. If you invest in energy stocks, are you going to make a killing? No. The prices of energy stocks has already been bid up to account for the fact that everyone knows this. The price of financial instruments moves to handle all possible information that is available. This is what it means for financial markets to be efficient.

This extends to financial innovation more generally. Have you thought of a way to make the bonds of a company worth more? Modigliani-Miller teaches us that the prices of the stocks will decline the same amount. Found a new way to make money buying CDOs? The extra premium may just be the liquidity risk you have taken on, or a knowledge risk from having too many underlining assets.

There is a whole field of literature in finance, where someone finds some abnormal return – momentum, the diffusion of earnings information, value-vs-growth, and everyone has to debate whether or not these are the results of imperfect markets or the results of risk factors we can’t see in our current models. The only responsible thing to do if you believe in markets is to place the burden on proving that the market is currently getting something sub-optimal, not the other way around.

As I’ve said before, we should think of our financial sector as something that can’t create a lot of value without taking on more risk. So whenever I hear someone pitch an idea for a way to “innovate” the financial market, I ask him “what makes you think that you are smarter than the entirety of the financial market? Are you smarter than everyone at DE Shaw?” It is possible, of course. But I approach it as if someone has told me they found a certain way to beat the casino at cards without cheating; one needs to make sure that better returns are just the result of hiding away the risk from where people can see it. We’ve found a new way to get a homeowner a mortgage? If it doesn’t involve increasing the earnings of the homeowner, be skeptical. Don’t even get me started on how bad financial innovation is with moral hazard and adverse selection…

Here’s the other problem: let’s say you innovate and you get a higher return. How can you tell that you didn’t just take on more risk? Statistical tests of this run into something called a “joint hypothesis problem” – “Tests of market efficiency must be based on an asset-pricing model. If the evidence is against market efficiency, it may be because the market is inefficient, or it may be that the model is incorrect.” This is key now, because we are seeing all kinds of things normal financial modeling doesn’t take into account. Liquidity, for instance. (Most financial engineering and innovation pretends you can ‘dynamically hedge’ – take that out, and a lot of the innovation appeared to just be tricks.)

So as a believer in efficient markets I’m inclined to believe that whatever innovation our kinetic and energetic innovators come up with has, until proven otherwise, no effect on markets or is just hiding the increase in risk that comes with the new rewards…