Scott Sumner and the Limits of Arbitrage

Scott Sumner:

….Think about all his recent posts mocking the conservative fear that big deficits will lead to higher interest rates. What evidence does Krugman use? He cites the low and falling 10 year bond yields. In other posts he has used TIPS spreads to explain why inflation is the last thing we should be worried about. Now flash back to March 2009, when Krugman warned that $780 billion in stimulus would not be enough to get the job done. Did he know this from his models, as he claimed? Or did he cheat, did he peek at the equity, commodity and bond markets, and notice that all were predicting a severe recession with lots of disinflation, if not outright deflation? I think he peeked.

My theory is there are two kinds of economists:

1. Those who look smarter than they really are, because they rely on the EMH to predict

Paul Krugman

Scott Sumner

etc

2. Those who look dumber than they really are because they rely on their own models to predict

Kevin Drum responds:

Of course, neither Krugman nor DeLong is a big fan of EMH, so Sumner is having a bit of fun at their expense in this post. Still, there’s a point to the snark, and it’s why I’m a smidge less sure about the market’s view of interest rates and inflation than K&D are…

Now, DeLong in particular has been tireless in making a related but separate point: it doesn’t really matter what you think about the future. If the market — whether or not it’s being fooled by a bubble mentality — is willing to loan the government money for 10 or 30 years at low interest rates, then the government should take the money. Once the rate is locked in, it means we’re getting cheap funding to stimulate the economy, and we might as well take advantage of it. This has nothing to do with either EMH or any attempt to predict the future.

A quick note somewhat unrelated to the specific discussion people are having: There’s really no problem with thinking the equities market is prone to bubbles and manipulation and that the bond market is fine. In fact, it’s one of the obvious conclusion for the the Limits of Arbitrage line of financial economic theory. Here’s the paper, and I’ll pass the microphone to Andrei Shleifer and Robert Vishny back in March 1997:

A. Which Markets Attract Arbitrage Resources?

Casual empiricism suggests that a great deal of professional arbitrage activity, such as that of hedge funds, is concentrated in a few markets, such as the bond market and the foreign exchange market. These also tend to be the markets where extreme leverage, short selling, and performance-based fees are common. In contrast, there is much less evidence of such activity in the stock market, either in the United States or abroad. Why is that so? Which markets attract arbitrage?

Part of the answer is the ability of arbitrageurs to ascertain value with some confidence and to be able to realize it quickly. In the bond market, calculations of relative values of different fixed income instruments are doable, since future cash flows of securities are (almost) certain. As a consequence, there is almost no fundamental risk in arbitrage. In foreign exchange markets, calculations of relative values are more difficult, and arbitrage becomes riskier. However arbitrageurs put on their largest trades, and appear to make the most money, when central banks attempt to maintain nonmarket exchange rates, so it is possible to tell that prices are not equal to fundamental value and to profit quickly. In stock markets, in contrast, both the absolute and the relative values of different securities are much harder to calculate. As a consequence, arbitrage opportunities are harder to identify in stock markets than in bond and foreign exchange markets.

Efficient financial markets aren’t efficient in Fama and Milton Friedman’s theory as if by magic or part of nature. Market efficiency isn’t sitting next to weak nuclear and magnetism in the state of nature. Market are efficient because knowledgeable traders (arbitrageurs) cancels out the noise traders and make a profit (and the noise traders lose money driving them out of the market). “There are idiots” in EMH; it’s just that there are smart people who are more than happy to take their money. That’s a good theory, but it is one driven by the performance, technologies, and incentives of arbitrageurs.

If, for example, noise traders generate risks that aren’t compensated then there’s no reason to believe arbitrageurs will take on these risks – who takes on uncompensated risks? – leaving market inefficiencies. Brad Delong is aware of this, as he created the economic models back in 1990 with Shleifer (from above), Summers, and Waldmann. Alternatively, the smart money might be in driving prices further away from fundamentals. And as they point out above, it is easy to chart out the payments of a government bond, or at least easier than the stock of a company (do dividends matter?) or something that puts a lot of weight on a copula being consistent across time.

The question for EMH is how these arbitrageurs breakdown in practice. I can see how they break down in the housing and CDO markets. I need to see mechanisms in which the 10 years breakdown to believe we could be in a Treasury bubble. There are a couple of things I could see, but in practice, I’m seeing Barry’s take on the Treasury Bubble as pretty accurate.

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3 Responses to Scott Sumner and the Limits of Arbitrage

  1. Pingback: FT Alphaville » Further reading

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