...human behaviour is hardly rational, but is driven by "animal spirits" that generate market bubbles and busts, and regulation is essential for reining in misbehaviour.
This "Adaptive Markets Hypothesis" (AMH) - essentially an evolutionary biologist's view of market dynamics - is at odds with economic orthodoxy, which has been heavily influenced by mathematics and physics...The formality of mathematics and physics, in which mainstream economics is routinely dressed, can give outsiders a false sense of precision.
...fixed rules that ignore changing environments will almost always have unintended consequences...The only way to break this vicious cycle is to recognise its origin - adaptive behaviour - and design equally adaptive regulations to counterbalance human nature.
- In the long run, market prices do reflect all available information.
- However, some of the facts they reflect are not exogenous (externally given facts); they are the opinions of market participants. (Others are exogenous, but hard to observe - I will come back to those)
- These opinions take time to form and test; the key mechanism for testing them is to attempt to make or take a price, and observe whether people accept it. For example, when selling a house, a seller may set a price 5% higher than that achieved by a neighbour, in order to find out whether buyers are willing to pay.
- These tests, in turn, influence the opinions of other observers - those opinions then also become facts which are relevant to the price.
- The nature of such price-setting tests are that they rarely jump straight to the "correct" level; buyers and sellers are rarely willing to pay a price wildly out of line with the last price paid, and so the increments are more gradual than the EMH would imply.
- Over time, therefore, prices will gradually move towards a stable level which reflects external information; but in the meantime there may be a free lunch, if you are better or braver at interpreting the external information than the market on average.
This I call the Slowly Efficient Market Hypothesis, or Slow EMH. It is less universal than the AMH, but has the strength that it, seemingly unlike AMH, can be mathematically modelled in a testable way. Look out for a future article which will do just that.