The Strength of Strong-Form

The Efficient-market hypothesis, developed by Eugene Fama, is probably one of the most contested topics in the history of financial economics. Both on an empiric and theoretical basis economists, traders and media pundits often claim to have the truth that either supports or undermines the observations of Fama dating back to the 1960s. The EMH states that asset market prices reflect all available information and hence obey a ‘random walk’ on a ‘fat-tailed’ distribution.

But when financial economists say ‘reflect all available information’ what exactly do they mean? There are 3 possible interpretations:

Weak form- traded assets reflect all past public information.
Semi-strong form- traded assets reflect all past information but also adjust instantaneously to reflect all present public information.
Strong form- traded assets, in addition to having the properties of semi-strong form also reflect current and past ‘insider information’.
To most people, if one of the above forms is the most plausible it is either the weak or the semi-strong. By my intuition at least, it seems implausible that markets are able to completely price information that cannot even be acted on by most agents. Eugene Fama himself describes access to information on a continuum, where at first the cost is quite flat before quickly skewing off to infinity as more information is obtained on the margin. Hence, by his own admissions it may seem that ‘insider information’ is too costly to attain for most agents.

Nevertheless, Fama and others in favour of the EMH insist that more statistical evidence was found in favour of the strong strand of EMH than for the weaker forms. How can this be? I am by no means well-trained enough to devour the reams of statistical evidence on both sides of the debate and hence will refrain from offering a general opinion on whether the EMH is inherently flawed or a beautiful prophecy; but I will attempt to explain how the Strong-Form of the EMH has more going for it than is commonly assumed. In fact, it seems that Strong-Form is to be expected from some classic financial economics theorems which expose the vulnerabilities of using ‘economic intuitions’ alone. Contrary to popular belief, in this vein a “strong-form” of the EMH is probably more consistent with highly volatile markets than the weaker versions.

The clue to understanding why the ‘strong-form’ may be empirically sound comes from an unlikely source. Nothing really needs to be said about investors obtaining fundamental information for themselves. Rather, it has something to do with the effect that asset trading itself has on the dispersion of information.

A formal and somewhat abstract way of thinking about price information dispersal throughout a market comes from the No-trade theorem. Informally, this theorem states that under conditions whereby the market is composed completely of rational traders (no-noise) and operating at an efficient equilibrium there is no scope to profit off of private information. This is because given that all traders are rational with acknowledgement of collective rationality, any attempt to initiate a trade will reveal the private agent’s informational advantage and hence change market expectations in line with that. Consequently, all insider information is automatically reflected in prices as if it were public information.

Note that the assumptions behind the No-trade theorem are obviously not met by reality, and that theorems themselves are only strictly true when their assumptions are met. However, when thinking about information diffusion in an economy notice the game theoretic nature of asset trading in the hyper-rational world of the No-trade theorem.

Implicitly there is some strategic interaction, where each agent attempts to anticipate the motives of the others, and due to strict rationality ends up concluding that their own information is less accurate. If any forms of the EMH are to be taken seriously then there is the inevitable recognition roughly speaking the market will be at some kind of ‘perceived’ efficient equilibrium with noise traders not having the financial capital to issue the largest trades.

Hence, whilst the assumptions of the No-trade theorem are not completely met even when the EMH holds, the No-trade theorem still provides a context for understanding how Strong-Form may actually be more plausible than expected.

The idea is that using Fama’s model of an information-cost continuum, only agents with access to substantial capital have the capacity or incentive to actually obtain that information and then trade on it. Following this, the trade using insider information is likely to be quite large, often issued by a known Hedge Fund which can ‘lever’ the information up to the hilt. The fact that the private information holder is only likely to exist if they are agents with an ability to trade large volumes implies that they are often sophisticated agents whose valuations are more likely to be perceived as fundamental rather than noise by the rest of the market. Thus, using the game theoretic analysis from the No-trade theorem it would be quite rational for other agents to reprice their own valuations in line with the offer/bid by the private information holder.

It can be expected that in a world of fast paced traders trailing behemoth funds there is little to be gained from trading on insider information which serves as a signal more than anything else. Practically, it may even be in the public’s interest to permit insider trading where there is scope to maintain the information-cost continuum (via an excise tax perhaps); seeing as it can signal an efficient pricing mechanism.

Furthermore, the existence of these ‘game theoretic’ patterns whereby smaller traders attempt to piggy-back off the information of more sophisticated ones in a world of Strong-Form EMH could also be more prone to volatility of the sort first identified by Mandelbrot. In this context, the ‘fat tails’ of financial markets can represent the cascading of less sophisticated agents attempting to bid immediately after large sophisticated ‘shock trades’. In turn, quick readjustments may be the realisations that high-frequency ‘trailing’ is often misplaced since large trades may simply reflect internal dynamics of the leading firm. This fits the observable facts that shocks are often random, and readjustments follow seemingly unimportant information.

Note, that none of the above discussion is bullet-proof financial theory, nor is it an exposition of the strength of the EMH. Rather, I have attempted to explain practically how insider information can be priced effectively in markets, and how it is linked to seemingly unexplainable volatility that may otherwise be used as evidence for irrationality.

Finance Under Attack

As the topic of financial stability becomes increasingly important in the Australian political landscape I have increasingly found myself confronted by 2 indubitably populist arguments that claim to undermine the consensus in financial economics. The 2 claims that I have been confronted with go as follows:

  1. The crash of September 15, 2008 is a perfect counterexample to the efficient market hypothesis. Clearly, innovation creates an information asymmetry in finance since sellers can deceive buyers via the ‘complexification’ of products.
  2. Bailouts provide an implicit subsidy to institutions that desire to take on excessive risk.

First off, it is probably helpful to recognise that there is a vast amount of misinformation circulating with respect to TARP and the Federal Reserve’s emergency liquidity facilities. In many political circles I hear the claim that the response of the Fed in 2008 was an implicit subsidy to the financial sector at the expense of the taxpayer. This claim however, is dubious at best.

In fact, if one looks at the actual cash flows from the emergency loan facilities it is clear that the Fed has ostensibly profited off of the crisis. From October 2008 onwards Bernanke made it clear that the Fed would constrain credit support to illiquid institutions only, and would not fund insolvent corporations. I would also claim that the Treasury department’s TARP has delivered a substantial profit. Thus, the position that bailouts are everywhere and anywhere a phenomenon of corporatist greed is not tenable in my view.

Interestingly enough though, the conservatorship of Fannie Mae and Freddie Mac (prior to TARP), did indeed involve substantial transfers of losses from the private to the public sector. These losses on the whole could amount to over $300 billion if the worst forecasts are to be believed.

This opens the argument, is there an actual case for central bank and treasury intervention on behalf of insolvent institutions? On the surface, it appears difficult to justify such an action given that it would involve the creation of moral hazard to some extent.

But how does this moral hazard actually manifest? Moral hazard undoubtedly develops from the class of agents that are shielded from risk by public policy. In the vast majority of conservatorship arrangements these agents are the senior creditors. Equity holders and the managerial class classically get wiped out and as such, those who are directly insured are not those who are direct risk takers. Instead the implicit subsidy takes an ancillary form, where creditors will generally be inclined to lend to risky institutions at lower rates. The insensitivity of interest to risk thence creates a profit spread that is conducive to leverage and risky investments.

But notice the implicit assumptions here. In the real world it is not the sellers of derivatives that are insured, but rather a distant group of savers. To assume that these saver understand their government insurance policy we assume a kind of hyper-rationality. These creditors can not only perceive the levels of risk embedded in investment bank assets, but can also foresee the chance that the public will insure against any possible downside. Here, the level of moral hazard emanating from public policy is directly proportional to the informational efficiency of financial markets. In other words, a world in which the odd bailout can create huge moral hazard problems is also the world in which markets have high informational efficiency.

Hence, argument (1) is completely inconsistent with argument (2) unless one can make the claim that the makeup of CDOesque consumers is less sophisticated than the makeup of creditors. I am not going to come out in favour of any position on financial regulation here, but I encourage those who take issue with the whole paradigm of financial economics to reconsider their dogma.

Promoting Economic Development- The Role of Financial Intermediation

In their somewhat recent publication “This Time is Different: 5 Centuries of Financial Folly” Harvard Professors Kenneth Rogoff, and Carmen Rhinehart developed a number of interesting conclusions regarding financial crises, macroeconomics, and the business cycle. Notably, they came to the conclusion that downturns in the economic cycle that were characterised by widespread financial stress would engender much slower recoveries. Speaking with Joshua Bolten just this year Ben Bernanke affirmed that this was, broadly speaking, due to the fact that after a crisis, it takes some time for the financial sector to return to normal operations (in particular, risk evaluations) even as the rest of the economy pulls out of the headwinds. In these testimonies Bernanke, Rogoff and Rhinehart all implicitly note that finance plays an important role in growth trends. Yet whilst the role of a healthy financial sector has been widely identified for its importance to short-term recoveries, the wider role of finance in longer term growth paths has been grossly underrated.

This brings us to the central role of banking and finance in an economy. For continued economic growth to be a reality, investment demand and savings supply must be in equilibrium.* That is a central premise of modern macroeconomics. Logically, investment and savings cannot be unequal, or else the economy will fall into a disequilibrium of frothy expansion, or rapid contraction. The role of financial institutions in a modern economy, is to ensure that this relationship is upheld. By establishing a financial equilibrium between lenders and borrowers through interest rates, the financial sector ‘recycles’ the supply of savings and liquidity in the economy into lending and investment. This is known as ‘financial intermediation’, and without it, economic savings would show up as leakages from the flow of income, serving to depress the forces of economic growth.

Under the current situation, the financial sector in the US has acted as a constraint on economic recovery to some extent by failing to mediate savings and liquidity with investment at levels associated with higher growth. This is basically because since the fall of 2008, financial institutions have placed an enormous price on risk, refusing to recycle savings and money into credit and investments that appear dangerous. Whilst this phenomenon is a bonus for financial stability, allowing these firms to clear up their balance sheets, it also means that monetary policy needs to take an almost impossibly expansionary position to ward off deflation.

Yet compared to the position of many emerging markets and developing economies, even over the long term, the risk appetite and lending availability in US financial markets appears almost surreal. Even in times of stable leverage, a sturdy macroeconomic policy mix, and microeconomic innovation, banking systems in emerging markets are inefficient, sluggish, and cronyist. In these circumstances, with corporate relations extending well into the sphere of policymakers and state owned enterprises, profitability can be assured without institutions having to make full use of their capital buffers. In other words, there is almost always a barrier to the proper intermediation of savings and investment in the less advanced economies. This also happened in the old industrial economies of the post-war era. Whilst corruption in this instance was not key, a lack of technological capacity meant a perfect intermediation of capital throughout the economy was impossible; even as monetary policy was similarly hampered by ‘liquidationist’ doctrines that refused to expand liquidity as compensation.

With this in mind it should come as no surprise that until humanity began to develop prototype financial institutions, production never really rose above subsistence levels. Without financial development, if enough income was generated to create a pool of savings, that income would essentially be destroyed as it was taken out of the circulation of spending. Hence, society would invariably revert to agricultural barter and underdevelopment. Taken to its logical conclusion, an understanding of the role of finance across economies also helps clear up a lot of the muddled empiricism levelled at various economic policies. For example, the vast majority of literature emanating from the Washington Consensus on economic growth would seem to indicate that Cuban economic policies tinker on the brink of disaster. Yet Cuba enjoys one of the highest standards of living in all of Latin America. Whilst policies like land-reform inspired urban gardening, and universal healthcare are obviously beneficial, the policy mix of other states should imply a better performance relative to Cuba. A performance that is yet to arise.

But although policy mixes are indeed important, they are essentially secondary to institutional functionality. With Cuba the counterfactuals are not obvious, however, the Castro dictatorship has proven adept (when compared with Argentina, and Bolivia) at rooting out and persecuting corruption, whilst implementing heavy penalties on inefficient workers. As a result, it is likely, that despite widespread misallocation of production, there is less financial resistance force on the Cuban economy when compared to less militaristic parts of South America.

In this context, if one takes the framework of modern macroeconomics seriously, financial innovation and efficiency plays a huge role in human and economic development. Societies that find themselves with stagnant growth despite conventional policy mixes and concentrated industrial policies should often look to the most basic elements of macroeconomic theory. Financial intermediation is one such element whose place in the short-term needs to be extended to long-term development. Bernanke and the intellectual giants of our age implicitly recognise this issue, but for much of the debate on development policy, it is overlooked.

*Note that the premise that savings must be ‘lent out’ towards investment, so as to create a macroeconomic equilibrium, is not completely accepted by the Post-Keynesian schools of economic thought. I share the Post-Keynesian concerns that there are incompatibilities between the ‘loanable funds’ mechanisms of savings-investment intermediation, and the modern functioning of a monetary economy. Nevertheless, I have not been able to logically prove the Post-Keynesian case to myself, and thus remain in the orthodox camp for the time being.

Fighting Capital Account Whiplash- ‘National Hedging’

On December 20, 1994 the government of Mexico suddenly announced a 13 percent devaluation in the ‘crawling band’ currency peg to the U.S dollar, following intense capital outflows beginning earlier in the year. In doing so, the currency regime organised by money doctors and IMF leaders that had reigned in inflation and expanded domestic liquidity for 7 years, was abandoned. The result of the 1994 devaluation however, was disastrous- setting off what has since been known as the Tequila crisis.

Mexican corporations and the government at this time had borrowed an immense amount of dollar denominated debt, and the devaluation immediately pushed up repayment costs and insolvency pressures. As investor nervousness grew and interest rates soared, the short-term funding strategies of Mexican commercial leaders proved detrimental; turning illiquid corporations into insolvency. Within a week the peso dropped another 19% whilst the large speculator investment base threw the country into a cycle of massive asset sell-offs. Debt burdens grew, and asset values plummeted. In the end, the collective scramble to raise liquidity and protect balance sheets pushed the country into a self-reinforcing disaster.

Such a positive feedback loop has been the subject of much financial analysis, and the Tequila crisis has served as one of the primary empirical bulwarks of Soros’ “Theory of ‘Reflexivity’”. In this context, small exogenous shocks can push nations and markets to brink of collapse without any real change in economic fundamental. Indeed, the same thing is happening today in a number of large emerging markets that have managed to attract foreign capital inflows from the Fed’s QE operations. Just in September last year, Bernanke’s mere announcement of QE tapering (not even an end to ZIRP) was enough to push the Indian Rupee into freefall and crush Indonesia’s dreams of price stability. (This sudden reversal of capital inflows is what I call ‘Capital Account Whiplash’)

Nevertheless, a situation of financial freefall after currency defaults is by no means certain. The British Pound Sterling’s withdrawal from the European Exchange Rate Mechanism in 1992 for example served to calm markets and boost competitiveness. Furthermore, if the devaluation had not been postponed by Bank of England interventions (which lowered foreign reserves) the result would have been an outright profit on the public account.

Why then did the British example provide such a different result to that of today’s emerging markets, and 1994 Mexico? To my mind, contrasting results (and consequently, a refutation to ‘Reflexivity’ Theory’s proposition that crises are behavioural in nature) can be explained by the way debt markets can reduce or add volatility to growth fundamentals, and thereby create positive or negative feedback loops.

In 1990’s Mexico, borrowing had two fundamental characteristics:
a) It was short-term, needing to be rolled over constantly.
b) It was denominated in foreign currency.

Hence, as Mexican markets stalled and firms were placed under revenue-side constraints, they also felt a sharp stab of pain on the lending side. As the peso devalued, the peso-cost of dollar debt exploded, and the price of avoiding liquidity crises was immense as interest rates soared on the short-term markets. The nature of Mexican leverage and debt indexation thus can be seen to have predictably exacerbated the impact an exogenous shock, as it was inversely correlated to revenues. Debt was automatically indexed so that as revenues expanded, debt costs fell; but when the economy was placed under pressure, debt costs also exploded. Mexican finance, therefore, was mechanically pushed into a positive feed-back loop by the liability managers of the economy.

In Great Britain during the 1990’s by comparison, the story of debt indexation is a very different one. Debt burdens here, were directly correlated to revenues, i.e loans were typically long term with fixed rates, credit was denominated in pounds, and speculators were balanced by institutional ‘vulture’ purchasers that bought against trends. (Sovereign wealth funds etc.) So, as the nation was bogged down by asset revaluations, rising inflation and falling terms of trade, corporations found themselves cushioned by increasing competitiveness, and falling real interest rates. The net result for borrowers pending a fixed exchange withdrawal was thus beneficial.

It is important to note at this point that the Tequila crisis under this framework was neither a result of fundamentals that were papered over, nor irrational exuberance.

So, what are the lessons for current economies facing the prospect of sharp external liquidity contractions in the very near future? Commercial leaders and politicians must reform the national capital structure, and make sure that debt is directly correlated to growth and revenues. If QE is expected to put sudden downward pressure on Emerging Market currencies then, foreign denominated public, and private debt must be replaced by local currency denominations now. Similarly, central banks should strive to reform the liquidity and regulatory environment (get rid of withholding taxes where possible for example) in debt markets so that fixed-rate, long term borrowings are encouraged over variable, short-term borrowings.

Although this is easier said than done. Politically, a project involving re-indexation of debt so that it is long-term and local will imply significantly higher interest rates up-front. Sovereigns will essentially be swapping their lending out of the US financial sector into smaller, less advanced local centres with higher spreads and smaller capacities for dispersing risk. Merely developing a local debt market liquid enough to absorb public borrowing is a huge task for Developing and Emerging markets whose volatile monetary conditions systematically exacerbate inflation and other currency risks for lenders.

But with time, global lenders and investors will recognise the improving capital stability resulting from financial reform. In the meantime Emerging and Developing Market Central Banks should adopt ‘Forward Guidance’ interventions to minimise currency risk expectations, and pray that U.S unemployment warrants continuations of QE for a while longer.