Compare Adam Smith on market failures:

“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies, much less to render them necessary.”
Source: Adam Smith: The Wealth of Nations; (1776), Book 1, Chapter 10, Part 2] or p.111 in this link:
http://www2.hn.psu.edu/faculty/jmanis/adam-smith/Wealth-Nations.pdf

“The third and last duty of the sovereign or commonwealth is that of erecting and maintaining those public institutions and those public works, which, though they may be in the highest degree advantageous to a great society, are, however, of such a nature that the profit could never repay the expense to any individual or small number of individuals, and which it therefore cannot be expected that any individual or small number of individuals should erect or maintain.”
Source: The Wealth of Nations (1776), Book 5, Chapter 1, Part or P.590 in this link:
http://www2.hn.psu.edu/faculty/jmanis/adam-smith/Wealth-Nations.pdf

For a recent text on market failure, try: John Cassidy: How Markets Fail (Penguin Books, 2009), reviewed here:
http://www.businessweek.com/magazine/content/09_47/b4156079791251.htm

This idea about business only having a duty to shareholders also fails on two other points:

Executive reward robs shareholders of their rewards for investing in the company. Large sums of money are taken by people simply engaged in a task they were employed to carry out – this is an additional tax on profits. If the duty to shareholders was as important as people pretend, then they would treat these people like other employees.

Companies need order to operate and a society that makes people well disposed to their activities – the point made above. This means that their first duty is to conform to the laws and customs of the markets they operate in. Government has a key role – Individual companies are natural monopolists and have no interest in a functioning market: The competition that Friedman extols can only take place when governments manage Markets to prevent monopolies so that there can be new entrants. Government has the same interests as emerging businesses

Worth reading friedman’s argument in full: http://www.umich.edu/~thecore/doc/Friedman.pdf

Taylor misses out the all important ethical rules in society that friedman expects companies to follow. What i think is unfortunate is that the notion of behaving ethically has been hijacked by discourses of ‘social responsibility’ whose main consequence is the production of glossy leaflets full of bullshit. Plenty of companies were already doing good for their community, but that doesnt count so long as they werent shouting about it.

“The task for progressives is not to attack business, nor simply to exhort it to behave differently, but to appreciate how business works.”

Er, I think that after a century or more of the glittering examples of the greed and gross exploitation of Ultracommerce, I reckon that we know exactly how business works. And that scale is significant. Small to medium sized businesses generally have a natural, organic link to the place where they originated, and these companies understand how they interact with their workforce and adjacent communities. But when you get to national, transnational, or globe-bestriding colossi whose turnover is greater than many nation-states, we are into an entirely different level of trade and finance, the realm of Ultracommerce.

Seems to me that the task for progressives is to insist on radical limits to corporate activity, size, and political reach. In any case, corporations are essentially imperial patchworks of smaller companies which would better serve the wider interests of Humanity were they free of their corporate overlords.

I think you misunderstand the quote. Friedman states ‘within the rules of the game’. The rules on environmental policy for example will be determined by the state.

“Friedman’s argument has been rejected. The Global Reporting Initiative, which encourages and supports companies in accounting for their efforts to act responsibly and do good, says the number of companies producing such reports has risen from 44 in 2000 to nearly 2,000 last year. ”

Gosh, that’s amazing. Well done them!

According to the ONS there are 2.1 million organisations registered for VAT or PAYE. Of which 58% are corporate (ie, not sole traders, partnerships etc).

They have managed to persuade a whole 0,015% of companies to fill out their forms.

Well done them!

I think we might want to revise a little bit here “Friedman’s argument has been rejected by some tiny almost immeasurable minority….”

“Corporate leaders have tended to espouse the policies that go with free market economics”

No, they haven’t. As that Smith quote shows, corporate leaders hate, hate, free market economics. They love capitalism, love a capitalism restricted to them and them alone but despise and fear free markets. Which is what Smith was talking about.

“These businesses will also find it easier to recruit and retain the most talented people and to encourage innovative thinking. ”

Err, yes, Karnani’s point, isn’t it?

“to encourage the ambition, courage and innovation necessary for business to be a powerful contributor not just to economic growth but to a twenty first century enlightenment. ”

Yes, excellent, more competition, more of that free in the markets stuff. As Smith himself pointed out.

Government has a key role – Individual companies are natural monopolists and have no interest in a functioning market: The competition that Friedman extols can only take place when governments manage Markets to prevent monopolies so that there can be new entrants.

This is the key point.

Successive governments have abdicated their proper role to prevent the formation of monopolies and cartels and ensure functioning markets. Instead they have helped the creation of corporatism by raising barriers to entry by imposing unnecessary levels of contrived bureaucracy.

This has resulted in the kind of state sponsored corporatism with which we are now cursed. Business is correctly motivated to make money and it fully understands the “social good” nonsense they are obliged by “progressives” to spout is rooted in mealy mouthed hypocrisy from both sides.

@5: “The rules on environmental policy for example will be determined by the state.”

Which paints over the challenges that governments have routinely faced attempting to enforce environmental policy – or competition policy and to maintain product quality standards. The last is why regulators such as the Federal Drug Administration are necessary.

How come my bank, Lloyds, has just made a £3 billion provision in its latest results to cover for compensation for mis-selling Payment Protection Insurance? At the very least, evidently eternal vigilence is essential to reap the claimed social benefits of markets.

Insider trading: A City banker who amassed almost £600,000 through insider trading with his wife and a friend has been jailed for three years and four months.
http://www.bbc.co.uk/news/uk-england-london-12345373

Friedman was thoroughly complacent about the possibility of economic and financial instability. Try this interview in the FT of Prof Carmen Reinhart on recurring patterns in 800 years of financial crises:
http://video.ft.com/v/82349517001/May-3-800-years-of-financial-crises

She is co-author of a book with Kenneth Rogoff: This Time Is Different – 8oo years of financial crises (Princeton UP, 2009)
http://www.economics.harvard.edu/files/faculty/51_This_Time_Is_Different.pdf

The chief executive pay boom, anyone?

What credit crunch? FTSE 100 chief executive pay rose by 32 per cent in the last year
http://www.dailymail.co.uk/news/article-1392440/What-credit-crunch-FTSE-100-chief-executive-pay-rose-32-cent-year.html

To be continued:

Continued from @8:

- Undisclosed conflicts of interest: “Goldman Sachs apparently failed to declare a potential conflict of interest which resulted in pushing up the cost of a £23.5billion bail-out of Lloyds Banking Group, City sources claimed last night. The allegation that the Wall Street bank may have put its own interests ahead of its British clients comes just a week after it was accused of fraud in the US.” [April 2010]
http://www.dailymail.co.uk/news/article-1268378/Goldman-Sachs-conflict-inflated-Lloyds-bail-costs.html

The recurring principal-agent problem?

Alan Greenspan: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”
http://online.wsj.com/article/SB122476545437862295.html

Stick market volatility: “In 1981 Shiller published an article in the American Economic Review titled “Do stock prices move too much to be justified by subsequent changes in dividends?” He challenged the efficient markets model, which at that time was the dominant view in the economics profession. Shiller argued that in a rational stock market, investors would base stock prices on the expected receipt of future dividends, discounted to a present value. He examined the performance of the U.S. stock market since the 1920s, and considered the kinds of expectations of future dividends and discount rates that could justify the wide range of variation experienced in the stock market. Shiller concluded that the volatility of the stock market was greater than could plausibly be explained by any rational view of the future.”
http://en.wikipedia.org/wiki/Robert_J._Shiller

In short, Friedman simply ignored huge swathes of concerns by other economists about the efficiency of markets.

The trouble with trying to punch wholes in Friedman’s argument is he was setting his case in an environment we do not have – ie of genuine market freedom where the reckless, the useless and the irresponsible would go out of business.

Nick (point 3) made a spot on observation about how wealthy philanthropy was always a part of our society – it just wasn’t coerced from them by the state.

As long as businesses are following the law of the land and not blowing up the planet then they will continue to create jobs and employ people. That’s socially responsible’ enough for me.’

http://outspokenrabbit.blogspot.com/

7
The state has also imposed regulations such as patents and copyright, do you think that companies such as Sony would have spent millions researching and developing new technologies without this protectionism? And without this innovation, how do you think the economy would look like now.?
Generally, the state’s involvement in imposing policies/laws have supported the interests of business, just one vital example, mass education.
The rules of the game are determined by government and in the interest of owners, even state benefits act in their interests despite cries of high taxation smothers business and negatively impacts on the economy.
Schumpeter was right, innovation and built-in obsolescence fuels demand, but would this happen in a real free-market, I don’t think so.

As long as businesses are following the law of the land

Well, as we’ve seen, quite a lot of businesses in the last decade or so haven’t been following the law of the land, and have successfully blown up the economy when their sharp practice came to light.

Friedman had a response to this, by the way – IIRC, he believed that companies wouldn’t cook the books or defraud their clients, because of the reputation damage that would be caused by acquiring a reputation for fraud.

Of course, this is much the same as saying “People won’t commit crimes because they might get caught”.

Friedman used to teach his students to identify their conclusions and reason backwards to assumptions that would support those conclusions. I have no idea what he says was taken seriously – most likely because his policies resonated with those at the top.

Throughout his writing, he completely failed to distinguish between rent and earned income. Banks were maximising their returns, but this was largely money extracted rather than wealth created. So saying they should maximise profit is misleading.

HSBC were actually one of the only banks to reject Friedman’s social responsibility prescription prior to the crisis – they were accused of a PR stunt, but hey presto they kept their leverage at 20-1, didn’t rip off their customers and slipped through the crisis largely unscathed.

Much of Friedman’s opinion stems from his slight OCD – like many, he wanted the world to look and behave like an economics textbook, and for economics to be considered an exact science. Of course, this is impossible because it involves people.

One of the more grating examples of this is where he attempts to argue in Capitalism and Freedom that when a business does anything other than maximise profit, it is somehow evil. Strange stuff.

So the State is supposed to prevent monopolies and foster a business environment where a truly free market can thrive. Fine, I think many of us would agree with that. Much criticism from progressives is of the excesses of monopolies and cartels and of their undue influence on government.

So how do we legislate to create this business utopia? How will our politicians, whose parties receive significant funding from big businesses, achieve this? They are hardly gouing to bite the hand that feeds them.

11 – “Do you think that companies such as Sony would have spent millions researching and developing new technologies without this protectionism?”

Quite possibly. I thoroughly recommend “Against Intellectual Monopoly” by Boldrin and Levine on this, particularly chapter 8:

http://www.micheleboldrin.com/research/aim.html

@ 11

The state has also imposed regulations such as patents and copyright, do you think that companies such as Sony would have spent millions researching and developing new technologies without this protectionism? And without this innovation, how do you think the economy would look like now?

There would still be innovation and the economy would be much wealthier.

“During the period of Watt’s patents the U.K. added about 750 horsepower of steam engines per year. In the thirty years following Watt’s patents, additional horsepower was added at a rate of more than 4,000 per year. Moreover, the fuel efficiency of steam engines changed little during the period of Watt’s patent; while between 1810 and 1835 it is estimated to have increased by a factor of five.

After the expiration of Watt’s patents, not only was there an explosion in the production and efficiency of engines, but steampower came into its own as the driving force of the industrial revolution.”

http://mises.org/daily/3280

@14

So how do we legislate to create this business utopia?

You have effective monopolies legislation and regulation.

How will our politicians, whose parties receive significant funding from big businesses, achieve this?

They won’t.

Because, as you correctly spot, they are sharing in the surplus profit created by the monopolies at the cost of the consumer.

@ pagar

Go on, what’s the next bit?

I hope the speech lost a lot in the editing.

I’d like businesses to think about more than profit too, but the first two arguments offered contra Friedman show that you haven’t understood what he meant by within the rules of the game. Friedman would say that if you want businesses to do protect the environment, help the long-term unemployed or whatever, then you put that in the rules, strucutre of taxes etc.

But I want to concentrate on this:

“we buy things we don’t need with money we haven’t got to make impressions that don’t last on people we don’t care about.”

who does that? I don’t do that. Do you do that Matthew? Do you Sunny? Do you FR? Tim J? And is this because we few are super clever and extricate ourselves from the mind-rays of corporate marketing, unlike the masses? No – outside my front door, on the highstreet, nobody is impressing anybody with their purchases. The brand of beer people buy may be influenced by advertisments, some people spend more than “necessary” on fashionable clothes, but by and large people buy things they want, with money they have, and corporate mind-rays have very little sway at all.

Which brings me to homo economicus.

for the love of good, please stop confusing a formalization of economic agents in a mathmatical model with an assertion about what people are really like. Please believe me, economists do NOT think people are perfectly informed, perfectly rational etc.

However, which is the best way to think about people, as a first approximation – as knowing their own minds and making decisions based on their on preferences, or as mindless drones, helpless in the grip of corporate manipulation?

Of course our preferences are shaped by culture, fashions, peer groups – and by corporate marketing – but I think this is an example of a left-wing small truth, big lie. Lefties of a certain stripe place far too much emphasis on the consumer drone angle, and far too little on the idea that people have their own minds and can think and act for themselves. Personally, I like the fact the economics starts out by thinking of people as knowing their own minds, and then adds on the behavioural stuff, as opposed to starting out like Matthew Taylor regarding people as puppets.

imho, I don’t think (some) lefties realize how patronizing and offensive they are when they bang on about consumer drones etc.

And as for capitalism relying on this selling us stuff we don’t need crapola – what percentage 4of economic activity is being classified as stuff we “don’t need”? Is heating, lighting, computers, washing machines, bread-makers, transportation, entertainment “things we don’t need” and would be without in a better world? I’ll stick with the economy that allows me to buy 30 Rock DVDs thank you very much, you can keep your socialist utopia in which only our “needs” are catered for.

oh f-ing blockquotes

16
Interesting story but you can’t patent steam and engines already existed, what Watt achieved was improvements to existing technology. This is not the same as creating new technologies such as playstations It’s more like developing electric cars, note all makers are doing this because electricity cannot be patented and engines already exist. If, however, makers develop a new technology which adds on the the existing engines, you can bet this will be patented and protected.
Agreed that improvements that add to the efficiency of existing technology will also add to markets, just as consumables such as a loaf of bread will, but it cannot create enough to maintain the economy, ie keep enough in work to pay taxes and consume and enough to invest in another round of production.

“or the love of good, please stop confusing a formalization of economic agents in a mathmatical model with an assertion about what people are really like. Please believe me, economists do NOT think people are perfectly informed, perfectly rational etc.”

+1

18
So, what’s the point of advertising (quite a large slice of our economy) if not to persuade people to purchase. Let’s face it, advertising only adds cost not value so why would companies spend millions each year on advertising? I would suggest in mho that it works.
And the 30 rock DVDs you value were only made possible by a large budget to support research and development and along the way they have been subjected to copyright and licensing and a large advertising budget.
As I have quoted before, my kids demanded a playstation and hey presto, Sony made one, ain’t that magic.

@ 20

The reason the industrial revolution stalled was because one guy had a patent on the engine and another a patent on the crankshaft. Without both working together, you had no real progress.

Supposing I developed a technique for cold fusion. Would the world be a better place if I patented it and tried to develop the technology myself or if I made the technique available to all energy companies?

@ 17

Go on, what’s the next bit?

Not sure there is a next bit.

Civil disobedience?

Emigration?

Hoping enough people will realise how they are being ripped off and vote for change?

It’s difficult to be optimistic because the fuckers are not going to release their grip voluntarily.

Steve b where did you get the idea I think advertising doesn’t work? Why just the other day I tried a new brand of soup I’d seen advertised.

Do you really imagine the only reason kids want play stations is because of the advertising?

23
No, the industrial revolution did not stall, are you sure you know what is meant by that term?

24
As I said @22 kids just spontaneously thought that they wanted a playstation and Sony provided it. And those kids who saw their friends with the playstation thought ‘I would like that to play on it’ and Sony, seeing the extra demand, increased their production.
Luis, you know as well as I do that large companies use adertising campaigns to sell new products and with something like the playstation (no I haven’t got shares with Sony) they choose times when childrens’ programme’s are being advertised, or else where would children get their information? Logic = new products require new demand.
And most people who are critical of economics are so because ‘you can’t formulate a mathematical model’ of economic activity and then tell everyone not to confuse it by talking about the behaviour of people. Many years ago I read Friedman’s book ‘Free to Choose’ and I remember he stated that ‘justice’ was a human concept and didn’t belong in markets. So market economics, which addresses the activity of people, should ignore human concepts and ideas because that isn’t part of the theory. Right.

“So how do we legislate to create this business utopia? How will our politicians, whose parties receive significant funding from big businesses, achieve this? They are hardly gouing to bite the hand that feeds them.”

Stage one is to reduce the power politicians have over what businesses can do. Becuase such regulations over what can be done will always, but always be captured by those with the money to tell the politicians what they want.

So, less regulation means less ability for those already there to hamper future competition.

Friedman himself, his PhD was on this very point: about the AMA (US Medical Assoc) and the way in which doctor licencing created a rent to doctors (please note, Friedman did not fail to distinguish rents and profits at all).

They wouldn’t publish it for several years it was such an explosive argument.

This doesn’t only apply to big business either. That every gas fitter must be a CORGI is just as much the creation of a guild that can capture a rent.

There is a certain tension between this idea that there should be minimal regulation, so as to allow, peomote, that free market which reduces the current capitalists power and rent collection, and the State having enough power to make sure that the current capitalists don’t just collect the same rents with guns and goons.

It’s not, sadly, a simple tension to balance.

This is, BTW, why I argue for less regulation (effin’ EU and the bendy bananas, making it illegal to make apricot marmalade, all that stuff) because less regulation allows the competition from the new small guys that keeps the rents collected by hte incumbents low.

“So, what’s the point of advertising (quite a large slice of our economy) ”

Pretty small actually. A few £billion out of £1.4 trillion? Certainly not more than 1% (£14 billion).

“Let’s face it, advertising only adds cost not value so why would companies spend millions each year on advertising?”

There is a part of advertising which is just trying to get you to buy this washing powder rather than that. Tehre’s also a part of advertising which is trying to tell tyou that there’s a new type of washing powder. Or a car that does 73 mpg. Or Quorn, no meat meat. Or did you know there’s a new Asda round the conrer from you, not 40 miles away like the old one?

Some part of advertising really is about providing information. Quite how much….well, but you will admit some? For example, The Guardian survives on hte profits of Autotrader. Which is really just people saying “1996 Audi TT for sale, Walsall, grt price!”. Information, yes?

“I remember he stated that ‘justice’ was a human concept and didn’t belong in markets. So market economics, which addresses the activity of people, should ignore human concepts and ideas because that isn’t part of the theory. Right.”

No, that’s not quite what Friedman, or anyone other than a Social Darwinist, quite means.

Markets are amoral, yes, and the study of how they work shouldn’t be clouded by considerations of justice.

As humans we do indeed have considerations of justice and we do want too think about them. Act on them even. But the implication of Friedman’s argument is that we think about them after the actions of the markets. And he did of course.

He, just like everyone else with an IQ greater than their shoe size, knows that in a pure market economy, an all markets all the time markets society, some simply won’t have a talent or skill that they can sell for enough to keep body and soul together. Yes, charity is all very well but it won’t be enough. Friedman’s answer was, OK, still have the pure market economy, but have a negative income tax. So those with no income will have an income. This is very similar to the citizens basic income so beloved of the Green Party (and me).

Friedman’s negative income tax never really took off: but an adaptation of it (and it is an adaptation of it) became the earnied income tax credit in hte US. The country’s largest poverty reduction program. We over here know of it as tax credits of course, introduced by Gordon Brown.

Yup, really, they really really do come from Milton Friedman.

Another way of putting this: justice is a bolt on after the markets have done their efficiency and technological innovation thing. Doesn’t mean justice isn’t important, only that we make as much as we can first, then divvy it up.

28
Thanks Tim, it’s a long time ago since I read Friedman, but, market theory will always point to human self-interest (not denying that exists) but will ignore all sorts of other aspects of the human psyche, it is highly selective.
We cannot just bolt on these things as an afterthought, humans spend a lot of their time participating in economic activity, they don’t put on hold the very things that make them human.

Steveb you don’t seem to be responding to what I actually write.

@20 steveb

You miss out the bit where Bolton & Watt spend years trying to prevent Trevithick & others from selling their stuff and trying to create a monopoly in steam engines. They put more effort into dirty tricks than into making a better engine.

@27 Tim

“Stage one is to reduce the power politicians have over what businesses can do. Becuase such regulations over what can be done will always, but always be captured by those with the money to tell the politicians what they want.”

Is this getting back to the idea that over-regulation caused the current economic crisis? Aren’t you into some kind of cleft stick, where you suggest governments need to remove regulations but if they did the megacorps would be all over us with their wicked ways?

Let’s move from ideal situations to where we find ourselves now. If regulation was removed what would happen?

“Of course, this is much the same as saying “People won’t commit crimes because they might get caught”.”

Reminds me of a cartoon I once saw. 2 economists walking down a road, one spots a £20 note lying on the floor. The other sees him looking at it thinking about whether to pick it up and says:

“Of course, that isn’t a real £20 note. If it was, somebody would have picked it up by now.”

@23 pagar

Whoops! Down the pooper you go again!

Luis,
You make several points, I am responding to your assertion @18 about the way people are motivated to buy things, eg seeing it on the high street. You argue with the OP and insinuate that lefties are wrong in assuming people are ‘consumer drones’. My responses to this are that your definition is too simplistic. I’ve mentioned advertising, peer pressure, and, not least, the introduction of new products which people have not demanded but are persuaded to purchase.
Perhaps I’ve conflated your posts with those of Pagar, which may have confused the issue and also my own criticisms of economics as a discipline.
Is there anything, in particular, that you feel I should have adressed and I will attempt to do so.

@12 flyingrodent

“Well, as we’ve seen, quite a lot of businesses in the last decade or so haven’t been following the law of the land, and have successfully blown up the economy when their sharp practice came to light. ”

Which laws weren’t businesses following which led to the blowing up of the economy? I am not aware of a mass of prosecutions as a result of the recent financial crises.

31
This is happening all of the time, companies are attempting to prohibit others from competing with them. That’s my point, market economics does not apply, it’s about copyright, patents, licensing and so on, and yes dirty tricks.
However, this had no bearing on the industrial revolution, it just prevented a piece of machinery from being produced by more than one source and/or a particular task not being carried-out as efficiently as it could have been.
There is a story (might be an urban myth) that a company holds the copyright for an everlasting light-bulb but won’t produce it.

Steve your telling me about peer effects and advertising – re-read my comment 18 and see where I mention peer effects and advertising. Plus you’ve got wrong end of stick about don’t confuse formal models thing.

“That’s my point, market economics does not apply, it’s about copyright, patents, licensing and so on, and yes dirty tricks.”

Oh good grief.

Steve, the whole thing about copyrights and patents is that everyone realises that with public goods an all market all the time market system doesn’t work!

You can’t go round shouting that “copyrights and patents aren’t free market” when the very damn point of them is to correct the failures of the free market.They might be the best way of correcting that failure, they might not be, that’s another matter.

But to say “here’s what we do to correct the failings of free markets….well, all shows it ain’t a free market, innit” is ludicrous.

Pathetic even.

Remember: the argument in favour of government spending on research is that research is a public good. The argument in favour of government spending on vaccines is that vaccines are a public good…..on education, and on and on.

Public goods are one of the places that free market fail…..inventions are public goods, thus free markets, absent c and patents, will….well, not fail, but perhaps be not as good as we want them to be. Like, umm, education, vaccinations, research…..

In hindsight and with the benefit of subsequent research, the quote from Friedman makes him look rather silly.

If stock market volatility is substantially greater than that of the underlying fundamentals, in what sense is it possible to claim that decisions in financial markets are “rational”?

Friedman’s dodge is his reference to business staying “within the rules of the game”. What those rules actually are and what they should be are then fundamental issues which can’t be put aside for elaboration on another occasion.

@39: “Public goods are one of the places that free market fail”

Good point – and something I overlooked @8 and @9.

Streeting lighting is the classic case of a public good because it isn’t possible to deny access to those who don’t pay and how much of I consume doesn’t affect how much you consume. Because of the benefits from street lighting of reduced traffic accidents and crime, few of us want street lighting turned off. Decisions about how much street lighting have to be made through political process.

I don’t think Friedman or anyone else would ever suggest volatile stock markets are rational. However, what he and everyone would say is they are, umm, volatile. What I think you are asking Bob is the price efficient. Well yes they are at any particular moment in time as all publicly known information with be incorporated in the price. If new information appears the price will adjust accordingly. If you or anyone else has information not generally known, as soon as you act on it the new information will be incorporated in the price. You see inside traders are providing a free service for everyone else.

Try this illuminating and amusing piece by John Kay on the “Efficient Market Hypothesis” relating to finance markets – and a few other issues as well:
http://www.johnkay.com/2010/04/14/economics-may-be-dismal-but-it-is-not-a-science

It’s really challenging to believe in the relevance of the Efficient Market Hypothesis when there is no transparency about the quality of the assets underpinning traded financial instruments – which was notoriously the case with traded derivatives in the run up to the recent financial crisis. As Warren Buffett warned in 2003:

“The rapidly growing trade in derivatives poses a ‘mega-catastrophic risk’ for the economy and most shares are still ‘too expensive’, legendary investor Warren Buffett has warned.”
http://news.bbc.co.uk/1/hi/business/2817995.stm

Of course, there is nothing new about financial crises and opaque financial instruments. We famously had a crisis in 1720 called the South Sea Bubble:

From Burton Malkiel: A Random Walk Down Wall Street, on the South Sea Bubble of 1720:

“The prize must surely go to the unknown soul who started ‘A Company for carrying on undertaking of great advantage, but nobody knows what it is.’ The prospectus promised unheard of rewards. At nine o’clock in the morning, when the subscription books opened, crowds of people from all walks of life practically beat down the door in an effort to subscribe. Within five hours a thousand investors handed over their money for shares in the company. Not being greedy himself, the promoter promptly closed up shop and set off for the Continent. He was never heard of again.”

“A year before the world’s first great stockmarket crash in 1720, Daniel Defoe wrote his famous condemnation of the broking community. The Anatomy of Exchange Alley (1719) describes in detail various alleged market manipulations and sham reports generated to push up stock prices to the advantage of the perpetrators. ‘Tis a compleat system of knavery; that ’tis a trade founded in fraud, born of deceit, and nourished by trick, cheat, wheedle, forgeries, falsehoods,’ he blustered.”
http://www.ft.com/cms/s/82e34474-f4b4-11db-b748-000b5df10621.html

Bob–Don’t tease. Post your EViews output.

@45: “Bob–Don’t tease. Post your EViews output.”

I don’t have any. I can digest and take account of econometric forecasts but I’m not an econometrician, just a long retired member of the Government Economic Service, which is how I know a bit more than most about how to find official data sources.

Every month HM Treasury publishes a survey of about two dozen independent forecasts of Britain’s economy produced by teams employed by financial institutions and various well-reputed think-tanks, consultancies and professional forecasting agencies – this is the latest Treasury survey from May:
http://www.hm-treasury.gov.uk/d/201105forecomp.pdf

I figured long ago that there was no sense in my attempting to compete with well-established teams like those covered in the Treasury surveys. If there is something useful to contribute, it’s reading and interpreting the economic entrails and applying economic theories with topical relevance.

A list of periods of irrational exuberance Bob to accompany your insight that volatile markets are volatile. However, it is not the point that prices are correct just that they incorporate all known information. You know why they are volatile? New information becomes known. I don’t believe the EMH in its strongest form in the sense that it is just luck when people consistently beat the market. See Warren Buffett for someone who has a long term record of beating general rises in the market. If prices were completely random and contained no embedded public information beating the market would be easy and it is not. There are numerous fund managers earning a multiple of a six figure salary who have not beaten the market any year in the last fifteen. You can’t beat the market in the long-run by using the same information and reasoning as everyone else because it will all be in the price. Some EMH blog posts for your perusal.

http://www.themoneyillusion.com/?p=695

http://www.themoneyillusion.com/?p=3773

Bob, I mean with regard to the EMH. It’s an empirical question, isn’t it? Or is it rhetorical?

On the EMH, Richard W’s example of Warren Buffett is a good counter example of an investor who has out-performed the stock market for long periods.

The extensive – apparently successful – shorting in the lead up to the recent financial crisis is an example of traders who were betting against the market. We have the documented examples of self-fulfilling prophecies – one arguable example being the mounting speculation against the Pound in September 1992 which forced the Pund out of the European Exchange Rate Mechanism. For the rest, try the balanced assessment of the EMH, including some confounding empirical findings, here:
http://en.wikipedia.org/wiki/Efficient-market_hypothesis

The very title of EMH is often invested in popular political discourse with moralising overtones which go beyond the technical issue of whether or not it is feasible in practice for an investor to regularly outperform the stock market.

A recurring UK policy concern is that the stock prices for companies subject to take-over bids often rise before the bid is announced. This could be due to shrewd speculation – or to extensive insider trading.

And as for capitalism relying on this selling us stuff we don’t need crapola – what percentage 4of economic activity is being classified as stuff we “don’t need”? Is heating, lighting, computers, washing machines, bread-makers, transportation, entertainment “things we don’t need” and would be without in a better world? I’ll stick with the economy that allows me to buy 30 Rock DVDs thank you very much, you can keep your socialist utopia in which only our “needs” are catered for.

I’m still hoping to find something that Luis writes with which I disagree in principle, rather than in degree. I’m starting to worry that the Coalition has made me a Wet.

49. Bob B

” A recurring UK policy concern is that the stock prices for companies subject to take-over bids often rise before the bid is announced. This could be due to shrewd speculation – or to extensive insider trading. ”

The rise in the price for existing shareholders is bad? I thought up was good. I would be more worried about the public official insiders at the BoE who always know in advance whether a governor speech is going to be bearish for sterling. Could be Treasury civil servants. Anyway someone leaks the information and others profit from the information as a perusal of the sterling exchange rate up to 24 hours before a speech over the last three years would indicate. Same thing happened when they were still in the interest rate cutting phase. The information was clear in the fx 30-60 mins before the announcement. Not at all obvious whether it matters.

@51: Richard W

Stock market prices are continuously recorded and monitored by the FSA. Even so, proving insider trading is challenging and costly – which is good reason to suspect that it is more prevalent than the rare prosecutions might suggest.

I’ve no personal insights into what happens in the BoE or HM Treasury but the civil service is certainly aware of the opportunities for insider trading. Whenever “market sensitive” information came my way it was labelled as such and we were expected to hold the information in confidence at least until the sensitivity had expired – and market sensitivity could include reports of, or referrals by the Office of Fair Trading.

Likely interest rate decisions by the Monetary Policy Committee of the BoE are deliberately trailed ahead in the media to minimise “cognitive dissonance” in the markets.

Managing market expectations rather than maintaining secrecy and jumping the markets is regarded as best practice nowadays and the IMF would likely comment adversely about badly managed expectations by central banks – especially by the BoE since London has the largest global foreign exchange market by a margin and exchange rates are very sensitive to expected moves in BoE interest rates. New Labour made a regular practice of introducing Pre-Budget Reports in the October or November preceding the March/April Budgets, partly to consult ahead but also to minimise tax surprises. This is the modern paradigm.

FWIW my impression is that colleagues were scrupulous and that the civil service here is very largely uncorrupt. The notorious exceptions have been in MOD procurement in the late1980s and in Welsh regional development. Applications for regional assistance grants can be for staggeringly large sums of money – applications for tens of millions of assistance regularly passed across my desk for comment.

“On the EMH, Richard W’s example of Warren Buffett is a good counter example of an investor who has out-performed the stock market for long periods.”

One outlier cannot prove or disprove the hypothesis. You need to test whether a bunch of time series are serially uncorrelated or asymptotically uncorrelated or whatever. Quite a few people have already done this, as it happens.

Further, and quite regardless of the EMH, it should be obvious that the average return to capital is… the average. It’s not possible for everyone to beat the market.

@vimothy

“One outlier cannot prove or disprove the hypothesis”

Warren Buffett is the outstanding outlier of one investor who has outperformed the stockmarket over long periods. For all I know there may be others and I’m aware of other bits and pieces of research claiming some or occasional regularities in stock market price movements despite the consensus that prices generally show random walk with drift.

One of the important issues in this debate is investing stock prices with some normative, prescriptive significance even when investors on average cannot out perform the market. The lack of transparency about the assets underlying some financial instruments – such as the CDOs and sub-prime mortgages – is compelling evidence of what has been dubbed “irrational exuberance”. Asset-price bubbles is yet another. Further evidence is Shiller’s research showing that movements in fundamentals can’t account for stock market vollatility.

The hiatus over the top star ratings awarded to financial instruments and financial institutions by credit rating agencies which failed shortly thereafter is hardly a testimony to the inherent rationality of stock market prices – even if investors on average cannot out perform the market.

“Credit rating agencies played a very important role at various stages in the subprime crisis. They have been highly criticized for understating the risk involved with new, complex securities that fueled the United States housing bubble, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO). . . ”
http://en.wikipedia.org/wiki/Credit_rating_agencies_and_the_subprime_crisis

Just what was the basis for those star ratings by the agencies?