Stock Markets Efficiency

“What problems they argue mainstream economics has?” based on
“Financial Instability (2001) by Steve Keen
Ch 11. Finance and Economic Breakdown" in 'Debunking Economics'
Why stock markets crash.”

By Michael Rybin
University of Utah, ECON 2020 (Macroeconomics)
Professor Do Youn Won
v04, August 1, 2012

Today we have laws or legal protections to prevent a stock markets crash.  Nevertheless, we lose millions and billions of dollars when the stock market dips or falls and companies like Enron or banks like Lehman Brothers fails.  This year some more economists predicted the worst stock markets crash is yet to come because of the huge 16 trillion dollar United States government debt and reckless government economic policies.  Some people believe the financial stock markets are simply not efficient or stable regardless of government economic intervention and policy.  Steve Keen attempts to answer why stock markets crash by explaining the inherent instability of stock markets, fractal markets hypothesis, inefficient markets hypothesis, and financial instability hypothesis.  He proposes that “open-ended shares be replaced by time-limited voting bonds in order to institutionally limit the degree of stock price instability”. 

Although people lose money in stock markets and all of the hypotheses seem to have valid points in their own context, time-limited voting bonds would not generate sufficient revenue to completely replace the revenue generated in trading open-ended stock shares.  None of the hypotheses presented by Steve included any arguments or evidence to solve the individual problem they themselves presented, let alone reduce the risk of crashing the stock market. 

It probably goes without saying that people do lose money trading stocks and financial markets have and will continue to crash or fail.  Even people who do not trade stocks lose money because some are subject to corporate retirement funds dictated by their company benefit programs --- and when companies fails, sometimes people lose all of their retirement and pension.  Unfortunately that is the plain truth.  No further evidence is needed beyond our own life history and experience or that of our grandparents who lived through the Great Depression in the United States, and with all due respect, to say nothing about similar events in other countries.  At the same time people have earned a lot of money from stock markets. 

Although people lose money trading stock and financial markets have crashed, time-limited voting bonds would not generate sufficient revenue to completely replace the revenue generated in trading open-ended stock shares.  An analogy may serve to provide an objective and fair comparison between time-limited voting bonds and the revenue generated in trading open-ended stock shares.  Included with the freedom and benefits of owning and driving an automobile is the risk of crashing in a terrible automobile accident.  To remove the risk of crashing along with potential disability or death, Steve Keen is proposing that we eliminate all automobiles and replace them with the existing public transportation systems.  It could be done, but currently there are not enough buses, trains, commuter rail cars, taxies, or airplanes necessary to meet everyone’s individual or collective transportation needs. 

This efficient market hypothesis “says that the stock market’s volatility is due to the random arrival of new information that affects the equilibrium value of shares.”  Initially, it does not sound like an “efficient” or responsible market system --- meaning, blaming the stock market’s instability and potential danger or risk on the news.  With today’s constant news and speed of reporting new information flowing through multiple avenues of technology and media, all around the world, seven days a week, twenty-four hours a day that seems like a very poor excuse.  However, what we can understand regardless of the peculiarity of the definition is that the stock market is volatile and not efficient.  Furthermore, replacing open-ended stock shares with time-limited voting bonds does not address the impact of news to the stock markets or bond markets and the volatility cited in the efficient market hypothesis.  Perhaps a more logical theory would be to consider limiting the news. 

The first reason why stock market’s crash is because of the fractal markets hypothesis --- defined as “highly unstable dynamic systems that generate stock prices which appear random, but behind which lie deterministic patterns”.  Let us use the Encarta Dictionary to analyze the definition of this hypothesis.  A highly unstable system [likely to fail or collapse] that generates stock prices which appear [seem likely] random but behind which lie deterministic [having an outcome that can be predicted because all of its causes are either known or the same as those of previous event] patterns.  In other words, a system that is likely to fail with seemingly random prices, but behind which have an outcome that can be predicted because all of causes to prices are either known or the same as those of previous event.  That definition seems insane.  How can the stock market and prices be likely to fail and simultaneously include patterns that are predictable when prices are known?  That is incomprehensible. 

Regardless, how does replacing open-ended stock shares with time-limited voting bonds resolve the instability of the fractal markets hypothesis --- or even for bond markets and bond prices?  It simply does not begin to address any related solution. 

The second rational of why stock markets crash is “inefficient markets hypothesis” where the stock market system overreacts to good and bad news leading to excessive price “volatility which inhibits the performance of the real economy”.  This is the best definition and reasoning yet.  We can only speculate as to how the proposal of replacing open-ended stock shares with time-limited voting bonds may provide a solution to this hypothesis.  Ok, it was not intended to, but what about good and bad news leading to excessive price volatility in bond markets?  No examples in the proposal provide a clear understand how it would solve the concerns of this hypothesis. 

The third assumption why stock markets crash is the financial instability hypothesis citing “speculative vehicles existing in an uncertain environment, whose reactions to uncertainty over time generate financial cycles which drive the real economy into speculative booms and debt-driven busts.  Ouch, what an unnecessarily painful and complex or useless definition!  Again, replacing open-ended stock shares with time-limited voting bonds in a speculative vehicle with an uncertain environment does not seem to address the root cause of this hypothesis. 

Nevertheless, all three non-equilibrium theories or hypotheses’ of finance have valid arguments within their own context that stock markets and capitalism face catastrophic financial and economic breakdowns.  However the proposal to manage or solve these problems by government policy replacing open-ended stock shares with time-limited voting bonds seems to hack at the leaves of the issue instead of the roots.  As Thoreau said, "For every thousand hacking at the leaves of evil, there is one striking at the root”.   

You can see that even though people lose money in stock markets and all of the hypotheses seem to have valid points in their own context, time-limited voting bonds would not be a good solution to protect the stock markets from crashing for two main reasons.  First, it would not generate sufficient revenue to completely replace the revenue generated in trading open-ended stock shares.  Most importantly, none of the hypotheses presented by Steve included any arguments or evidence to solve the individual problem they themselves presented, let alone reduce the risk of crashing the stock market.  At the same time, it would be good to reconsider solutions to the individual hypotheses relative to protecting the stock markets from instability or crashing. 

Copyright © 2012 Michael Rybin All Rights Reserved.