With No Power, Comes No Responsibility: Efficient Market’s Role in Regulation (part 1)

“With no power, comes no responsibility”. The catchphrase from the movie "Kick-Ass" seems to describe the current state of financial regulation rather well. Unfortunately, the larger Conversation on financial reform has been anything but kick ass. We have a tragedy of the commons scenario where every regulator, policy maker, academic and practitioner has joined the blame game.

No. It is not their fault. After all, people merely followed what the intellectual luminaries preached, which made the Efficient Market Hypothesis (EMH) one of the “best selling” ideas of all time. By assuming that prices reflect all known information, the EMH is convenient, user-friendly, and rationalizes laziness as an appropriate policy. It is a hypothesis that can never be wrong (cannot be disproved). The Efficient Market Hypothesis had us at hello.

The EMH truly liberated the people. It guided policy makers to pursue deregulation, freed regulators from their jobs, and saved practitioners from performing in-depth analysis. With free time on everyone’s hands, creativity reigned. Complex derivatives such as CDOⁿ proliferated and the EMH encouraged the industry to adopt a “sell first, ask later” motto. Let the market figure out how to price them, says the EMH. Financial innovation quickly transcended the industry. If the EMH were a person, the Nobel Peace prize would be its to lose.

We find ourselves in a very different world today. The EMH is now being crucified as the elegant theory that caused the financial crisis. As Krugman suggests, people mistook beauty for truth and economists everywhere climbed aboard the EMH-Titanic that was destined to hit the iceberg.

However, the fault was never with the theory per se. The EMH is silent on its ability to explain bubbles and crashes, and offers no real use to policy making. No power. No responsibility.

What we need today is a more powerful theory to guide policy and put responsibility back in the hands of the regulators. We do not need more debates on the financial reform, which have done nothing but amplify confusion. Without coherence, there is no reform. And we are running out of time.

In part two of this series, I propose a Cyclical Efficient Market Hypothesis (C-EMH) that integrates viewpoints from psychology and quantitative finance to complete the EMH. The result is a model that is useful to guide policy making and regulation.

Jim Rogers makes my head hurt too

Too many long posts lately. Here's a short comic relief. Professor Krugman in his usual satirical tone, absolutely nails Jim Rogers. Krugman assigned his readers a homework to explain — in English — what’s wrong with the words that are coming out of Rogers' mouth, who said, “Well, capital has already been flowing into Asian economies, as you can see by the fact that they’re the world’s biggest creditors.”

Here's my homework solution: If somebody is the world’s biggest LENDER (creditor), by definition money is flowing AWAY from that person.

Krugman 1. Rogers 0.

p.s. I've been waiting for a long time for someone to drill Jim Rogers. Thanks Paul.

Auditing the Federal Reserve is Economic Suicide

Given the potentially fatal repercussions, auditing the Federal Reserve is one of the most underreported stories by the media today. Investors today should be fearful of this development. It is shocking to see three out of four Americans supporting a bill that could lead to economic catastrophe. The passing of Ron Paul’s H.R. 1207 bill may bring serious and unintended inflationary consequences that can destroy investors’ wealth.

While it may not be the intent of the lawmakers, Ron Paul’s bill, a.k.a. Federal Reserve Transparency Act, will enable the congress to influence the outcomes of monetary policy through an audit of the Federal Reserve’s day-to-day operations, thus severely compromising the independence of the U.S. central bank from political influences.

The free market understands that auditing the fed is a very dangerous line to cross. If crossed, U.S. inflation will likely skyrocket over the next decade to unseen levels. The U.S. economy will tank under a hyperinflationary environment. Bond investors lose money as interest rates rise. Stock investors earn negative real return as equity risk premium rises and aggregate PE ratio nose dives. The US Dollar erodes due to higher domestic inflation relative to foreign inflation. Gold and commodity prices rise.

How Does Auditing the Fed Cause Inflation?

Inflation is caused by a central bank that loses control of its money supply. There are two ways that a politically compromised central bank can lose control of its money supply.

Road to Inflation #1: Repeating the Political Cycle

When the central bank is not independent, politicians have historically pumped up the money supply (for temporary economic boost) shortly before an election to buy votes with lower unemployment rate. After the election, the effects wear off, returning the economy to its natural rate of unemployment but at a higher inflation rate than before. Because it is hard to fight off inflation quickly, by the time the next election rolls around the economy has not been squeezed back to its original inflation rate. Politicians pump up the money supply again, this time from a higher base inflation. As this cycle repeats itself, the central bank loses control of the money supply.

Road to Inflation #2: Financing Government Spending

A central bank that lacks independence from politicians makes it tempting for the government to finance an inappropriately large portion of its spending through printing money. A central bank that promises to finance too much government spending also loses control of the money supply.

Will the Bill Pass?

Although Obama and his economic team oppose this bill, it may not matter much. The risk of the bill passing is increasing every day. Ron Paul is using the recent economic recession as an opportunity to sway angry politicians to advance his personal agenda of ending the fed. The table below shows that government officials are embracing the Federal Reserve audit. In fact, support is so overwhelming that we are dangerously close to reaching the veto-proof status. Once reached, the President will have little say in the outcome. Deadline for voting of this bill has been set to December 2010.

In sum, auditing the Fed’s daily operations will cause it to succumb to political pressure, lose control of the money supply, and create sticky inflation that could be much worse than the 1970’s. America is an angry nation right now. When it comes time to vote on the bill, it remains to be seen if cooler heads will prevail or if America will swallow the economic suicide pill.

*Related links: Reactions from 6 economists, Bernanke, Bernanke (2), Geithner, Washington Post, and general public.

The Efficient Market, Debugged

What is the link between the price discovery process and fixing software bugs? In a debugging process, one can never eliminate all the bugs*. This is because fixing a known bug can potentially create more unknown bugs, implying that there exists a point of diminishing returns where fixing more bugs will not yield any more benefits.

The stock market shares the same essential characteristics as open source software: anyone can participate. In the stock market, anyone can buy and sell securities. Likewise, any programmer can participate in an open source project. When a stock market participant discovers the “solution” to a price (i.e. fixes a bug) based on certain information that he’d gathered, he will simultaneously affect the price (i.e. creates a bug). This newly arrived at price becomes a new piece of information that acts as a signal to other traders who cause the price to change again (i.e. creates more bugs). And because not all bugs can be fixed, prices at any time cannot be correct and never will be.

How much money should one devote to “fixing bugs” in the stock market at most? The answer is: spend money up to the point of diminishing returns! This point is defined simply by the Kelly Criterion.

Where E(r) is the expected return, r_f is the risk-free rate of borrowing and lending, and s² is the variance of the expected return. Wealth is destroyed when more resources are allocated than necessary (Kelly Criterion’s f). This is exactly what caused the current boom/bust cycle of the finance industry – there was simply too much finance. The society had overspent its resources (beyond the point of diminishing returns) to making the markets more efficient. Isn’t it ironic that in the pursuit of more efficiency, we have made it more inefficient, and destroyed our own wealth?

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*In theory, it is possible for a software to be completely bug-free. However, in practice, the more complex the system, the higher than probability of a buggy system. In the same token, the efficient market hypothesis is correct in theory, but the complexity of the market system causes prices to tend toward equilibrium, but never quite get there.