The efficient market hypothesis disproved.

Financial Markets are not Supply-Demand Compliant

We’ve all heard about the basic rule driving the economy: the law of supply and demand. After a simplistic presentation on how it applies to the real economy, we will see that it actually does not work on financial markets. We will then find out what French neo-Keynesian economist André Orléan recommends.
This article is based on his most recent and seriously important research.

That’s [Real] Economy Stupid.

Flash back to the text books:
As more agents want to buy, demand increases, and competition amongst buyers put an upward pressure on prices. On the other hand, as more agents are ready to sale, supply increases, and competition amongst suppliers put adownward pressure on price.

These two opposite forces end up forming an equilibrium (ie. a price) balancing demand and supply capacities. This is the self regulation theory of the markets: a.k.a. the invisible hand.

This has been the mainstream working hypothesis to explain the real economy for a while, in which agents buy products to use them. Speculation does exist of course, but the law of supply and demand applies and works quite fairly.

Now let’s see how things work out in the ‘Finance’ economy.

That Financial Economy is Stupid!

In the ‘financial economy’ it is actually not exactly the case…
To put it straight, when price goes up, demand increases, rather than slowing down like in the real world. (Have you ever noticed how punters rush to buy stocks that go up?) When prices go down, demand decreases, rather than increasing like in the real world (Have you ever notice how nobody want to buy stocks that crash?).
This is due to the substantial fact that agents in a financial market are not buying assets for their use, but purchase equity to make a profit later on. This profit will come as a benefit after sale. Unlike on the good old farmer’s markets, the actual intrinsic quality of what is traded on financial markets is not relevant to buyers, only the price forecast is. This price will end up being settled according to the will of agents, whether they buy it or not. Therefore, rational agents buy when prices go up, because it’s the most obvious signal that the value will be higher the day after! Whatever the quality of the traded item, if prices go up you should buy and buy again tomorrow.

How could such behaviour reach an equilibrium? How could such mechanism set the right price for the ‘traded stuff’ (read: equity or asset)?

It’s All About Bubbles and Crises

(The bigger, the better)
The accelerating mechanism we briefly introduced applies to the rising phases of financial markets (the famous Bull Market). It is actually a self fulfilling model (economists talk about pro-cyclicality). As long as agents believe things will rise, so will they…. and bubbles can sparkle in every champagne glasses, at every New-Year parties in the City. The only obstacle to an endless rise is lost confidence about tomorrow’s rise.
When this happens, things turn nasty. The very same mechanism applies. The only difference is that it goes… downward. The Bear follows the Bull, like crises follow bubbles, like panic follows enthusiasm… or hangovers follow binge drinking. Everybody looks for a life-jacket. The trouble is that, in a closed system, someone’s gains are somebody else’s loses… and because insiders and bankers usually put their lifejacket on first, we let you guess the chances that everyday punters get out of the crash in good shape.

So to recap and to be clear: these successive and massive upward and downward swinging trends are inherent to financial market. The point is that bubbles and crises are not temporary failures due to inappropriate behaviours of some deviant agents. They result from true rational decisions. This is the very fabric of financial market’s DNA if you like: bubbles follow crises.

To put it another way, it is an amazing case of individual rational decisons made by agents (they do objectivelly make the best possible choices) leading to irrational collective outcomes on the market (demand goes up when prices go up).

By the way, lots of commentators already pointed that the sub-prime crisis could very soon be followed by a public debt crisis. (Watch out for Greece default risk)

Le Laissez-Faire is Over?

(Quick fixes won’t work)

What can be done to stop that vicious circle? Well that’s the precisely the point: N-O-T-H-I-N-G. Because of the veryinherent nature of the cyclical mechanism governing financial markets: this is the stuff they are made of. Go and tell drug addicts that they can ‘keep doing whatever they do’, but must stop getting high… it doesn’t work. You accept the nature of the beast, or you don’t. But you cannot have it both ways.

Therefore, unlike what the G20 would like to everyone to believe, no transparency regulation will ever make financial markets more efficient to set the right price. They just won’t do it and are condemn to endlessly fluctuate and destroy in one swing of the pendulum the value they created in the previous cycle. However if you cannot cure it, you might contain it. That’s the good old idea brought back by André Orléan: How to prevent a financial crisis to flood into the entire economy, real one included? Segregation is the forbidden word. Let’s build firewalls.

(President Obama touring the world in search of regulation ideas)
Remember when facing the aftermath of the 1929 financial crisis, American elders decided to segregate investment from commercial banking, with the famous Glass Steagall Act passed in 1933. This specific provision was practically repealed during the liberal saxophonist presidency, with the Gramm Leach Billey Act of 1998, quickly followed by the creation of the too big to fail Citigroup…
Well, here is one interesting idea Obama might want to ponder.

To quote Thucydides: “History is Philosophy teaching by examples.”

{ NKN }

More in French:

Les Sciences Economiques et Sociales – Compte-rendu de la conférence d’André Orléan.
http://ses.ens-lsh.fr/1256812259698/0/fiche___article/
André Orléan : “le G20 a manqué sa cible” :
http://www.latribune.fr/actualites/economie/france/20090817trib000411175/andre-orlean-le-g20-a-manque-sa-cible.html
Dailymotion – Kezeco: André ORLEAN 1 – une vidéo Actu et Politique :
http://www.dailymotion.com/video/xapynb_kezeco-andre-orlean-1_news
Le Monde: Les économistes en question, 02/2010
http://www.lemonde.fr/opinions/article/2010/02/05/les-economistes-en-question-par-frederic-lemaitre_1301559_3232.html
Le Monde Diplomatique, blog: Instabilité boursière : le fléau de la cotation en continu
http://blog.mondediplo.net/2010-01-20-Instabilite-boursiere-le-fleau-de-la-cotation-en

More in English:

Beyond transparency:
The current consensus is that the financial sector needs more regulation. This perspective sees markets as sound in principle, merely distorted by concealed risks. However transparency is no guarantee against bubbles and crashes. It is the rationale for the universal interconnection of capital that needs to be disputed, argues André Orléan.
http://www.eurozine.com/articles/2008-12-18-orlean-en.html