Monday, 11 August 2008

Undercover equilibrium: Holiday reading 2

The other popular economics book I read on holiday was Tim Harford's Undercover Economist. It's an interesting if quick read, and I can entirely see how it stimulated admissions to undergraduate economics programmes. It strikes me, though, that Harford's examples work best when the notion of price is unproblematic. He is presenting classical economics, so he assumes that prices are known and that all agents have a view as to the correct price for a good or service. Things get a lot more interesting once prices are not observable or when agents don't know what the 'right' price is. As, umm, in the debt markets at the moment. The Big Picture has a related discussion concerning the failure of equilibrium economics.
I have several favorite examples of where markets simply get it wrong. When I spoke with the reporter on this, I used the credit crunch as exhibit A. It began in August 2007 (though some had been warning about it long before that). Despite all of the obvious problems that were forthcoming, after a minor wobble, stock markets raced ahead. By October 2007, both the Dow Industrials and the S&P500 had set all time highs. So much for that discounting mechanism.

We've seen that sort of extreme mispricing on a fairly regular basis. In March 2000, the market was essentially pricing stocks as if earnings didn't matter, growth could continue far above historical levels indefinitely, and value was irrelevant.
My own view is that finance is not an equilibrium discipline, mostly, so while classical economics might work well in explaining the price of coffee - one of Harford's examples - it does rather less well in asset allocation or explaining the return distribution of financial assets. Rather new news arrives faster than the market can restore equilibrium after the last perturbation, meaning that most of the time equilibrium is not a useful concept.

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