The seeds of my dissent from economic orthodoxy were pretty much sown for me by my 1st professor on the 1st day of my 1st economics class.

This prof had gone to a great personal trouble to begin our exposure to the dismal science with a very down-to-earth and super-important lesson. She went so far as to spend her own cash on some things from the store, of varying cost, and gave us all at the beginning of the class random items. Some people got candy, some got socks, one or two got things of greater value.

This was a masterful teaching stroke, by someone who cared deeply about her subject and teaching it to newbies: she would have us all participate in voluntary trade within the classroom and end up ≥ than we started. Gains from trade—the fundamental point about economics—are really “the only thing we know about welfare”. Sure, some people start off with more—more wealth, more smarts, better looks, genes that will make them grow taller so they can reach the mayonnaise jars from the back—but hey, at least we can make all of them better off and not hurt anyone by allowing them to trade freely.

Right?

We each reported, on a scale of 1 to 10, how satisfied we were with the Stuff we had been randomly given at the beginning of the class, and the prof wrote these scores down on the board. Then we were asked to stand up, walk about the room, and see if anyone would voluntarily exchange Stuff with us. Multiple transactions were allowed, even encouraged—and after a few minutes of cluelessly blitzing with each other, the trading day was closed and we resumed our seats.

The prof asked our scores again, fully expecting that ∀i in the class, utility before ≥ utility after.

But one girl reported a lower score.

Instead of taking this as evidence against her belief that transactions are always mutually beneficial—a cornerstone of normative economic theory—the prof instead scolded the girl. “Well, what’d ya do that for?!”

By the way, this was not a prof who prepended test questions with the phrase “According to the theory we learned in class,” which means I still dispute that I got that one about the lobstermongers right! (Since it asked about “What would happen” not “what the theory says would happen”.)

At the time I thought the outburst a bit rude and over the years to come I remembered the episode. (well, obviously) I still think of it as a microcosm of certain intellectual misdeeds by economists. The framework is too important to hold onto; if anyone undermines then you get angry and yell at them! It’s a plausibility war, after all.

Not too far off from real comments by economists: But if you took away the mutually-beneficial assumption, then you’d have no theory at all! (Regardless of whether nullset is the only true theory we have.)

The assumptions about what goes on in transactions are so appealing that even when you see them violated in front of your eyes, they’re still so implausible and—hey—what about all this stuff I learned about indifference curves? If I saw so many graphs with them not overlapping or going backwards, then that has to be the truth, because maths!

Nevermind that people don’t always know what they want, or maybe it’s contradictory or impossible, and even in well-defined classroom experiments they may just, um, do it wrong.

Happy Independence Day. Here’s to hoping you don’t use the independence to shoot yourself in the foot.

Free Money

@isomorphisms: Higgs Boson Particle to be observed on/before 31 Dec 2012 = 68.0% @Intrade bit.ly/MP3Eo0

@isomorphisms: Higgs 2013 = 80%, Higgs 2014 = 85%, Higgs 2015 = 80.1%. Oops #EMH #arb

There’s $2 three years from now sitting on the table for whoever wants to pick it up.

[T]he Efficient Markets Hypothesis [is] in contention for one of the strongest hypotheses in the whole of the social sciences.

Strictly speaking the EMH is false, but in spirit it is profoundly true. Besides, science concerns seeking the best hypothesis, and until a flawed hypothesis is replaced by a better hypothesis, criticism is of limited value.

Martin Sewell

Um … the criticism might not be useful to science, but knowing that the EMH is false is certainly useful to market participants.

The Kelly Rule for optimal bet sizing says to leverage your bet in geometric proportion to your confidence. So a small reduction in confidence means a big reduction in (optimal) leverage.

I could also wheedle about how obvious modifications of the EMH are more correct than strong EMH, but I won’t. My main thought on this quote is that Sewell has effectively redefined “truth” so that his viewpoint is unfalsifiable. (What example could I cite to demonstrate that EMH is not “profoundly true in spirit”?) On the other hand, it would be naive of me to think that esthetics and organa are not driving the engine of any kind of theory—be it economics, physics, or Foucault.

Anyway … despite the fervour of the abstract (from which I’m quoting), Martin Sewell’s History of the Efficient Markets Hypothesis is an informative read. 

market makers are normally paranoid that the other side of the trade “knows” what is going on and that it is a pickoff.

as a market maker, you think “what can i do against this that makes sense?” so you look for a vertical or 1×2, for example. or if there is nothing, then “how much i am going to bleed out of you in order to make [this] worth the risk?”

apine

Most people think that day-traders don’t add economic value. The NuclearPhynance traders’ phorum might change their minds. Those [economists] whose idea of finance = prices converging efficiently upon a “true” value due to a kind of value-investor who also sells short—might see in apine’s words a different story. Financial markets can be more like a discussion between people who don’t necessarily know what’s going on, but try to figure that out based on what everyone else is saying.

For those who don’t understand what “liquidity” means to a trader: it means a market maker who is willing to get scraped up in a scary environment. Liquidity sometimes means a market maker (sometimes: a high-frequency trader) who is willing to play on a muddy pitch and not even charge much for the trouble.

A boxer expends much energy avoiding punches, even if they’re only feints.

When the price of a stock can be … set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market prices rationally.

Warren Buffett

μ d𝓽 + σ dW𝓽, my #$$

μ dt + σ dWt, my #$$

The simplest model of a stock price movement is that the log of the price moves in a direction, plus some noisy drift (like adding a Gaussian W𝓽 at every timestep).

Agustin Silvani gives a counterexample: Federal Open Market Committee meetings precede a volatile market episode, meaning long-term changes in μ and short-term spikes in σ come after an FOMC announcement.

“Stop hunting” by dealers and other smart-money players can sometimes shake up the price pattern ONLY during a super-short period. This occurs most in the least regulated market, FX, because dealers will pull the rug out from under their retail clients’ feet. The dealers can see their clients’ stops and will just blatantly cheat the retail clients (according to Silvani), because they only need to retain a big client’s business. (Hence it’s more profitable to cheat the small fry — there will always be more.)

Efficient markets, my #$$

Not only does this violate the Black-Scholes model (a freak σ^7 comes in and then disappears), it also violates the Strongly Efficient Market Hypothesis, which says that market price—at any instant—reflects all available information and are the best measure of the “true” value of an asset. You would obviously get a more accurate valuation from taking a one-hour average than from relying on any instantaneous price, in the above graph.

According to Silvani’s story, the dealers are very efficient at bilking worse-informed or less-experienced participants, but don’t use this as a Prediction Market!