Arguments over whether financial markets are "efficient" -- and, if so, what "efficiency" even means -- are among the most confusing in economics. People use that loaded word sometimes to mean that markets get prices mostly right; at others only to mean that markets are really hard to predict. Even the economics Nobel Prize committee seems a little confused, as it awarded a share of the most recent prize to both Eugene Fama, the father of efficient-markets thinking, and to Robert Shiller, one of the idea's strongest critics (economist Lars Hansen also shared in the prize).
But there may be a way to make sense of things yet, if you listen to two European physicists. We may be confused about markets and market efficiency, they suggest, in large part because we're using an ill-suited metaphor in thinking about how markets work.
Traditional thinking about market efficiency starts from the idea that any deviation from the efficient equilibrium -- a momentary mismatch in the prices of two stocks, for example -- ought to create incentives for investors to act in ways that will quickly erase that deviation, restoring the equilibrium. The metaphor is of a system in stable equilibrium, like some water in a bowl, which settles down soon after it's perturbed.
The physicists, Felix Patzelt and Klaus Pawelzik, argue that this simple story doesn't do justice to how such feedbacks work in markets -- and that another metaphor is far more appropriate. Imagine, they suggest, trying to balance a stick upright on your finger. It isn't too hard to do, and most people can manage it, at least for a while. Stay vigilant, and whenever the stick departs from the straight-up position, move your finger and hand even further in that direction to compensate.
However, you will also find -- as many careful experiments have shown -- that this kind of control is highly fragile. There are times when things feel under control, but these safe periods always give way without warning to stressful episodes during which the stick lunges dramatically from side to side, kept upright only with desperate effort.
Patzelt and Pawelzik showed three years ago that this erratic outcome is more or less inevitable. If the controlling individual -- or any adaptable machine you put in its place -- has natural limitations on how quickly and accurately it can react, then the control it achieves will be of a highly erratic kind. The erratic instability is reflected in a specific mathematical pattern, a so-called power law reflecting the heightened frequency of abrupt and surprising big movements, as well as their tendency to cluster together in sharp turbulent episodes.
What does this have to do with markets? Well, this mathematical pattern is significant because markets show the very same signature of instability. The power law shows up in the "fat-tailed" distribution of the movements of asset prices, the Black Swans of the markets, as well as in the erratic variation of market volatility through time. This similarity itself may not be too surprising, as the analogy between the market and the stick goes quite far. After all, by trying to identify and exploit profit opportunities, investors effectively act to steer markets back toward an equilibrium state. Yet market participants, like anyone balancing a stick, also have some limitations on what they can do in their response time, the accuracy of the judgments, and so on.
And they, like anyone balancing a stick, never quite manage it. The conclusion, Patzelt and Pawelzik argue, is that the very forces that make markets generally very hard to predict -- that keep them "information efficient" in the lingo -- also act to make markets prone to sporadic upset. In more sophisticated models that go beyond mere analogy -- models in which market participants try to profit, and so act to eliminate market imbalances -- they find that market efficiency or near efficiency also brings with it a pronounced tendency to sudden large upheavals. Stable equilibrium just isn't the right concept.
There's a deep irony here. For it was Fama himself -- in his very first paper way back in 1963 -- who initially helped spread awareness that markets have fat-tailed distributions, as the mathematician Benoit Mandelbrot had discovered. Only later did Fama gain lasting fame for his ideas about market efficiency. But neither he, nor anyone else in economics as far as I'm aware, has ever made a connection between the two ideas, seeing that unpredictability and instability may be two aspects of one dynamic.
What does this mean for managing markets, and for learning how to avoid the worst disasters? It's fair to say that no one yet knows. But the close link between market efficiency and inherent instability is something financial economists need to take a lot more seriously.
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