2 posts tagged with "efficient markets"

Today was the first day of the 21 day COVID-19 lock down.

I spent my morning struggling to get groceries. Fortunately the nearby super market was open and most of the important items were present.  Items like milk and floor cleaner were over - but most vegetables, rice and yes, Maggi was available. If you see somebody else buying something, you also keep a couple of packets of it. It took 40 minutes to clear the payment queue - but well, that's a small inconvenience given the situation we are in.

Today, I read a few pages from Noam Chomsky's Understanding Power. Noam Chomsky is a acclaimed scholar with lot's of controversial opinion - so it's a fun read. One essay which caught my eye was his discussion on free markets.

He argues that

there is not a single case on record in history of any country that has developed successfully through adherence to "free market" principles : none

He gives example that most successful pockets of economies have grown with state intervention. United States had excessive state intervention from early days - right from defence funding which gave birth to the Silicon Valley tech companies to the earlier textile industry which survived because of high tariff on imported goods.

We see even this playing out today with China's protectionist govt. policy giving birth to multibillion companies like Alibaba, Tencent and Baidu. While back home in India, the poster child of startups, Flipkart was acquired by Walmart.

This made me think. Is the narrative of free markets just a hogwash?

Chomsky says

the "free market" ideology is very useful - it's a weapon against the general population here, because it's an argument against social spending, and it's a weapon against poor people abroad , because we can hold it up to them and say "You guys have to follow these rules," then just go ahead and robs them.

China never worried about being protectionist. Still its tech industry is doing pretty well and even challenging the US.

Is India's policy of keeping markets open, just falling into the narrative of "free markets are good" which other countries want us to believe in? Should India be more interventionist?

In our first year MBA class, we were taught the Efficient Market hypothesis. It basically implies that it is impossible to beat the market on a risk adjusted basis. If you want to beat the markets, you have to take more risks.

Now, this hypothesis relies on a class of people/agents who can be loosely identified as "entrepreneurs" - who identify any opportunity to make higher returns, make money out of it and correct the prices. Hence, markets again become efficient.

The thing to note here is that, this class of people which I have called above as "entrepreneurs" are those agents who operate on the margins and always looking to push the boundaries. e.g. If there is a new cheaper way to drill oil, entrepreneurs will exploit this technology by forming ventures which exploit this - and bring the prices down. The market thus gets corrected. If there is a new way to deliver goods cheaper by drones, there will be entrepreneurs who will start ventures to provide this service - and hence will make delivering goods cheaper. This will reduce the price of delivery and hence the logistics market will get corrected. You get the drill...

But, being in the space of creating ventures and constantly thinking about it for few years now, I think that not enough thought has been given to how these "entrepreneurs" are created. There are no single, well defined process by which entrepreneurs are created. Some accidentally discover an opportunity, some tinkered for long years to reach there. There is lot of luck involved. For example, Jeff Bezos came to know about the potential power of the Internet - by working for DE Shaw - which was a hedge fund trying to exploit the emergence of computers and the Internet. Ray Krock, who took over Mc Donald from its founder - and scaled it across the world. There is not set pattern for it.

Since the process by which entrepreneurs come to be is so random, how can something like the Efficient Market hypothesis - which relies on "entrepreneurs" exploiting every possible opportunity - be true. There are many areas where very few entrepreneurs enter - just because of the nature of that market - and these markets stand uncorrected for a long period of time. Markets which involves hardware are uncorrected for a long time - because very few entreprenuers go there. Areas which are loved by VCs get lots more attention - and hence are more efficient.

Of course, if by some random chance, an entrepreneur goes to an unattended area - and achieves success - then a lot of money flows into it - and the market gets corrected. But, till that entrepreneur stumbled upon that area - it was uncorrected for a long time. A case which comes to mind, is the area of RPA (Robotic process automation) which was unattended for a long time - till UiPath somehow stumbled into it - after barely surviving for 8-9 years. Of course, after UiPath - lots of money flew into this market and the market is overheated now.

So, the very mechanism by which markets get corrected is so flaky - so based on luck, that it always remains uncorrected for long periods of time - before it gets corrected.

The invisible hand of the market works through the toil of entrepreneurs. But the creation of entrepreneurs is unpredictable, and thus the invisible hand also plays to its own tune.

Efficient market hypothesis is just taught to students, to make them feel that the world works through well defined rules. While in reality, there is so much depth and complexity in the world, that simple rules like EMH can't possibly ever explain it.