Bringing the action of political authorities under the discipline of the financial market is a mistake.
After years of heretical monetary policy, the "hawks" of the ECB and other central banks would like to re-establish "market based" criteria for buying and selling securities. The idea is that the central bank should only buy or use as collateral securities that are well valued by the market. If the market rejects them, the monetary authority must also consider them junk and leave them to their fate.
In essence, the old liberal litany of the "efficient" financial market is back in the limelight: the market is never wrong in the valuation of securities. It is therefore to its shrewd discipline that we should all submit, including the economic policy authorities. But are free market forces really that efficient? The vast anecdote of stock market booms and busts would seem to indicate otherwise. However, more is needed to draw robust conclusions. The studies of Economics Nobel Prize winner Robert Shiller, and others like him, tried to verify whether the thesis of the efficient market is confirmed or denied by the empirical evidence.
These studies start from a consideration. If the market were indeed efficient, then the current market prices of securities should be determined by the discounted value of future income - dividends, interest, etc. – which can be foreseen on the basis of the optimal use of all the information available today.
Only rationally expected future incomes should determine market prices, no other elements should influence them. But is it really so? To verify this, these studies propose a simple and ingenious method. They compare the market prices with another set of prices, called "hypothetical" prices, which the researchers calculate later on the basis of unexpected but actual incomes, i.e. those that have actually been paid to the owners of the securities.
The difference between these two sets of prices concerns unexpected future events, such as a sudden famine, or an unprecedented pandemic, or the outbreak of a war, or other similar shocks. As contingencies, it is obvious that these future shocks cannot be incorporated into the rational forecasts which should shape current market prices. The hypothetical prices, on the other hand, are purely fictitious prices that are calculated by researchers only after the shocks, and therefore it is evident that they take them into account.
But then, if one accepts the efficient market hypothesis, i.e. if market prices are assumed to reflect only a rational forecast of future incomes, the data should give an unambiguous result: market prices, calculated before unexpected shocks, should be much less volatile than the hypothetical prices, calculated after those shocks. Well, Shiller and the other scholars on the subject have verified that things are exactly the opposite: market prices fluctuate much more than hypothetical prices!
Despite all the apologists for financial laissez-faire, this result demolishes the efficient market thesis. Indeed, it indicates that market prices cannot simply depend on a rational forecast of future incomes but must be influenced by something else: for example euphoria, panic, destabilizing speculation, i.e. elements so "disturbing" as to make market prices fluctuate even more than the fluctuations caused by pandemics or wars.
The thesis of the efficient financial market is therefore denied by scientific evidence. The implication is clear. Bringing the action of political authorities under the discipline of the financial market is a mistake. It will be like putting ourselves in the hands of a madman who loves to gamble.
Original article published on Money.it Italy 2023-01-31 08:08:12. Original title: Attenti, la disciplina del mercato finanziario non è “efficiente”
