Why Do Economists Opine in Ignorance About Our Financial System?
Since the acute phase of the Great Financial Crisis started in 2008, Economists have not been bashful about showing their ignorance of our financial system.
In case you think I am being unfair, the macro-economics profession admitted prior to the Great Financial Crisis its models did not include a financial sector. So for several decades preceding the crisis, you could get a PhD in Economics with no fundamental knowledge or understanding of our financial system.
Yet this admission didn’t prevent Economists in 2008 from saying they are “experts” on the financial system and offering up their opinion. It hasn’t stopped them since either.
The difference between Economists and you and I is we would actually take time to study the financial system before making any claims about expertise. You and I would ask and find an answer to questions like “why is our financial system designed the way it is”.
By not taking the time to actually figure out the answer to this question, members of the Economics profession have left themselves in the ongoing position of opining in ignorance.
The latest example of this comes from Jason Furman. His Twitter bio tells us Professor Furman is a “Professor of Practice at Harvard. Teaches Ec 10, some tweets might be educational. Also Senior Fellow @PIIE. Was Chairman of President Obama's CEA.”
This is heady stuff.
Unfortunately, he doesn’t understand the design of our financial system (so one can only imagine how bad the advice was he gave to President Obama that contributed the failed policy response to the Great Financial Crisis).
His tweet from 3:51 pm on April 6th, 2021 begins with:
@AnnieLowrey's story on index funds misses clearly making two first order important points: 1. You should invest in them 2. Even with the growth of index funds we still devote too many resources, not too little, to price discovery in financial markets.
Let’s focus on his second point about devoting “too many resources, not too little, to price discovery in financial markets”.
Fair or not, we need to look at this comment in the context to how our financial system is designed. The foundation of our financial system is an explicit agreement between the government and investors. In exchange for the government ensuring each investment provides the disclosures investors need to know what they own, investors take full responsibility for all gains and losses on these investments.
Disclosure is important. It allows investors to independently “Trust, but Verify” Wall Street’s valuation story for each investment.
Behavioral Economics has shown that everyone likes a good story. Would anyone think designing a financial system based on trusting the stories Wall Street tells and blindly investing is a good idea?
Disclosure is also not a one time event, but a continual process. This allows investors to continually reassess the risk/return of their investments and change their exposure as the risk/return assessment changes. (By the way, investors reducing their exposures when risk increases is what is referred to as market discipline.)
Not surprisingly, the ongoing process of verifying Wall Street’s valuation stories takes a lot of resources.
So how does Professor Furman justify his assertion “too many resources” are being used? He goes on to say:
Some worry that if everything is an index fund then no one paying attention to where to allocate capital etc. But 100% indexing is not an equilibrium. The fact that actively managed funds can't make returns in excess of fees indicates they aren't doing anything useful.
Conversely, dedicating too many resources to active investing is an equilibrium because of the rent seeking benefits to getting information a millisecond before someone else. The market can't solve the problem of the overallocation of resources to finance.
His statement is a wonderful example of throwing enough jello against the wall and hoping something will stick.
Let’s consider for a moment what is the impact of active investors on prices. In theory, they use the disclosed information to assess each stock, its potential risk/return and its fundamental value. They purchase a stock to push its price up towards its fundamental value. Conversely, they sell or don’t invest in a stock to push its price down towards its fundamental value. Over the long term, by making these informed decision they make sure capital is allocated to its best uses and that stock prices reflect this.
But what about the fact these active investors have a hard time outperforming passive portfolios consistently over a decade? It doesn’t indicate they aren’t doing anything useful. Each active investor is going to concentrate their investments in the stocks they understand and they think are furthest below the stock’s true fundamental value. By doing this, the active investors should be offering their clients a better trade off between amount of risk taken and return.
Or consider how he lumps in the resources used by “traders” with “active investors”. The benefit of getting information a millisecond before someone else is you intend to front run their trade. It has nothing to do with assessing if the stock is fundamentally under or over valued. If the information is positive, the traders expect active investors to buy. So the traders buy first and then sell the active investors the stock at a higher price. If the information is negative, the traders expect the active investors to sell. So the traders sell first and then buy the active investors’ stock at a lower price (covering their short from selling first). Simply requiring any stock purchases be held for a day would eliminate this activity and the resources dedicated to it. This of course wouldn’t be troubling to active investors as their investment horizon is greater than a millisecond.