the plan for the future

Efficient market hypothesis versus behavioural finance

1 March 2014

There appears to be a contradiction between efficient market hypothesis and behavioural finance. In a sense, the contradiction is about changing perceptions (or uncertainty) about future income. The perceptions make the change in equity prices appear rational. But why do perceptions change? To some extent it appears to be a consequence of the business cycle and the availability of credit.

During a boom phase rosy projections of the future appear rational so credit is available and during the bust phase grim projections of the future appear rational so credit vanishes. The projections and the availability of credit can reinforce the cycle, making it rational to expect more (profit or loss depending on the phase of the cycle) to come. Both the efficient market hypothesis and behavioural finance miss this important point.

Reducing or eliminating the business cyle could do a great job in improving the efficiency of the markets as projections of future income will become more stable. In this way there will be fewer misses in the expectations. This is what monetary and fiscal policies aim to do. The problem of those policies is that they increase moral hazard as market participants expects government and central banks to help them out in times of trouble. For that reason you may need a self-correcting system. I will outline one here:

1. Holding liquidity should be expensive. This can be done using holding tax on currency, which may need to be somewhere between 0.5% and 1% per month. As a consequence there probably will be a constant stimulus as people are not inclined keep their money on the sidelines. They will invest or consume, hence there probably will be more stable economic growth.

2. The maximum interest rate on money should be zero. This can cap risk taking in the financial system as interest is also a reward for risk. As a consequence banks probably are less willing to take on risky loans. It can still be attractive to lend out money as the holding tax can be evaded in this way, which will earn 0.5% and 1% per month.

3. If the economy is more stable, and if there is a maximum interest rate of zero, direct investment in equity tends to be more attractive. As a consequence there probably will less be debt. Should the economy do well, then there may be less money available for lending because of the maximum interest rate and the improved expected return on equity. As a consequence there may be less money available for consumption and overheating of the economy is less likely to occur.

4. There should be a fixed amount of currency so credit may not increase indefinitely. Any credit contraction will probably not lead to a deflationary spiral because the holding tax makes liquidty expensive. The economy can now adjust and defaults are possible without too much harm done.

5. An interest rate of zero can be a positive real return if the amount of money is relatively stable and the economy grows. In a growing economy, more or better products and services become available but the amount of money remains the same. In this way prices may drop and the value of money may rise making positive returns possible. Interest rates can go negative when there are excess savings so consumption and savings can always be balanced.