Efficient Markets and Communities of Rhetoric

There are few things more obnoxious than the know-it-all first year philosophy student.

You know the one. He (and yes it’s usually a “he”) thinks he can understand everything with the barest of efforts. Mostly, he thinks he can find the Achilles heel of all the great and venerated thinkers. Nozick can be dismissed because all real-world processes involve some injustice at the beginning and throughout. The entire social contract tradition can be dismissed because in the real world there are no literal social contracts. Moral philosophy can be banished entirely by simply invoking a paragraph from Hume (found on the Internet rather than by reading a whole book no doubt) about the perils of deriving an “ought” from an “is”.

What makes it hubris is the notion that he is the first one who has made these criticisms, and that thinkers who have continued to be read for centuries can be banished by uttering a few statements like incantations. If a work has been around and widely read for a sufficient length of time, you can safely assume:

  • All obvious criticisms have been made.
  • All obvious criticisms have been responded to.
  • A back-and-forth has occurred and the conversation has moved forward.

The fact that great works continue to be considered such even after the conversation has advanced usually means that there is something to the work, beyond its apparent flaws. It should not be surprising to us that great works have flaws—their authors are only human. But the fact that so many intelligent, well read, discerning people continue to read such works should give us pause before resorting to the know-it-all’s dismissal.

Efficient Markets, Efficient Literatures

The above is my attempt to gently coax people to stop worrying and learn to love efficient markets.

OK, maybe not the actual Efficient Markets Hypothesis, though I think most of the animosity aimed at EMH is misplaced. But EMH uses what Dan Klein calls the flattened model of human knowledge, something I do not subscribe to. In this model, knowledge is mere information processing. Information is a good like any other that has subjectively-valued benefits and costs to acquire. It’s a useful model, but woefully incomplete. As McCloskey and Klamer put it, it completely removes judgment and social context.

The computer uses a program and depends on a human purpose served. Without social programming you do not know what to pay attention to in reading the phone book (for example, in what order to take the numbers, or what the numbers mean, or to what uses the number 911 can be put, or what Aunt Hattie’s number means to you personally). Information is not simply a natural property. Humans must judge the information relevant or accurate or interesting for it to be “information,” selected from the blooming, buzzing confusion of the world. Information, to put it another way, is only part of knowledge.

Even though it does go about it in a very reductionist and mechanistic way, I do think that EMH gets at something important. What it gets at was hinted at with the example from philosophy at the beginning of the post.

It would be foolish to deny that investors have biases, or that as a group they often go systematically astray. But as with the great thinkers in philosophy, the relevant question is not “are they flawed?” It is “can you, individually, really expect to do better?” Or better still, “is there something I could learn from them?”

More to the point, the real question is whether you really think that some knowledge of cognitive biases and historical trends is enough to put you on equal footing with the aggregate knowledge of a huge number of people who all have a lot of money riding on their decisions?

Taking this seriously does not mean treating such aggregate knowledge as infallible. But failure to take this seriously turns people who could be intelligent critics of conventional wisdom into little better than our conceited philosophy student.

Just as market skeptics go astray when they do not take the knowledge embedded in the culture of investing seriously, methodological skeptics often go similarly astray by not taking scholarship seriously. I know this, because I lived it. Methodological skepticism is rampant among heterodox economics, and the sort sympathetic to (if not outright a part of) the Austrian school tends to be dismissive of mainstream economic scholarship.

I indulged in this for a long time. The grounds for my dismissals were the inherent compromises taken in the construction of aggregate metrics and econometric models. Funny thing, though—this dismissal didn’t do much to change my conclusions about what the right sort of economics was. In the end, I realized my own hubris in this. As I put it elsewhere:

I used to be skeptical of Alex Tabarrok’s rule of thumb to trust literatures, not studies, because I wondered whether the literatures in social science were really all that good even in aggregate. Tabarrok himself, as well as Deirdre McCloskey, convinced me to take literatures seriously in the end. Whatever problems you can think of that would limit the effectiveness of systematic study or measurement in a given area, odds are that the big community of specialists have argued about such limits to death and proposed and implemented endless approaches to get around or compensate for them. That does not mean that literatures are without problems or that outsider critiques aren’t valuable; to the contrary. But outsider critiques are usually only valuable if they’ve bothered to actually get familiar with what they’re criticizing, though the foundation of their criticism may come from a different community of rhetoric than the object of their criticism. Let’s call it the efficient literature theorem—most of the time, most literatures have captured most of the methodological problems any one individual could think of, and formulated and implemented more thoughtful and careful responses to those problems than any one individual would be capable of designing and making use of in isolation.

To repeat, this does not make conventional wisdom or consensus within communities above criticism or even in the right ballpark. It simply means that meaningful criticism is hard, and getting in the right ballpark much harder. I used to be attracted to the general skepticism of people like Russ Roberts, but increasingly it seems like a bit of a cop-out. I would advise him to go back and re-read The Rhetoric of Economics. McCloskey is no methodological optimist, but she believes that scientific communities, as communities of rhetoric, are able to work together to advance our knowledge. The truths discovered by these communities are always small-t truths rather than Truth; always contextually determined, always given their meaning by the hermeneutic circle (or less pretentiously, but no less obnoxiously, the paradigm) in which they are interpreted.

This is not anti-realist, it is simply one understanding of how communities of people work together to try to find truths.

The Long Tail of Conversation

To get less abstract about it, let’s return to the guidance we gave the first year philosophy student.

  • All obvious criticisms have been made.
  • All obvious criticisms have been responded to.
  • A back-and-forth has occurred and the conversation has moved forward.

Let’s apply this to finance. “But confirmation bias!” for example, is not a very compelling criticism of investment markets. Do you really think that no one in finance has heard of confirmation bias? Big, well-known, and obsessively listened to figures like Warren Buffet, for example, have spoken at length and for decades about the many varieties of self-deception.

Investors make up conversation communities. At a given moment in the history of such a community, the topics under discussion will form a power law distribution. A few topics get an enormous amount of attention because they are perceived as novel or important, but there is a very long tail of topics that are discussed in smaller and smaller subsets of the community. The irony of “but confirmation bias!” style critiques is that these days I think psychological biases are in the head of the tail in terms of what gets discussed; though I’ll admit this is my perception as a relative outsider.

Topics are in the long tail for a variety of reasons. A lot of it is because there are some topics that simply aren’t relevant, or are discussed primarily by crackpots; think of your garden variety conspiracy theory. However, there is an important set of topics that are in the tail because they have already be discussed to death, a consensus has been formed around them, and for most people in the community the consensus simply fade into background assumptions. A small set of dedicated specialists within the community continue to contribute to these topics in order to continue to advance them. These topics had a heyday where they were a central focus of the community, and it’s likely that they will return as a focus some day again; these things come in cycles.

Becoming familiar with some of these topics is what it means to “drink deep from the well of knowledge” when it comes to becoming part of a particular conversational community. The amateur and the newcomer are recognizable by their inability to see beyond the topic of the moment; the true expert can draw on much more of the intellectual capital invested by previous participants in the conversation.

Criticism From the Inside and Out

That said, the frameworks the develop within these communities create blindspots by their very nature. This is both their advantage and disadvantage. There’s an analogy here with property rights and its alternatives. Pete Boettke likes to say that all forms of resource allocation are really just different ways of saying “no“. Resources are scarce, so even if you are against property, all the other viable alternatives boil down to some method of keeping people from using everything up and dying from starvation.

Similarly, a conceptual scheme filters out nearly all possible information, interpretations, and ideas. McCloskey likes to say that we should not use the word “data” since it means “things given”; instead we should speak of “capta” or “things seized”. A conceptual scheme informs our judgments as to what directions of inquiry are the most promising, the most likely to yield interesting insights for us to seize.

This is inherently biasing. To systematically favor certain types of information, interpretations, and ideas over others just IS what is mean by “bias”. Bias is not something that needs to be overcome; it is necessary. Structured thought is not possible without bias.

However, not all biases are created equal. Moreover, there is a plurality of conceptual schemes and conversational communities with overlapping objects of interest. Sometimes these frameworks come from the outside—Kahneman’s description of how he first encountered economics is instructive:

One day in the early 1970s, Amos handed me a mimeographed essay by a Swiss economist named Bruno Frey, which discussed the psychological assumptions of economic theory. I vividly remember the color of the cover: dark red. Bruno Frey barely recalls writing the piece, but I can still recite its first sentence: “The agent of economic theory is rational, selfish, and his tastes do not change.”

I was astonished. My economist colleagues worked in the building next door, but I had not appreciated the profound difference between our intellectual worlds. To a psychologist, it is self-evident that people are neither fully rational nor completely selfish, and that their tastes are anything but stable. Our two disciplines seemed to be studying different species, which the behavioral economist Richard Thaler later dubbed Econs and Humans.

And so began the conversation between psychologists like Kahneman and Tversky as well as heterodox economists like Thaler on the one side, and more mainstream economists as well as other classes of heterodox economists such as the Austrian school on the other.

One thing to notice is that when two conceptual schemes encounter each other, the proponents of each often level criticism that amounts largely to talking beyond one another. Each framework has justifications that are internal to it, so it is natural that the proponent of framework A would rely on that framework’s internal logic to call framework B unjustified. But it is precisely because the proponents of framework B have accepted a different internal logic that a disagreement is occurring.

What’s interesting is that it doesn’t take outsiders per se for this dynamic to develop. Alasdair MacIntyre’s favorite example is the 12th century clash between the scholastics working within the medieval Aristotelian tradition on the one hand, and the partisans of the Augustinian tradition on the other. The thing about this is example is that many of the partisans of each had been at least exposed to some of the other in their education, though few “drank deep from the well of knowledge” of the other’s tradition.

In any event, I think MacIntyre (with some small modifications) provides the best answer for adjudicating among the claims of rival and incommensurable traditions of thought.

The most fruitful path is for those who have already developed a deep expertise of their own tradition. So we aren’t talking about first year philosophy or economics students here, but those who have spent a lot of time in the long tail of topics in their conversational community.

Then one must go deep into the rival tradition—Aquinas, MacIntyre’s icon of this, was equally an expert in both traditions. One need not necessarily go that far, but one should be able to defend the strength of the rival tradition in a way that a partisan for that tradition would recognize as knowledgeable. In gaining this knowledge,  you can identify the areas that proponents of the tradition consider to be problems with the framework; problems defined in the framework’s own terms.

Progress is possible, according to MacIntyre, when you show that a different framework—either the one you started with or some new synthesis—has more resources to resolve the problems internal to the rival framework than it does.

To be clear:

  • You start with framework A, which takes time to become an expert in.
  • You encounter rival framework B and work to understand it as well as one of its proponents.
  • You are now in a position to say how framework A, or some new synthesis C, has more resources to address the problems that framework B’s own proponents have struggled with and been unable to resolve.
  • Presumably framework A or new synthesis C is also better at making progress on its own terms than framework B.

And that is MacIntyre’s theory of inquiry in a nutshell.

Notice that even where criticism is concerned, you have to go deep into an existing community of rhetoric and learn their ways.

This is really the key point I wanted to make in this post: the individual is fundamentally ignorant. To the extent that we’re able to rise above mere ignorance at all, it is by spending a lot of time retracing the paths tread on by previous generations and present experts. These paths are numerous, even for considering a single question; you could not walk them all even if you spent your whole life trying to.

Epistemic humility is crucial, and one important step to that goal is taking the knowledge of conversational communities seriously—including the knowledge in markets, and in academic literatures.

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