Efficient markets as normative systems

Recently, I came across this outstanding interview with Eugene Fama published by The Market / NZZ. Besides the main subject discussed -the inability of central banks to control inflation-, the interview is intertwined with gripping assertions about the limits of knowledge, such as the following ones:

Bubbles are things people see in hindsight. They don’t identify them in advance. Sure, you can look at the behavior of prices, and you may be able to identify cases where they are too high. But if you only look back and say: «Oh, stocks went down a lot, so that was a bubble», then that’s 20/20 hindsight. At the time, there was no evidence that there was a bubble.

I don’t say markets are completely efficient, but they’re efficient for most questions that I address. Models are never a 100 % true. If they were, we would call them reality, not models. But for almost all purposes, market efficiency is a very good approximation.

The real question is: How do you pick Warren Buffett? The way you pick him is after the fact, since he has done very well. Now, suppose I take 100,000 investors and say: Let’s let them run for 30 years and pick out the winner. Because you roll the dice so many times, even if none of them is a good or bad investor, many investors will do well and many will do poorly purely by chance. Statistically there is also going to be a big winner, but solely due to chance. In other words: There will be extremely good outcomes and extremely bad outcomes, but you just can’t tell who is successful because of luck and who because of skill.

This quotations resemble the distinction made by Friedrich Hayek between relative and absolute limits to explanation (The Sensory Order, 1952):

8.67. Apart from these practical limits to explanation, which we may hope continuously to push further back, there also exists, however, an absolute limit to what the human brain can ever accomplish by way of explanation -a limit which is determined by the nature of the instrument of explanation itself, and which is particularly relevant to any attempt  to explain particular mental processes.

8.68. If our account of the process of explanation is correct, it would appear that any apparatus or organism which is to perform such operations must possess certain properties determined by the properties of the events which it is to explain. If explanation involves that kind of joint classification of many elements which we have described as “model-building”, the relation between the explaining agent and the explained object must satisfy such formal relations as must exist between any apparatus of classification and the individual objects which it classifies (Cf. 5.77-5.91).

5.90. The model building by such an apparatus of classification simplifies the task and extends the scope of successful adaptation in two ways: it selects some elements from a complex environment as relevant for the prediction of events which are important for the persistence of the structure, and it treats them as instances of classes of events. But while in this way a model building apparatus  (and particularly one that can be constantly improved by learning) is of much greater efficiency than could be any more mechanical apparatus which contained, as it were, a few fixed models of typical situations, there will clearly still exist definite limits to the extent to which such a microcosm can contain an adequate reproduction of the significant factors of the macrocosm.

8.69. The proposition which we shall attempt to establish is that any apparatus of classification must possess a structure of a higher degree of complexity than is possessed by the objects which it classifies; and that, therefore, the capacity of any explaining agent must be limited to objects with a structure possessing a degree of complexity lower than its own. […]

Being confronted with an absolute limit to explanation does not mean that chaos lies outside those limits. Indeed, what we have beyond the scope of our models is a complex order -in this case, efficient markets. A kind of order whose “[…] existence need not manifest itself to our senses but may be based on purely abstract relations which we can only mentally reconstruct” (F. A. Hayek, “Law, Legislation, and Liberty”, Chapter II; 1973), and because of that its explanation finds not practical limits but absolute ones. For example, in this field, “passive investing” would be homologous to a law-abiding behaviour or to the moral saying “being honest is the best policy”. Of course, for such systems -economic, legal or moral- to evolve there have to be some “prices”, i.e.: people who trade in the short term or who perform innovative behaviours which establish a new legal precedent or a new habit.

But for this innovation to happen it is indispensable for the agents to count on a framework of stable regularities -usually called abstract or spontaneous orders- upon which they could draw their own “maps”, create new expectations, and coordinate their plans with other agents. That indicates that we have already spent enough ink writing about the economic way of looking at the law, and perhaps it is time to start pondering markets as complex normative systems.