Milton Friedman on the efficient market hypothesis

In the orgy of eulogization and evaluation that has followed the death of Milton Friedman, a couple of odd myths have been promulgated.

One is that his monetary theories have been discredited. What has been discredited is Friedman’s belief that monetary policy could be run on a purely automatic basis, by simply allowing the money supply to grow at a certain pace. It turns out the money supply is far too slippery a thing to measure accurately enough for such a policy. But Friedman’s main messages — that inflation is always and everywhere a monetary phenomenon, and that central banks should focus all their energies on keeping prices stable — have been accepted at the Federal Reserve and pretty much every other respectable central bank on the planet.

Another myth, central to a Michael Kinsley essay in Slate this week that I dissected in the Curious Capitalist today, is that Milton Friedman believed that financial markets were efficient. Shawn Tully at Fortune does a great imitation of Friedman saying something along the lines of, “Yes, over the long run, markets might be efficient, but in the short-term …”

I didn’t get anything quite like that out of Friedman when I interviewed him on the subject in 2004, but he did, as always, deliver an interesting quote. I had mentioned that Friedman’s friend and long-time intellectual ally George Stigler had told then-Chicago-grad-student Baruch Lev at a cocktail party in the 1960s that he didn’t believe in the efficient market hypothesis.  Friedman responded:

You don’t have to believe it. I don’t believe it. We all know the market is not efficient in a descriptive sense. But that doesn’t mean that the efficient market is not the best approximation if you don’t have anything else to use. …Warren Buffett proves that there’s not an efficient market, and yet Warren Buffett is what makes the market efficient, and both statements are right. If the market were 100% efficient, nobody could make any money making it efficient, and then it wouldn’t be efficient again. So in a way it’s self-contradictory to suppose that there really is an efficient market.

Friedman didn’t believe markets were perfect. He just thought that they were better, and more accommodating of human liberty, than government. He may have oversold that argument on occasion. But don’t go calling the man an efficient marketeer.

How electorates and markets change their minds

I spent election night 1994 shuttling between the Montgomery campaign headquarters of Jim Folsom Jr. and Fob James, the candidates for governor of Alabama that year. Incumbent Democrat Folsom was a decent if unimpressive man. Republican James, who had been the Democratic governor about a decade before, was a know-it-all-who-didn’t-really-know-anything jerk. James won, Folsom lost, and I was kind of sad about that.

Then I got in my car and began the drive back home to Birmingham. I switched the radio to AM to listen to election news, and began taking advantage of that wonderful property of AM in the middle of the night to listen to election news from all over the country. The story was similar on pretty every much station I tuned to. Democrats who had been in office for decades were being turned out everywhere.

My personal politics are all over the place, but I nonetheless found the news thrilling. The House of Representatives, in the hands of the same ossified party since the mid-1950s, had been given new bosses.

Last Tuesday night’s turnaround was less historic and dramatic, but I found it similarly exciting. I’m always very dubious of claims that election results represent “the will of the people,” given how conflicted and ill-defined and malleable that will tends to be. But every once in a while the electorate expresses in pretty clear terms its dissatisfaction with the way things are going. And therein lies the beauty of a functioning democracy — a nation can change course, can change its mind, without violence or other disruption.

Financial markets are capable of changing their minds, too. When they do it on a micro-level, differentiating between individual companies or securities (or even individual political candidates in something like the Iowa Electronic Markets), it’s a cleaner, more efficient process than an election. But when markets really need to change course, when investors’ expectations about the future are suddenly dashed in an across-the-board way (like in the U.S. in 1929-1931, or Asia in the late 1990s) the result can be a really big mess. There are a few things, it turns out, that politicians actually handle better than free markets do.