A Modest Proposal for the Prevention of Stock Price Bubbles

A modest proposal to reduce the probability of future stock bubbles.

This is inspired by commenter sociologicalimagination on this post by Tyler Cowen:

mid-term question: how many NBER papers on the efficient market hypothesis could I print out every week (with my stimulus money) that have been proven utterly false in the past 6 months?

The efficient-market hypothesis comes in three flavors: strong, semi-strong, and weak.  Strong says that prices reflect all information, public and private, so no one can earn “excess returns” (better-than-average returns gained by crafty trading).  Semi-strong says that prices adjust rapidly and completely to newly-available public information, so no one can earn excess returns by analyzing public information or past prices.  Weak says only that future prices cannot be predicted from past prices.

I take sociologicalimagination’s comment to mean that the strong form is certainly false.  A lot of firms took on risk that very few recognized or understood.  What could protect us from future emperor-has-no-clothes moments with the likes of Bear, Lehman, AIG, and Countrywide?

We need a better way to let the people inside those firms let us know when something bad (or good) is happening.  Let’s legalize insider trading so they can send us price signals.  And to be safe, let’s let them short their employers’ stocks too.  That would get us closer to an efficient market.

I don’t know whether insiders could have sent a strong enough signal to head off the crashes of 2008.  (If they did, we wouldn’t know we had dodged a bullet.)  Insiders can herd just like independent investors.  Maybe the risks were too systemic, and simply not visible from the perspective of any one firm.  Some insiders will probably make unfair profits by selling ahead of bad news.  And we’ll have to appologize to Martha Stewart.  But think of how much we’re going to pay for extra enforcement over the next few years.  Wouldn’t it be better to give millions of dollars over years to insiders, in exchange for braking the market, rather than losing hundreds of billions in destroyed market value and future taxation?

(Brief sojourn into non-Iraq economics blogging.  As always, not the opinion of the U.S. Dept. of State or any other entity.  Semi-regular Iraq blogging to return soon, I hope.)


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