Financial markets involve various individuals engaged in the buying and selling of financial assets. Most of the time, the actions of the market participants are driven by popular ideas. If the market participants were to follow a theory that corresponds to reality, then the market will reflect this. Conversely, if the decisions taken by the market participants are based on assumptions that are detached from reality, then the direction of the market is likely to follow.
According to Milton Friedman,
The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.
Hence, according to Friedman, since it is not possible to establish “how things really work,” then anything goes, as long as the theory could generate accurate forecasts. This means that what matters is not trying to understand the nature of things (i.e., to ascertain the economic fundamentals) but to have a theory that generates accurate predictions. But is forecasting capability a valid criterion for accepting a theory?
For instance, all other things being equal, an increase in the demand for bread will increase its price. This conclusion is true, and not tentative. Will the price of bread go up tomorrow, or sometime in the future? This cannot be established by the theory of supply and demand. Should we then dismiss this theory as useless because it cannot forecast the future price of bread?
The criteria for selecting a theory should not be its predictive ability but whether the theory is logically valid and corresponds to reality. In Philosophical Origins of Austrian Economics, David Gordon writes that Bohm-Bawerk maintained that concepts employed in economics must be traced to their ultimate source. If one cannot trace it, the concept should be rejected as meaningless.
As an example, the Efficient Market Hypothesis (EMH) also dismisses fundamental analysis, arguing that the market adjusts so quickly to information that it is futile paying attention to the fundamental analysis. Whatever information this analysis will reveal is already contained in asset prices. It follows that there is no point in paying attention to the fundamental analysis. A simple policy of random buying and holding will do.
Now, according to the EMH, past information is already in the market and does not have an effect on the future. According to Hans Hoppe, it is the past knowledge of individuals that shapes and constrains individuals’ future values and knowledge, thereby influencing future actions. If it were otherwise and the past didn’t have any effect on the future, a world of chaos would exist where the accumulation of knowledge would not be undertaken and economic advancement could not take place.
It is hard to imagine that the effect of a particular cause which begins with a few individuals and then spreads over time across many individuals can be assessed and understood instantaneously, as suggested by the EMH. For this to be so it would mean that market participants can immediately assess future consumers’ responses and counter-responses to a given cause. This, of course, must mean that market participants not only know consumers’ preferences but also know how these preferences might change. However, consumer preferences cannot be revealed before consumers have acted.
Do We Know Something About Ourselves?
Contrary to popular thinking, economics is not about gross domestic product (GDP), the consumer pr
ice index (CPI), or other economic indicators as such, but about conscious purposeful human action. That human beings act, consciously and purposefully, cannot be refuted. Anyone that tries to falsify human action contradicts himself.
Ludwig von Mises—the originator of this approach—called it praxeology. Using the knowledge that human beings act, Mises was able to derive the entire body of economics. For example, this theory can assist in refuting the popular view that the key driver of the economy is demand.
In the market economy, wealth-generators do not produce everything for their own consumption. Part of their production is used to exchange for the produce of other producers. Hence, in the market economy, production necessarily precedes consumption. This means that something is exchanged for something else because of different subjective valuations. This also means that an increase in the production of goods and services enables an increase in the demand for goods and services.
Demand is constrained by an individual’s ability to produce goods. The more goods that an individual can produce that others value, the more goods he can demand. Furthermore, what enables the expansion of production is expansion of production, saving, and capital investment. It follows, then, that the key driver of the economy is not demand but production and saving.
Focus on the Essence, Not Economic Indicators
Most financial market participants respond to a multitude of economic data. Thus, if an economic indicator, such as GDP, displays strengthening, then the market participants tend to push the stock market higher. Or, if price inflation moves up this is perceived as bad news for the financial markets, because it is believed that the central bank is likely to tighten its interest rate stance.
Rather than following many economic indicators it is better to focus on the essential factors that drive the economy—production, saving, and capital investment. Private saving not only lowers the interest rate but also supports individuals in the various stages of production.
For instance, according to a logically-based analysis, an analyst has concluded that voluntary saving is weak. Consequently, this would imply that the stock market should be trending down. However, this conclusion runs contrary to the stock market direction, which is trending upward. Does it then imply that the analyst should abandon logical economic analysis and follow the market?
If one has soundly established that savings are weak, then one should stick to this view. At least one can be aware of a possible economic weakness ahead and the consequent implications on the financial markets.
An investor could still consider various short-term strategies that correspond to the view of the majority of the market participants. As time goes by, the investor could start exercising a greater caution on account of the likely implications of the decline in savings, production, and capital investment on the financial markets.
Expectations in Free versus Hampered Markets
In a free market economy, whenever individuals form expectations that run contrary to reality, this sets in place incentives for a renewed evaluation and different actions. In a free market, reality asserts its dominance rather quickly.
However, this is not so in a distorted market economy. By enforcing their policies, governments and central banks can set a platform for a prolonged deviation of expectations from reality. Notwithstanding, neither the government nor the central bank can indefinitely defy reality.
Whenever market conditions deviate from actions based on sound economic theory, reality will eventually reassert itself.
Conclusion
Contrary to certain popular views, the market does not have superior knowledge. If the majority of the market participants follow mistaken ideas, the market will display these ideas for a certain period of time until reality takes over again.
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