Efficiency and fragile speculative financial markets: against the Tobin tax and for a creditable market maker - Special Invited Issue: Money, Trust, Speculation and Social Justice - Part 3: Trust and Speculation

American Journal of Economics and Sociology, The, Oct, 1998 by Paul Davidson

In developing this noise traders argument, however, Stiglitz has cornered himself into a logical inconsistency that requires him to use a contradiction to try to extract himself. Implicit in Stiglitz's model is that there is something strange and different about financial markets vis-a-vis product markets. Stiglitz (1989, p. 102) accepts the argument that the imposition of a transaction tax in any product market will distort the Pareto-efficient price structure. Stiglitz argues that a similar tax in the financial markets, however, does not have such a deleterious propensity but rather "such a tax may be beneficial" (Stiglitz, 1989, p. 102). Because short-run speculation trading is attributed solely to action of fools (noise traders), it is said to interfere with the efficient capital allocation function of financial markets. The tax, by making it more costly for fools (as well as for all other mortals(14)) to engage in financial market activity therefore improves the efficiency of financial markets.

If financial markets are efficient and immutable market fundamentals are the determinants of the future returns, then those irrational agents who make persistent errors will either become extinct via some Darwinian economic process, or they will survive only by learning how not to make persistent mistakes.(15) Nevertheless, the pragmatist Stiglitz recognizes that after several centuries of significant volume of daily trades on financial markets - and daily trading volume has increased dramatically in the last two decades - speculation continues to exist and even increase. But how can persistently mistaken noise traders continue to exist in an efficient market system where rational traders can feed off these fools?

To resolve this dilemma of the centuries old existence of speculation in financial markets, Stiglitz appeals to authority - the ultimate free market authority and successful circus impresario - P. T. Barnum. Stiglitz (1989, p. 106) misquotes Barnum's dictum "There's a sucker born every minute"(16) as "There is a fool born every moment" and even incorrectly attributes this homily to one G. T. Barnum. Nevertheless, Stiglitz's appeal to Barnum's authority implies that society continues to produce, even in the long run, fools who irrationally believe they can beat the market.

Faced with the contradiction between the implications of the efficient market hypothesis, where those who make persistent errors are eradicated, and his attribution of volatile financial markets to the persistent existence of foolish market participants, Stiglitz has done the only "rational" thing that a potential Nobel prize recipient can do. He ignores this logical inconsistency. Instead Stiglitz (1989, p. 106) buttresses his argument that "irrationality is pervasive" by appealing to the facts that this ubiquitous, persistent irrationality exists even among Stiglitz's brightest economics students.(17) If students at our most prestigious universities are such irrational dolts, then what can one expect of the average financial market participant, bereft of exposure to any efficient market analysis?