Barack Obama led the popular vote by 7% on November 4. A hefty margin for sure in a presidential race, but nothing at all compared to the electoral vote turnout: a good 37% margin. And except with rare occasions where the granularity of the state system falls on the other side of a close race (i.e., the 2000 election), electoral vote margins are almost always starkly amplified over the popular vote margin. Why is this, and what does it tell us about markets?

Earlier I wrote about Efficient Market Theory and its shortcomings in failing to describe overweighted information in stock prices. The example used there was horse betting, but the electoral college is also a great, and much more accessible example, whose design highlights the way information may become overweighted.

The key to this overweightedness hinges on the fact that the popular vote is not a probability. A 53%-46% spread does not mean that John McCain has a 46% chance of winning. As a matter of fact, if we are to look at the electoral college as a measure of the probability of either candidate winning, John McCain was severely overrepresented in the college with respect to the poll numbers. If supporters of McCain and Obama were homogeneously distributed throughout the country, even a 1% edge in the popular vote would give Obama the entire college. In a winner-take-all system, a few points (the margin of error) away from 50% in the polls and probability of a win drops precipitously.

The exact same effect can be observed in the House and Senate with regard to party control and vote outcomes. Each additional Democratic congressman shifts the aggregate passed legislature 0.45% in the House and 0.63% in the Senate in the liberal direction, according to one measure of such things (Stimson, 2008) - until the halfway point. The single congressman that gives the Democrats control of Congress carries with him a 48.9% shift in policy in the House, and a 34.8% shift in the Senate (conversely, the same is true for Republican control in the opposite direction). Legislation, like the presidency, is winner-take-all, and the only probability that matters is at the margin when the proportion is 50%.

Predictions in the stock market are similarly boolean, in that investors decide whether a particular stock will return a profit or a loss over the course of their investment. They are not interested in how it meanders up and down along the way except insofar as that represents a trend upwards or downwards - at least no more than the popular vote matters to the election. A stock price carries no more information about the future performance of that stock than the electoral college contains about the popular vote: it too is not a probability. And also like the electoral college, these predictions influence the outcome. Buying a stock on the expectation of a positive return will cause its price to rise, just as casting a vote for a candidate will increase his popular vote proportion. Finally, a stock in price/earnings equilibrium (that is, when all information is present and weighted optimally) can be thought of as at the 50% margin with regard to gains vs. losses, in that, according to Efficient Market Theory, its price is equally likely to go up or down depending on news - basically, any news while the stock is at equilibrium is that last senator that pushes the stock into positive or negative territory.

Stock movement is thus decided at the margin, where the expectation boolean is determined. If enough stock is sold at once in a particular company because of a bad piece of news, the stock price drops and the boolean turns negative, which tells people that the expected earnings no longer justify the (original) price - it will generate a loss with respect to the overall market if bought at the current price. But this triggers more people sell while they have the chance, and before long, the negative data has driven the price down to where it is justified by the new expected earnings. Just like the electoral college, a company need only move a few points down from price/earnings equilibrium to initiate a precipitous drop in stock price.

No, seriously. As wonderful as civic duty is, there’s also civic responsibility. If you plan on voting in November, answer the following questions out loud before reading on:

Who are the two major party candidates?

Who are you voting for this November?

Why?

If you could not answer the third question, don’t vote. If your answer for the third question was “I can relate to him” or “the other guy’s eletist”, do not vote. If your answer used the words “Hope” or “Change” as reasons, do not vote. If your answer included the concepts of “national hero”, “black man”, “female vice president”, or “Mulsim”, do not vote. None of these are good reasons to vote for anyone, and that last one is flat out false.

If you made it past this first part, congratulations. You’re not an idiot. Unfortunately even good reasons can be wrong reasons. Now answer the following questions out loud:

Of the two major candidates, which one is typically considered Liberal and which one is typically considered Conservative?

What does it mean to be Liberal or Conservative in this context?

If your answer to the first question was anything but “McCain is typically considered conservative and Obama is typically considered liberal” (possible exception granted for an ideological disputation about whether conservative really applies to either one), do not vote. As imperfect as these labels are, they provide at least a rough marker for the candidates’ position on issues. Though it is beyond the scope of this article to verify the answer to the second question, if you couldn’t answer it, or if your answer didn’t include anything about the economy or government spending (I’ll give a dubious pass to a moral issues explanation too), don’t vote. Without the answer to that second question, you’ll have no idea about the framework that the candidates use to make decisions.

If you didn’t make it past the two sets of questions, you’re in good company. According to surveys, the majority of Americans wouldn’t. Their votes amount to nothing more than electoral static that rewards dubious campaign promises and sensationalism. A nice slogan and a snazzy graphic designer do not make a good president. A folksy, charming demeanor does not make a good president. Issues make or break a president, and if you don’t contribute to an emphasis on issues in the election, you’re contributing to media sensationalism.

But, no one wants to admit being a part of the problem, and not voting would be an admission of that. Luckily, you don’t have to be! If you failed either of the tests, take a moment first to decide what you believe and why. Not on a whim - do research. Everyone likes cutting taxes, but what are the cons to that? Universal healthcare is a nice and desirable thing, but what would be the drawbacks to that? After that (not before), take a look at the position pages of both McCain and Obama, and see who lines up better.

Keep in mind that voter registration drives are most often set up by candidates who want you to vote for them. They’d rather you cast an uninformed vote for them rather than no vote at all. But for the country at large, a non-vote is far preferable to an uninformed vote.

But an informed vote still trumps all. If you passed both sets of questions, or are making amends by researching the issues, I encourage you with the same force as any voter registrar, vote! And encourage others to vote as well - on the condition that they know what they’re voting for.

the efficient-market hypothesis asserts that [prices in] financial markets already reflect all known information. It further states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.
-Wikipedia, Efficient Market Hypothesis

Efficient Market Theory holds that because all investors are rational, this requires that they use all the information they possess in making purchases or trades. Thus, if information exists in the market, it will be reflected in the price. A corollary of this is that only unexpected information can bring about true changes in the market: by the time an expected change happens, the market will have adjusted. This can be seen every time the Fed changes interest rates. Most investors have a reasonable expectation as to the action they will take, and so adjust their behavior to compensate well beforehand, making the effect of the rate change itself virtually nil.

Certain behaviors follow from this theory: first, that since you can’t outperform the market in the long term, buying an index fund and holding it forever is the best investment one can make in the long term. By pegging your earnings to the average growth of the stock market (the S&P 500, for example), one doesn’t incur fees by trading around, and trading around wouldn’t do much long term good anyway except as a function of luck, meaning you’re just as good holding onto it as putting it somewhere else. You cease to collect information because you trust the information that the stock price gives you

There is strong evidence that certain variations of the theory very closely correspond to actual markets in the US and UK. On the other hand, there are certain investors who can consistently outperform the market:

These investors’ strategies are to a large extent based on identifying markets where prices do not accurately reflect the available information, in direct contradiction to the efficient-market hypothesis which explicitly implies that no such opportunities exist.

If all available information is contained in a stock price (and it is), then how do people like Warren Buffet and George Soros exist and consistently profit from the stock market?

The answer lies in trust, and weighted information. EMH requires that all investors use all their knowledge, but it does not require that they know everything, nor that different investors know the same things. Consider a horse race: every better knows the same information about the horses, and the normal distribution of decisions based on risk is perfectly adhered to. Let’s say the odds on one spectacular horse are 70-30 in its favor based on the collective and informed bets of everyone currently there.

Now imagine the crowd doubles due to an influx of newbies. Each one sees the odds on the screen, trusts the wisdom of the crowd before them, and bets on this horse. Suddenly the odds are 85-15 in its favor. Did anything in the horse inherently change? No. Was any information lost or changed in the marketplace? No; the information was simply disproportionately weighted. Suddenly the underdog horse is a much better buy - you get an 85% return (not counting what the establishment skims off the top) for what is still essentially a 70% risk. Nevertheless, you would not know this from trusting the board.

Similarly in stock markets, people have a propensity to buy stocks following someone else’s lead. If Soros picks up a lot of stock in a particular company, people trust that and buy stock themselves, giving himself a short-term boost in the manner of a self-fulfilling prophecy. If Buffet sees this behavior and owns some of that stock himself, he can note that Soros’ information is overweighted in the market, causing a jump in stock price despite no underlying change in the stock’s business itself. By riding this wave and selling at the peak of it, watching the behavior of investors deemed trustworthy (especially big ones like Soros and Buffet) and bidding opposite to them (after a short delay to allow their effects to be felt first - for example, buying a stock newly cheapened after Buffet and followers unload it) is a way to, counter to strict EMH, consistently outperform the market.

In the case of the horse betting example, the reaction of the informed would be quick enough that they would trade their bets and shortly balance out the discrepancy, making the market effectively efficient for all but the quickest and most observant. But that requires that there be quick and observant people that benefit from this. Furthermore, the ability of one in a stock market to reap the returns on his investment by selling at any point he chooses makes it possible for the quick and observant to ride these waves, rather than waiting for the final result and payout, by which time the market will have corrected itself. If there were a substantial secondary market for bets - meaning bets could be bought and sold from peers based on the current odds, with the expectation of a payout on the order of those current odds before they level out - then one could conceivably make a consistent profit on the horse racing tracks just as in the markets by riding waves of misweighted information.

The catch is, of course, that if everyone catches onto this technique, there is no more trust as a heuristic - nobody follows anyone else’s stock picks - so all information is weighted equally, and EMH really holds true in its purest form. Conversely if everyone trusted the market and resigned themselves to matching its growth by investing in index funds, the market wouldn’t have any information to reflect. Stock prices are set by the people who trade, which according to EMH is suboptimal behavior. This is the irony of EMH: it doesn’t hold true unless no one believes in it - and acceptance of it invalidates it.

Change is the official buzzword of the 2008 Presidential Election. Everyone likes to throw it around: Obama started the craze with a series of high-minded-sounding but empty slogans, and now the word has even been co-opted by John McCain, seeking to recover his maverick image. But what exactly are we changing from? Partisan politics and rancor? I don’t think even the most ardent Obama supporter would be able to back up that claim. Obama likes to make reference to “the failed economic policies of George W. Bush”. But what exactly would be different?

As it turns out, neither party is willing to question the underlying economic assumptions that are leading us into recession. Ever since Nixon famously proclaimed “We’re all Keynesians now”, the party system in America has changed from being a competition between fiscal responsibility and fiscal irresponsibility, to a contest of how to be the best and most effectively fiscally irresponsible.

Roosevelt as the first modern Democrat brought into the mainstream the idea of deficit spending to stimulate the economy and smoothen the business cycles. While this may or may not be an advantageous strategy when coupled with surplus savings in times of prosperity, this has (with one exception) never been the case, and is thus an unequivocally bad strategy with the end result of accruing an infinite national debt, the full faith and credit of whose government eventually collapses.

We can see the beginnings of this happening now: the higher the national debt grows, the greater the risk of default on payment. This is exactly the mechanism behind rising interest rates for bonds, setting the bar higher for other, relatively riskier private bonds, and choking out private investment. More immediately and tangibly, there was a deliberate and vocal lack of faith in the full faith and credit of the United States government when it tried to reassure investors that it would stand behind Fannie Mae and Freddie Mac and not let them fail. People didn’t buy it, continuing to sell stock until they collapsed, requiring the government to take on even more debt on their behalf.

Democratic administrations typically whittle away surpluses by giant spending programs - hence a record of higher economic growth under Democratic administrations. But these optimistic numbers belie the underlying truth that government spending is only a temporary stimulus, and can do nothing to effect long term economic growth or potential. What goes up must come down.

Republican administrations since Reagan, who instituted the largest tax cut in history, accomplish exactly the same end by different means. By cutting taxes rather than increasing spending, Republicans hope to put money in the hands of those who will invest it and build productivity, which does have an effect on long-term economic growth and potential. However, they do this at the government’s expense, which because of the aforementioned choking out effect cancels out any investment boost, making their endeavor perhaps more sensible, but even less effective than Democratic strategies.

Thusfar it looks like neither candidate has the willpower, or even inclination, to change this cycle. They both throw around terms like “fiscal responsibility”, or even occasionally make reference to balancing the budget, but never as more than secondary items, and continue to think in terms of economic stimulus. Secondary campaign promises never make it past a hostile Congress - and believe me, if history is any indication, Congress will be hostile. John McCain may pledge to end pork barrel spending, but he’s pledged even more strongly to cut taxes. Obama may believe in “trusting the market but correcting its excesses” (whether that even makes sense is a discussion for another day) and not leaving a bill for our children to foot, but in the end, he’s more interested in welfare and stimuli than real fiscal responsibility.

What’s the ideal way for a government to handle the question of money? There’s a lot of discussion in economic circles as to whether a gold standard or fiat currency, or even freebanking, is the ideal way to go to foster the most stable or most productive economy. Unfortunately, each system of currency we’ve tried (and even those we haven’t) has fundamental flaws making them unsuitable for a post-industrial economy.

To start from the beginning, Bartering is inefficient. I don’t know of many people clamoring for a return to the barter system, so I won’t spend much time on it, but the system limits transactions to times and places where one has on his person a suitable exchange. There are good reasons money was developed, and a barter system is totally unsuitable for an industrial economy.

The Gold Standard - or a fixed currency - was tried for a long time - most of human history in fact - and even still has its proponents. People agreed gold was valuable despite its inherent lack of value, and since it was inconvenient to carry gold everywhere, eventually paper currency was developed to stand in its place. The reason the gold standard worked for so long is that for most of human history, there was virtually no economic growth or increase in productivity. Feudalism was in place for thousands of years in many places, and even the rise of the merchant class and overseas trade, though enabling cheaper transport of goods, did not significantly increase productivity. The gold standard was stable because relative to gold, whose supply did not grow, the overall economy’s growth was negligible.

But then came the industrial revolution. Suddenly workers became vastly more productive, and new wealth was created where it did not previously exist - something heretofore thought impossible under Mercantilist thought. Real wealth was growing at a rate unprecedented in human history, and the money system could not cope. Since the amount of gold does not increase, and a dollar on the gold standard is worth a fixed amount of gold, the wealth increase relative to gold can only drive the value of the dollar upwards over time. This sounds like a good thing to ears accustomed to inflation-fighting rhetoric, but what this does is it creates a disequilibrium between the value of currency and the value of assets - deflating the dollar and driving prices down. Expected deflation creates an incentive to sell assets and hoard currency, knowing that it will be more valuable down the road. This disequilibrium was the driving force behind the first business cycles in human history, and eventually of the Great Depression: companies hoarded money even as productivity soared, keeping money out of the hands of wage earners, eventually leading to a classic production glut.

So we eventually end up going off the gold standard. But Fiat Currency has the opposite problem. With no automatic mechanism in place to regulate its value, the government steps in to pull strings - in almost every case leaning towards inflation. The rise in the money supply exceeds the rise in productivity - which gives the illusion of an economy growing faster than it actually is. This again creates a disequilibrium between currency and goods, giving incentives to value goods higher than an equivalent amount of money on the expectation that the price will rise. Though government tinkering has in many cases been able to smooth out the business cycles inherent in a deflationary economy, there are still serious consequences to an inflationary model as well. The incentive to hoard goods over currency is an incentive to go into debt to buy goods, which we see happening not only around the US, but in the government as well: national debt continues to soar, even as our economy continues to lag. The housing crisis that caused the current lag was in fact caused by this disequilibrium: while the 1929 crash happened because currency was overvalued (because of expectations that it would continue to rise in value), the 2008 housing crisis happened because houses were overvalued relative to cash (again because of unfounded expectations that prices could only rise).

There are obviously dangers in both an inflationary and deflationary economy. But what if the value of currency could be driven by competition and the market? On its surface, Freebanking would seem to solve this problem: good currencies succeed, bad ones fail, and the good ones keep each other in check valuewise, so that none of them falls into inflation or deflation. However, this presents its own, more mundane problems: the consumer credit card market is a perfect parallel. Proprietors only want to equip themselves for a few cards (currencies). Basically anyone will take Visa and Mastercard. Fewer take Discover and American Express, and beyond that good luck getting anything with it. Same thing with currencies: once one or two do well enough for a long enough time, they will entrench themselves in the same way that Visa and Mastercard have, making other currencies drop in relative value simply because they aren’t accepted consistently - perhaps later being bought out, or merging to compete. And once we have one or two major currencies, competition is lost along with all the benefits of free-banking, and we’re back to the former problems, depending on the type of the dominant currency.

Though many would say that we’ve done well enough on the gold standard or fiat currency for long enough, both of these are unsustainable. Just as earthquakes can be rated based on how often they occur (i.e., a once-in-200-years quake), so can economic booms and busts. The industrial revolution was recent enough that we don’t know how often they come, but they come, and if Russia is any indication, the Great Depression is not the worst the US will ever wear. The question is not if, but when, as long as we are living with a disequilibrium between currency and goods - if there is inflation or deflation.

The payoff of a stable currency would be enormous: booms and busts would cease. Safe in the knowledge that the value of their goods and currency will not shift around relative to each other, confidence will skyrocket, opening up all kinds of new capital for investment, even enough for a new prosperity of the magnitude of the industrial revolution. The question is, how do we do it? Is there a particular good that is consistently well-indicative of economic growth to which we could peg the currency? Could it be pegged to economic growth estimates or forecasts?

Bounce some ideas off me; I’m open to them and still searching for a reasonable solution.