Economic noise, or simply noise, describes a theory of pricing developed by Fischer Black. Black describes noise as the opposite of information: hype, inaccurate ideas, and inaccurate data. His theory states that noise is everywhere in the economy and we can rarely tell the difference between it and information.
Noise has two broad implications.
- It allows speculative trading to occur (see below).
- It is indicative of market inefficiency.
People trade speculatively because they disagree about the future, making different predictions about the fate of companies and commodity prices, among other economic variables. These disagreements stem from the fact that everyone interprets information or data differently and subjectively. But because of the complex nature of the world's markets, not all market data is "information." Much of the daily price fluctuation is due to random change rather than meaningful trends, creating the problem of discerning real information from noise. This problem is what drives trading in a market; if everyone knew all things, then no speculative trades would occur because it is a zero-sum gain. In real life, however, trades occur as a kind of bet on what is noise and what is information; generally the more skillful, and technologically advanced, "gambler" wins.
This trade takes place between what Black calls information traders and noise traders, where the former operates based on accurate information and the latter trades based on noise. Unfortunately, there is no way of precisely parsing the noise and information from a data stream or signal, so the so-called noise traders tend to think that they, in fact, trade on information that others in the market simply reject as noise. Thus, methods of parsing noise and information from a signal are becoming increasingly important in the market-place, especially as strategies used by high-tech alternative investment firms, such as some hedge funds.
A particular type of trader Black makes special mention of is the entrepreneur. Like the above-mentioned traders, entrepreneurs have theories about what will happen and what is happening. In this case, though, they have theories as to what people want. When they are correct, there is a little boom; I make what you want, you make what I want, we trade and we are happy.
But the world has noise and entrepreneurs make mistakes. They make things others don't want. Thus, they don't work as hard, money is wasted and the economy is harmed. When this happens on a massive scale, there is a bust.
Critics argue that this disobeys the law of large numbers; with so many entrepreneurs trying, the aggregate success rate will be constant. (This assumes that producers are more or less independent; critics say they are, proponents say they're more interconnected.)
Noise is everywhere and people make it all the time. Black argues that econometrics is filled with it in the forms of unobservables and mis-measurement. No matter how many variables one puts into a model, there are always more to add but can't (ones you can't observe) and the ones you have will always have error. This is how noise manifests in econometrics (as well as poor interpretation of regressions, such as assuming correlation means causation).
- Noise. Fischer Black. Journal of Finance, 1986.