Efficient Markets - Not So Much

The theory of efficient markets has taken a beating in the latest economic debacle. Joe Nocera, writing in the New York Times, takes a look at some recent abuse the theory has taken.

You know what the efficient market hypothesis is, don’t you? It’s a theory that grew out of the University of Chicago’s finance department, and long held sway in academic circles, that the stock market can’t be beaten on any consistent basis because all available information is already built into stock prices. The stock market, in other words, is rational.

In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.

The efficient market theory (EMT) has its origins in Adam Smith's "invisible hand" but it got its modern juice from the discovery that it allows lots of neat mathematical models to be built. It's not just supposed to apply to stock prices, of course, but to prices of housing, oil, financial securities and anything else traded on a large scale. The grand generalizations of science are what give it its immense power, and when a science gets one, it can consider itself to have arrived. The principle of conservation of energy is such a principle for physics, and natural selection serves the same role in biology. Geology has its own version in sea floor spreading and continental drift. With the EMT, economists, or at least the Chicago school, thought they had their own.

The universe is stingy with its secrets, though, and grand generalizations need a lot of testing before they can be considered validated. The efficient market must now go the way phlogiston, N-Rays and Maxwell's ether. The EMT managed to do a lot of damage in its heyday, and the way it did its damage was due to the fact that people in positions of power believed it. Most especially, Alan Greenspan, the Republican party, and Bush's last bozo to head the SEC believed it, and believing it they decided that regulation and intervention were unnecessary and counterproductive, and consequently neglected their responsibilities. Nocera quotes Jeremy Grantham, a prominent critic of the EFT.

The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”

Part of the problem is built into one of the cardinal assumptions of the EMT: that the market has all the available information. The construction of hyper-complex financial products that essentially nobody understood invalidated this. Ratings agency guys looked at Maximum Entropy models of securities performance and saw, as one put it, lots of Greek letters. Some people did understand that mortgages were being given to people very unlike historical borrowers and who were very unlikely to be able to pay if the housing market halted its unprecedented boom. A few of them were wise investors who steered clear and the rest were salesmen hoping to sell to some other sucker before the world noticed that the emperor was unclothed. The fact that the SEC chaiman and the legendary Alan Greenspan sat idly by did a lot to convice the suckers that the game was on the up and up, but it wasn't. I doubt that fraud will be proven against those who sold the garbage - too many of them bought their own swindle, but fraud it was.

Lack of information played its role, but human nature had its own part as well. Humans are not the long term profit maximizing machines imagined by EMT kool-aid vendors, but creatures designed to compete and survive as a predator in a world of predators, the most dangerous of which were our fellow humans. The predator - think Bernie Madoff - is not thinking about long term profit maximization, he's thinking about his next meal.

The thing is, markets usually really are sort of efficient - more efficient than central planners for most things, but confusing this useful rule of thumb with an inviolable principle led to the greatest financial debacle in modern history.

So let's not bury the notion of the efficient market, let's just put it to bed for a bit. Just in case it might take on airs again, we might consider putting a stake through its heart, however.