Tuesday, October 15, 2013
In praise of the efficient market hypothesis
Posted by David Smith at 09:00 AM
Category: Thoughts and responses

This is from my book The Age of Instability, written at a time when the efficient market hypothesis was being blamed for pretty much everything.

If economic models failed during the crisis, so according to some of the most vocal critics, did something else central to the macroeconomic and regulatory framework in the period leading up to the crisis. This was the efficient market hypothesis, versions of which had been around for most of the 20th century but which was best defined by Professor Eugene Fama of Chicago University, in a seminal 1970 article, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, published in the Journal of Finance. Fama’s central concept was very simple, which was that financial markets are efficient in the sense that the price of, say, a company’s stock, reflects all the known information at the time.

There were, according to Fama, various degrees of ‘strength’ with which the proposition could be stated. In the weakest version, the current price only refelcted past information on prices, in the ‘semi-strong’ version – which is what most people have chosen to use – it reflects all publicly available information affecting the company, while in the strongest version, the price reflected all publicly and privately available information. This simple idea was, in its time, revolutionary and drew enormous praise. ‘There is no other proposition in economics which has more solid empirical evidence supporting it than the efficient market hypothesis,’ said the Harvard financial economist Michael Jensen in 1978. It implied, most obviously, that it was hard for investors to claim to consistently beat the market. Today’s price reflected all known information today. Tomorrow’s price would reflect the state of information tomorrow, which might be different but which nobody not in possession of that information in advance could hope to anticipate. Prices followed what Fama described as a ‘random walk’.

It may have been simple but, as the crisis of 2007-9 unwound, it also appeared that the efficient market hypothesis did enormous damage. Lord Turner, chairman of Britain’s Financial Services Authority, carried out a review of the circumstances leading up to the crisis, which was published in March 2009. It poured a large dollop of scepticism on the efficient market hypothesis, effectively blaming it for some of the problems. ‘The predominant assumption behind financial market regulation – in the US, the UK and increasingly across the world – has been that financial markets are capable of being both efficient and rational and that a key goal of financial market regulation is to remove the impediments which might produce inefficient and illiquid markets,’ Turner wrote. ‘A large body of theoretical and empirical work has been devoted to proving that share prices in well regulated liquid markets, follow ‘random walks’, and that it is therefore impossible to make money on the basis of the knowledge of past patterns of price movement, with prices instead changing as new information becomes available and is assessed by a wide range of independently acting market participants… In the face of the worst financial crisis for a century, however, the assumptions of efficient market theory have been subject to increasingly effective criticism, drawing on both theoretical and empirical arguments … Given this theory and evidence, a reasonable judgement is that policymakers have to recognise that all liquid traded markets are capable of acting irrationally, and can be susceptible to self-reinforcing herd and momentum effects.’

The efficient market hypothesis did not just lead regulators astray. Despite a growing body of doubt ‘most of the economics profession continued to swallow the efficient market hypothesis hook, line and sinker,’ wrote Buiterxx. It was embodied in their economic models and it formed the basis for the sophisticated mathematical models that underpinned the financial engineering that clever people undertook on Wall Street, London and elsewhere, creating the instruments that proved to be so dangerous and destructive. ‘It led bankers into blind faith in their mathematical forecasting models,’ wrote Skidelsky. ‘It led governments and regulators to discount the possibility that financial markets could implode. It led to what Alan Greenspan called (after he had stepped down as chairman of the US Federal Reserve) the “underpricing of risk worldwide”.’

On the face of it, Fama’s theory was responsible, nearly 40 years on, for untold economic and financial damage. The implications of this failure were profound. Instead of assuming the markets were always right, it would be safer to assume they were usually wrong. This is turn would open the floodgates to opponents of markets in other areas. The ‘market solution’, whether it be to providing a better deal for consumers, delivering public services in a more efficient way, or any number of other areas in which markets could be extended, could now be called into serious question. It had failed in the financial markets and was probably failing everywhere else. Or probably not. The efficient market hypothesis suffered from excessive interpretation by some of those who seized upon it but its most important element looks to have survived intact. This is that the price of a stock or security on a given day is the best distillation of all the available information relevant to it. That does not exclude what critics of the hypothesis describe as ‘momentum’, or ‘herd’ effects. The knowledge that other investors are buying the stock or security and intend to buy more is part of the available information that helps set the price. The hypothesis does not say anything about what the price will be tomorrow, or even in a few minutes’ time. The information affecting the price can change quickly and drastically. The most important implication of the efficient market hypothesis, moreover, was that professionals could not legitimately claim to consistently beat the markets.

There is no such thing as a free lunch. Long-Term Capital Management (LTCM) came unstuck in 1998, as described in Chapter Two, for believing that it could profitably trade market inefficiencies on the assumption that there would always be a return to equilibrium. Those claiming consistently above-normal returns, whether they were fraudsters such as Bernie Madoff or investment banks claiming to have uncovered news ways of generating high-yielding returns in a low-yield world. The efficient market hypothesis should have told regulators there was something suspicious about this. If they were hung up on an extreme, unrealistic and wrong version of the hypothesis – the markets are always right, both now and in what they imply for the future – more fool them. If Wall Street’s ricket scientists fell into a similar trap, then they were a lot less intelligent than they thought they were. The efficient market hypothesis, interpreted correctly, was unfairly castigated.