Home > Economics - General > Refuted economic doctrines #1: The efficient markets hypothesis

Refuted economic doctrines #1: The efficient markets hypothesis

January 2nd, 2009

I’m starting my long-promised series of posts on economic doctrines and policy proposals that have been refuted or rendered obsolete by the financial crisis. There will be a bit of repetition of material I’ve already posted and I’ll probably edit the posts in response to points raised in discussion.

Number One on the list is a topic I’ve covered plenty of times before (in fact, I was writing about it fifteen years ago

), the efficient (financial) markets hypothesis. It’s going first because it is really the central microeconomic issue in a wide range of policy debates that will (I hope) be covered later in this series. Broadly speaking, the efficient markets hypothesis says that the prices generated by financial markets represent the best possible estimate of the values of the underlying assets.

The hypothesis comes in three forms.

The weak version (which stands up well, though not perfectly, to empirical testing) says that it is impossible to predict future movements in asset prices on the basis of past movements, in the manner supposedly done by sharemarket chartists. While most of what is described by chartists as ‘technical analysis’ is mere mumbo-jumbo, there is some evidence of longer-term reversion to mean values that may violate the weak form of the EMH.

The strong version, which gained some credence during the financial bubble era says that asset prices represent the best possible estimate taking account of all information, both public and private. It was this claim that lay behind the proposal for ‘terrorism futures’ put forward, and quickly abandoned a couple of years ago. It seems unlikely that strong-form EMH is going to be taken seriously in the foreseeable future, given the magnitude of asset pricing failures revealed by the crisis.

For most policy issues, the important issue is the “semi-strong” version which says that asset prices are at least as good as any estimate that can be made on the basis of publicly available information. It follows, in the absence of distorting taxes or other market failures that the best way to allocate scarce capital and other resources is to seek to maximise the market value of the associated assets. Another way of presenting the semi-strong EMH is to say whether or not markets are perfectly efficient, they’re better than any other possible capital allocation method, or at least, better than any practically feasible alternative.

The hypothesis can be tested in various ways. First, it is possible to undertake econometric tests of its predictions. Most obviously, the weak form of the hypothesis precludes the existence of predictable patterns in asset prices (unless predictability is so low that transactions costs exceed the profits that could be gained by trading on them). This test is generally passed. On the other hand, a number of studies have suggested that the volatility of asset prices is greater than is predicted by semi-strong and strong forms of the hypothesis (note to readers – can anyone recommend a good literature survey on this point).

While econometric tests can be given a rigorous justification, they are rarely conclusive, since it is usually possible to get somewhat different results with a different specification or a different data set. Most people are more likely to form their views on the EMH on the basis of beliefs about the presence or absence of ‘bubbles’ in asset prices, that is, periods in which prices move steadily further and further away from underlying values. For those who still believed the EMH, the recent crisis should have shaken their faith greatly. But, although the consequences were less severe, the dotcom bubble of the late 1990s was, to my mind, are more clear-cut and convincing example of an asset price bubble. Anyone could see, and many said, that this was a bubble, but those, like George Soros, who tried to profit by shortselling lost their money when the bubble lasted longer than expected (perhaps long-dated put options would have provided a safer way to bet on an eventual bursting of the bubble, but Soros didn’t try this, and neither did I.)

More important than asset markets themselves is their role in the allocation of investment. As Keynes said in his General Theory of Employment Interest and Money, this job is unlikely to be well done when it is a by-product of the activities of a casino. So, if the superficial resemblance of asset markets to gigantic casinos reflects reality, we would expect to see distortions in patterns of savings and investment. The dotcom bubble provides a good example, with around a trillion dollars of investment capital being poured into speculative investments. Some of this was totally dissipated, while much of the remainder was used in a massive, and premature, expansion of the capacity of optical fibre networks (the fraudulent claims of Worldcom played a big role here). Eventually, most of this “dark fibre” bandwidth was taken up, but in investment allocation timing is just as important as project selection.

The dotcom bubble was just one component of a massive asset price bubble that began in the early 1990s and is only now coming to an end. Throughout this period, patterns of savings and investment made little sense. Household savings plunged to zero and below in a number of developed countries (including nearly all English-speaking countries) and the resulting current account deficits were met by borrowing from rapidly growing poor countries like China (standard economics would suggest that capital flows should go in the other direction). The massive growth of the financial sector itself, which accounted for nearly half of all corporate profits by the end of the bubble, diverted physical and particularly human capital from the production of goods and services.

Finally, it is useful to look at the actual operations of the financial sector. Even the strongest advocates of the EMH would not seek to apply it to, say, the Albanian financial sector in the 1990s, which was little more than a series of Ponzi schemes. They would however want to argue that the massively sophisticated global financial markets of today, with the multiple safeguards of domestic and international financial regulation, private sector ratings agencies and the teams of analysts employed by Wall Street investment banks is not susceptible to such systemic problems, and is capable of correcting them quickly as they arise, without any need for large-scale and intrusive government intervention. I’ll leave it to readers to make their own judgements (maybe with some links when I get around to it).

Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century. More to follow!

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  1. costa
    January 2nd, 2009 at 11:41 | #1

    Nice Post John.

    The EMH never really recovered from the collapse of Long Term Capital Management in the late 90’s staffed by some of the modern portfolio theory academics. In fact the writing was on the wall back in the 1987 market crash where portfolio insurance (using black and scholes replicating strategies) contributed to a market meltdown.

    I think it also shows why Eugene Fama has yet to win a nobel prize. But your last sentence is a bit of a leap of faith from EMH to mixed economy. As a general statement – yes, but I think we can agree not too much or perhaps too little. This is the art of a modern mixed economy.

    I think the various financial crises since deregulation enables competing views like behavioural finance, Minsky and even good old Keynes to make a comeback from the likes of Friedman and Schumpeter. I guess it is a good case of mean reversion in Economic theory!

  2. Joseph Clark
    January 2nd, 2009 at 13:28 | #2

    I can’t see how this kind of empirical “refutation” of EMH has any practical value. If you misrepresent EMH as a scientific theory then you can’t fail to refute it. There will always be some price that does not adjust correctly – for any number of reasons. The fact that anybody is able to earn high wages or profits for any length of time is itself sufficient to disprove that prices are always efficient.

    So what? What makes EMH interesting and useful is its implication that inefficient prices provide opportunities for profit; how quickly or perfectly they adjust to these opportunities is a separate empirical issue. The standard argument that EMH is “falsified” so markets don’t work and capitalism is bad (or similar) completely misses the point.

  3. Michael of Summer Hill
    January 2nd, 2009 at 13:30 | #3

    John, recent events suggest ‘subsidies’ will be part of the government’s fiscal armoury necessary to maintain economic growth and/or prop up businesses which are in dire straits. Take for example Russia, the government there has pledged over $200bn this financial year to prop up some 1,500 flagging companies which account for 85% of Russia’s GDP. For this very reason I have to agree with you that a ‘mixed economy’ seems to be more plausible than any other economic system.

  4. January 2nd, 2009 at 14:17 | #4

    “Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century.”

    That’s a non sequitur, based on a hidden assumption about the wisdom of state direction in state run areas. It is entirely plausible that the central planning side would also fail, possibly through different causes – and 20th century experience bears this out too (Five Year Plans, anybody? The Groundnut Scheme?). As to whether humbler central planning within a mixed economy worked out better, that’s still an open question bearing in mind claims that today’s problems were partly driven from that side of things and merely showed up on the private side. I do think it could work – if everybody (central planners included) knew what they were doing, which is another way of doubting it. Failing that, muddling along with some intellectual humility on all sides seems the best bet. Someone once modernised the three laws of thermodynamics as “you can’t win, you can’t even break even, and you can’t get out of the game”.

  5. Jim Birch
    January 2nd, 2009 at 14:34 | #5

    Is there any theoretical justification for the EMH that doesn’t sound like it came off the back of a corn flakes packet? As far as I can see it’s pure religion: another simple “sounds-good” explanation for something that’s actually more complicated than the human brain can handle. It’s possibly even a case of a “why the sun comes up every day” superstition that allows you to sleep at night, ie, we’re all engaged in this activity so it just can’t be crazy.

    Mathematically, EMH says that even though any individual choice may be whacky the (dollar) weighted average choice must somehow be correct. It doesn’t follow, does it?

  6. Sinclair Davidson
    January 2nd, 2009 at 14:55 | #6

    Classic evidence on the EMH here.

    More evidence here.

  7. gerard
    January 2nd, 2009 at 14:59 | #7

    Steve Keen had what I thought was a very good discussion of the EMH in his Debunking Economics book.

  8. Brendan
    January 2nd, 2009 at 15:23 | #8

    PM Lawrence. To illustrate the failure of mixed economies, can you come up with better counter examples than “Five Year Plans, … The Groundnut Scheme”? Otherwise I think you sould be less dismissive of JQ’s premise.

  9. Brendan
    January 2nd, 2009 at 15:31 | #9

    PM Lawrence, my apologies for thinking you were arguing the examples above were meant to be about a mixed economy- I misread your comment and now see they were not but part of some other thread about the wisdom of central planning.

  10. January 2nd, 2009 at 16:57 | #10

    I gave the counterexamples to purer central planning cases since the failures there clearly relate to the central planning, thus showing that planning per se also fails. I then pointed out that mixed approaches may well have failures stemming from that that show up on the private side. Inherently, that would be a lot harder to trace.

  11. jquiggin
    January 2nd, 2009 at 17:18 | #11

    Sinclair, thanks for the refs. The Fama article is useful and stands up surprisingly well after 40 years. I’d agree with his conclusion that weak form efficiency is well supported, strong form implausible and semi-strong important but much harder to test. Still, I’m looking for something more recent than 1969.

  12. jquiggin
    January 2nd, 2009 at 17:26 | #12

    PML, the frequency with which I’ve seen references to the Ground Nut Scheme (a failed exercise in development assistance 60 years ago) leads me to suspect that there can’t be many such extreme failures. Interestingly, Wikipedia gives a see also to a private sector comparator

    But if there is one lesson that ought to have been learned back at Sydney Cove is that governments and agriculture don’t mix very well.

  13. Sinclair Davidson
    January 2nd, 2009 at 18:22 | #13

    There is a 1991 follow up piece (by Fama) in the Journal of Finance – December issue (log in would be required for non-uni users) there is a ungated version at SSRN but its down for maintainence over new year.

  14. Brendan
    January 2nd, 2009 at 18:32 | #14

    #10 “thus showing that planning per se also fails” … that’s drawing a fairly long bow – but then why not go a bit further and say all planning is bound to fail?

  15. January 2nd, 2009 at 18:46 | #15

    Evidence that news and volume play a minor role in stock price jumps here.

    Evidence that financial analysts show pronounced herding behaviour is here. According to the abstract — “These results add to the list of arguments suggesting that the tenets of Efficient Market Theory are untenable.”

  16. mp
    January 2nd, 2009 at 19:01 | #16

    #12 – you can question the degree of the failure, but other examples of govt failure could include WA Inc, the Pyramid Building Society (which had an almost explicit govt guarantee), the Christmas Island Spaceport and the Queensland Magnesium plant.

    On a related point:
    It is clearly a non sequitur to argue that market failure means government intervention will result in a welfare improvement.
    I for one agree that financial markets are clearly imperfect, but governments are far worse at allocating capital.

  17. rog
    January 2nd, 2009 at 19:03 | #17

    Whilst attributing blame for an event to a hypothesis, in this case the GFC to the EMH, is easy it doesnt go to the root cause of the GFC.

    The cause of the GFC is government.

  18. Alanna
    January 2nd, 2009 at 19:08 | #18

    How so Rog? The cause of the GFC is government? Please elaborate. I rather thought it was lack of government myself.

  19. January 2nd, 2009 at 19:46 | #19

    rog, it does not make sense to talk about the ‘root cause’ of the GFC. Markets are have complex networked relationships with feedbacks. For complex systems such as these it is difficult to talk about causality, and even more difficult to talk about something as complex as the GFC having a single ‘root cause’.

    For example, if governments regulate markets poorly, and this leads to some wild fluctuations, does this mean that government is the cause, or something in the market is the cause? Maybe you could say that government is the cause because if government didn’t exist, the GFC wouldn’t happen. BUt I suspect that if government didn’t exist, the global financial market wouldn’t either.

  20. Alanna
    January 2nd, 2009 at 20:06 | #20

    I think mostly everyone would acknowledge government failures in supporting markets that were essentially unviable in the past, or supporting markets for their own political self interest by the quite common porkbarrelling. No one would surely suggest that governments are free of human imperfections. The inadequacies of governments are not under dispute by me – yet what I do dispute (and strongly) is the notion that markets do not fail (or that the markets are free of human imperfections either) and that markets are superior in all aspects to any form of government intervention or planning. We swing from one extreme to another without recognising that governments and markets are not, and should not be considered adversaries. They should progress in an orderly and complementary fashion like shoes and socks. The purpose of government intervention and planning is to assist the smooth functioning of markets which is desirable. Intervention when it is required to protect competition or infrastructure and no intervention when no intervention promotes genuine competition and entrepreneurial abilities. By this I dont mean promotion of the entrepreneurial abilities of only the largest (and already established / concentrated / monopolistic) firms. The encouragement of smaller entrepreneurs is much needed and has been somewhat lacking (what unnecessary time does a BAS take to a builder starting out??). There has been far too much government kow towing to firms with the financial wherewithall to lobby hard, and not nearly enough assistance given to small businesses.

  21. January 2nd, 2009 at 20:15 | #21

    I think its good to see some acknowledged concensus here on the weak form of the EMH as its a theory which has always been poorly presented and abused in the media ie: it means the market is always correct …. which it doesn’t at all.

    This has also been used as a reason to use index funds however my perception is that this would have also led you into the biggest bubbles ie Nasdaq 2000. There is a reference above to analysts herding being a refutation of EMH which I would have thought is no refutation at all and may in fact be confirmation from another perspective?

    Not sure how the Dimenmsional Funds are travelling these days but as far as I know were associated with Fama (quoted above) and I used to regard these as “EMH with a brain”?

  22. Marginal Notes
    January 2nd, 2009 at 20:33 | #22

    Presumably the EMH is meant to apply to rural land values as well, but casual observation suggests that rural property values pretty much factor in a long-term projection of the current price for the commodity in question, especially on a rising market – witness the boom in sugar land values in Queensland in the 1990s. Since the most optimistic (least far-sighted?) bidder makes the purchase, how can the ‘market’ be rational? It is bound to overshoot.

  23. rog
    January 2nd, 2009 at 20:53 | #23

    As EMH is a hypothesis it has yet to be properly tested.

  24. rog
    January 2nd, 2009 at 21:13 | #24

    There has been no failure of the market – it has efficiently priced the risk as it became known. As govts increase their intervention we can be assured of greater price movements – govts are not known for their efficiency.

  25. observa
    January 3rd, 2009 at 00:02 | #25

    “Broadly speaking, the efficient markets hypothesis says that the prices generated by financial markets represent the best possible estimate of the values of the underlying assets.”

    Too true but Austrian economics would be smiling wryly at the very measuring stick of ‘price’ and how solid is its ultimate connection with ‘value’. Implicit in any analysis of markets is real rather than illusory or nominal pricing. For that we have to rely on the very ‘value’ of fiat money and deliberately targetting 2-3% monetary inflation can quickly hide all measure of inefficiencies and non-market interventions. Well if not quickly then the distortion could grow malignantly over time, despite starting out in very benign fashion.

  26. January 3rd, 2009 at 00:14 | #26

    Great article. However, I think that the real problem with EMH is its blind application by economists and market players without regard to whether or not the “market” is level or tilted, i.e., fair or unfair. Also, EMH makes a whole bunch of assumptions about the dissemination of information and the perfect dissemination of information which often aren’t true.

    Both underlying assumptions are wrong. Also, sometimes the application of EMH and game theory will drive asset prices below their “real value”. An example of that is mark to market accounting for non-liquid assets. A combination of EMH and game theory drive illiquid assets to distressed levels. There is neither a fair market nor dissemination of information to investors. But, mark to market proponents disregard these small flaws in the EMH justificaiton and flog mark to market accounting just the same.

    Another example of EMH blindly being applied is CDS. Again, the basic underpinnings of EMH are violated by CDS (especialy the fair market assumption).

    I have written a number of articles on this topic which readers may find interesting (including a CDS article that was published in the FT last year). Some of the links are below.

    John, your writing is really great. I look forward to reading your thoughts again in the future.



    And my blog site http://www.firstcapital.com/blogs/mark_sunshine/

  27. d4winds
    January 3rd, 2009 at 00:22 | #27

    (1) a pure “animal spirits” explanation of stock market fluctuations (inclusive perhaps but not necessarily requisite of “herding”) with no or an extremely tenuous relationship between the real economic value of capital resources and stock prices can be consistent with semistrong or weak EMH.
    (2) EMH efficiency is a pure TRADING efficiency argument, that is necessary for but by no means sufficient for economic efficiency in capital allocation.
    (3) The jump from EMH to allocative efficiency of markets (“..they’re better than any other possible capital allocation method…”) is not prima facie false, owing to (2), but neither is it justified, owing to (1).

  28. Will
    January 3rd, 2009 at 01:59 | #28

    Perhaps the problem is not with our ability to determine prices but the whole idea that the secondary market prices of financial assets are important or even relevant. Is the EMH something we should even care about?

    Financial assets represent the right to receive a series of cash flows over some extended period of time, and which are ultimately generated by some real productive enterprise. Maybe the financial system would be in better shape today if it was recognized that the relevant test of an investor is how the actual long term cash flow compares with it’s original expectations.

    This is quite different from investment performance based on the secondary market price of financial assets, which is a second order property of the assets affected by many factors other than just the underlying real productive enterprise.

    To say that short-termism is bad is not simply a slogan; financial assets like shares and bonds are long term, and it is ultimately wrong for short term investors to be buying them if they can’t hold them for the long term. In other words, why should short term investors expect that someone else will always be willing to buy them out of their long term investments? Ponzi, anyone?

    If you have a short term investment horizon, as many people do, then we have banks to intermediate deposits into long term loans, through the magic of the law of large numbers (average deposit inflows and outflows should be relatively constant over the long term) and the presence of a lender of last resort.

  29. Carl Futia
    January 3rd, 2009 at 03:10 | #29

    If you substitute the words “no free lunch” for “efficient markets” you typically find much more public acceptance of the hypothesis. After all, it’s main prediction is that markets rarely make EXPLOITABLE mistakes,i.e. mistakes that can be recognized as such when they occur and that can be exploited via some investment strategy that is spelled out in advance.

    As far as I can tell this prediction has enormous empirical support.

    The hypothesis that public officials can outguess the financial markets because they know more about the future course of the economy has exactly zero evidence to support it.

  30. Lurker
    January 3rd, 2009 at 03:43 | #30

    the efficient (financial) markets hypothesis. It’s going first because it is really the central microeconomic issue

    You’re already starting off on the wrong foot. EMH is a macroeconomic hypothesis.

  31. Lurker
    January 3rd, 2009 at 04:01 | #31

    The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century.

    The experience of the 20th century is more war-induced human bloodshed than any prior century. The logical implication is that you are either looking at the past through rose-colored glasses or that a mixed economy doesn’t work.

    (Never mind the fact that the largest country in the world didn’t even start a mixed economy until less than 20 years ago.)

  32. January 3rd, 2009 at 04:36 | #32

    I’m afraid there are still some market fundamentalists who will try to keep the EMH alive, by arguing that it is precisely because we are always in a somewhat mixed economy, especially when both the US and the UK nationalize their banks or insurances…

  33. RPB
    January 3rd, 2009 at 05:11 | #33

    As the lurker noted, we have not seen the full outcome of the largest mixed economy in the world. Mixed economies themselves become dependent on proper management of government finances and must realize proper predictions of underlying fundamentals. Countries tied to commodities especially falter under mixed economic regimes. See Russia, Iran, Venezuela and Saudi Arabia. They are in dire straits and the near future government efforts to prop up the market will make market valuations dependent on those prop up efforts. The day the government makes a miscalculation or cuts back on those efforts is a disastrous day for those economies. Unfortunately, it appears as if the US and China is heading down this route. By trying to prolong a economic bubble, these countries will soon feel the wrath of a vicious crowd out effect and economic stagnation. Obviously, the free market is imperfect and optimal government intervention in the economy is not zero.

    However, as rog points out without support, the US government has been largely responsible for the creation of this bubble. With ultra low interest rates and investment/housing favorable tax policies, agents in the US economy speculated on housing and financial assets because they had the opportunity. They were given the opportunity as the US government sought methods to lessen the impact of the internet asset bubble. Financial firms did similar under the auspice of reinsurance of their purchases and the derivative desk created perception of a liquid market for their product. The government failed to properly regulate these products and created an environment where firms jepordized long term growth for short term gain. The low rate environment made it necessary for many in asset management to invest in CDO, CLOs, CDS, MBS, etc paper because comparable returns were hard to come by investing in the real economy. Being asset management is a competitive market, those who did not provide like returns (of derivative products) went out of business.

    Furthermore, companies did not derive most of these capital gains and profits through real improvements in effeciency, quality or output. They derived the majority of their gains through finance, levarage and other non-production increasing means.

    The government created an environment where finance generated an unprecendented amount of GDP growth. Now government intervention is making a worse mistake than the Japanese in supporting not only asset values, but PHYSICAL CAPITAL ASSETS whose existence was merely made possible because of the asset bubble environment. Unfortunately for the labor which run these assets, they are obsolete in the absence of a credit/financial/asset bubble market where people are able to purchase these products. GDP must contract to reflect this new environment. US Government, eager to avoid pain of its constituents and be re-elected, has incentive to suppport this asset/capital bubble. This is far out of wack with what is necessary and proper in the free market.

    If you need to look further into this type of poor government invention, look to agriculture. As it stands ethanol production accounts for roughly 1/3 of all US corn production. With plummeting RBOB prices and relatively high corn prices, these ethanol plants are closely at a rapid pace – even with the tax credits. If this economic infeasibility remains, and despite the mandate these plants continue to go out of business, you will see an agriculture crisis unheradled since the great depression. The renewable energy mandate has created an artificial market that is economically infeasible. It is doing the same with other capital assets that need to be washed away.

    A contraction is necessary along all lines of business is necessary to demonstrate which businesses can feasibly operate in the new environment. We need to find demand in a non-inflated economy where finance of old savings does not produce a large majority of demand. However, elected government officials hold rational incentives to do otherwise – thus the failure of government. China’s incentive lies in not creating an environment where revolution takes places. Perhaps in China’s case this asset distortion is a necessary evil, perhaps in the US we need a slow drop to correct the market across financial, physical and producing assets, but government cannot escape the free market. And in many cases, government intervention makes matters substantially worse.

    Governments should exist to properly regulate an economy. Much more interference beyond regulatory measures has appeared to worsen our present crisis because it tried to dampen our last asset bubble crisis.

  34. rog
    January 3rd, 2009 at 06:32 | #34

    Whilst markets are not perfectly efficient the commercial world is better able to judge reality than government officials (for evidence refer back to the comment by Alan Greenspan that he was shocked that the market did not act as he thought they should)

  35. January 3rd, 2009 at 06:58 | #35

    AIG is all-but bankrupt because Financial Products, founded by Sosin/Rackson/Goldman, employs current academic theory, i.e., the Efficient Market Hypothesis (EMH) to model markets as efficient, always in equilibrium and self correcting where security prices simply react to random news releases. The EMH models individual security price movements as “independent random variables” where purchase or sale is a “zero net present value transaction,” resulting in neither the buyer nor seller having an advantage. Consequently, security trading is modeled like casino gambling where price volatility determines risk assessment. The EMH concludes that because prices always fairly reflect intrinsic value and it is impossible to know what markets are going to do, consequently, fundamental analysis isn’t cost effective. With all due respect to my academic colleagues, the EMH model is both naïve and specious, i.e., it relies on incorrect premises and, therefore, cannot correctly model market risk. A discussion follows.

    Markets are not always in equilibrium nor self correcting but rather are a discounting mechanism, i.e., professional traders look ahead and bid prices either up or down prior to earnings and/or economic news announcements; that is why prices can go up on bad news and down on good news. Security prices from day to day seem random, however, diversification cancels out unsystematic risk, therefore, markets as a whole only have systematic risk. Using a diversified market portfolio, monthly rather than daily data, trend lines and conditional probabilities correctly models systemic market risk; thereby disqualifying the flawed EMH’s reliance on securities’ price frequency and the use of price volatility as a proxy for portfolio risk which is not sufficient information when hedging positions. Financial Products computer models depend upon the EMH, demonstrating why incorrect theories have major consequences, conceivably, even being the root cause for the next Great Depression.

    (Eric L. Prentis is the author of “The Astute Investor” and “The Astute Speculator,” http://www.theastuteinvestor.net )

  36. TerjeP (say tay-a)
    January 3rd, 2009 at 07:52 | #36

    The market worked to price in the financial crisis even whilst the US government tried to prop up the notion that business as usual should continue. In a two horse race between the government getting it right and the market getting it right I think on this occasion the market ran a poor race but the government still did worse.

    The fact that currency is nationalised in every nation on earth (it wasn’t so a century ago) and the price of credit (ie interest) is managed via government interventions (central bank open market operations) on a daily basis suggests that global finacial markets are a million miles from purity. If you stick strong drugs in your body you’d expect the bodies signals to be less than optimal so the notion that you can pollute markets without any negative impact is naive. Price signals are a primary conduit of information for markets.

    Speaking of strong drugs the existance of a global illicit drug market kind of suggests to me that the comment by Peter Wood at 19 in which he suggests that without governments we wouldn’t have a global financial market is naive in the extreme.

  37. Socrates
    January 3rd, 2009 at 09:00 | #37

    TerjeP 34

    I take it then you are opposed to the views of Adam Smith and Milton Friedman, who were both in favor of state issued money? Are they too far left for you?

    They held those views despite being aware of the possibility of private money. Smith knew of its flaws from practical experience.

  38. Socrates
    January 3rd, 2009 at 09:07 | #38

    Does anyone have a view on the website “Financial Rankings” I just found. Is the information reliable? It is at:

    Some of the graphs I found tragically funny, like the one on World’s Largest Banks and changes in rankings (and deletions) over the past two years.

    But other graphs were a bit disturbing, like US Debt, and the one showing remaining US Adjusted Rate Mortgages yet to reset (another large tranche due in 2010). The one marked “Real S&P Performance” for the past 8 years is not flattering for fans of efficient markets.

  39. gerard
    January 3rd, 2009 at 11:05 | #39

    Steve Keen proposed that the EMH, in the case of the stock market, means at least four things:

    1) The collective expectations of investors are accurate predictions of the future prospects of companies.

    2) Share prices fully reflect all information pertinent to the future prospects of traded companies.

    3) Changes in share prices are entirely due to changes in information relevant to future prospects.

    4) As the information arrives in an unpredictable and random fashion, past movements in prices give no information about what future movements will be – stock prices follow a ‘random walk’.

    Is it a macroeconomic hypothesis? “These theories were microeconomic in nature, and presumed that finance markets are continually in equilibrium”. I would say that if defined this way the EMH seems obviously wrong. but as with most economic theories, it is not really a solid scientific hypothesis, and there is probably quite a wide scope for defining it to fit with whatever evidence you have.

  40. El Mono
    January 3rd, 2009 at 12:09 | #40

    Practically the EMH means that i personally can not (consistently) profit from trading from information i find out about a company, because by the time i hear it the info is already facotred into the price. This is a pretty good lesson to teach people when they first start to buy shares. I don’t think it has much use past this though.

  41. gerard
    January 3rd, 2009 at 13:13 | #41

    could have alerted people to the impossibility of Madoff’s consistent gains over good times and bad.

  42. Wendy
    January 3rd, 2009 at 14:00 | #42

    The last paragraph is absolute nonsense. How can you derive such statements from the (in)validity of EMH or from the facts? What is your evidence that government is better at long-term planning than the private sector? In what sense? In what context? Are you mad? Have you not paid attention to the events of the 20th century?

    And when have we even had laissez faire? Everyone alive today has always lived under a mixed economy. During the times when regulation was rolled back, we prospered (80s & 90s). During times when regulation was increased, such as the last decade, a long-term secular bear market was the result. And I would kill for the financial sector to be allowed to correct itself without the “large-scale and intrusive government intervention” that has been going on for almost a year.

    And if you have a problem with “the massive growth of the financial sector” diverting “physical and particularly human capital from the production of goods and services,” then you should be expending effort calling for the abolition of fiat money and the Federal Reserve, which made such a situation not only possible, but inevitable.

  43. Wendy
    January 3rd, 2009 at 14:08 | #43

    Further, EMH has nothing to do with defending free markets. It is an economic theory which is completely irrelevant to the question of whether markets should be free or not. Markets should be free because IT IS WRONG TO INITIATE FORCE AGAINST OTHERS, and it is not made right by citing “the public good.”

  44. Socrates
    January 3rd, 2009 at 14:30 | #44

    Wendy 45

    I think that is far too extreme. If you take that justification to its logical conclusion then we can’t have a police force, because it will sometimes initiate force against others (criminals). And we can forget about a defence force. Or is the market a higher value than survival?

  45. gerard
    January 3rd, 2009 at 15:34 | #45

    Ayn-Randroid alert!

  46. Alanna
    January 3rd, 2009 at 15:34 | #46

    Wendy #45 Beg to differ. The EMH theory is one justification for free markets ie they are efficient and therefore more efficient when left alone. Its just a shame private markets only provide education and health care to those who can afford to pay for it. They also become distorted and subject to the whims or blatant misinformation spread about by every entrepreneurial con man under the sun when left alone (one after the other is being paraded before us in the daily newspapers and its horrifying – the extent of rampant gambling and rorting within the capital / financial systems). Free markets also generate fraud, greed an inefficiency no doubt postively related to the degree of freedom and lack of regulation in those afflicted markets. Should I be left alone to steal my neighbours goods? Good – then I will and I shall laugh all the way to the bank. Should the market be left alone to initiate fraud on a massive scale over bad debts misrepresented to those without the ability to return the debt and then packaged and bundled as safe securities and sold around the world by those who did not bear the risk? This dark mould at the heart of the US system – the loudest proponents of free market systems. The market when left alone completely alone (laissez faire) does not generate efficiency and yes there is the public good to think about. Not thinking about it is irresponsible and unethical in the extreme. In the words of JKG “the market has become a disguise for inequality” and on the role of government – “good statesmanship always required the comforting of the afflicted and the afflicting of the comfortable.” Of course those who are forced to comply are not going to like it (who would pay rates or taxes if asked?). It is the majority governments work for, not particular disaffected individual’s preferences for freedom from regulation.

  47. jquiggin
    January 3rd, 2009 at 15:55 | #47

    Wendy, I’ll be spelling out the final para in more detail as we go on.

    But obviously, if you don’t care about the consequences of the policies you think are right, there’s not much point in commenting. You might be better off finding some Marxists to argue with.

  48. Nick K
    January 3rd, 2009 at 15:59 | #48

    There is a good case to be made that the GFC was caused mainly by government and regulatory distortions of the market for a few reasons:
    – central banks kept interest rates too low for too long, encouraging excessive debt and inflating asset prices
    – government policies such as more favourable tax treatment for real estate compared to other investments fuelled asset bubbles which eventually burst
    – when governments offer various bailouts and safety nets for companies and individuals in trouble due to bad financial decisions, this increases moral hazard and encourages more wreckless financial decisions
    – in the US, there were various measures by governments to pressure the banks to extend more credit to low-income earners and those with bad credit histories

    None of this is to say that markets would produce perfect outcomes in the event of less government intervention, or that there would never be market failure. But I doubt that things would be any worse than the current situation.

    At this stage, the only doctrine looking more shaky than the Efficient Markets Hypothesis is the Efficient Government Hypothesis.

  49. gerard
    January 3rd, 2009 at 16:34 | #49

    I don’t know how much this has to do with the EMH – if anything. But I find this article very interesting as an example of how remote the basic microeconomic model of economic competition can get from reality. It is about how the telecom oligopoly shamelessly rips consumers off in the USA, and if anything I know Australia’s situation is worse (when it comes to quality, value-for-money phone and internet service, Australia is at the ABSOLUTE arse-end of the world).


    What Carriers Aren’t Eager to Tell You About Texting

    …A text message initially travels wirelessly from a handset to the closest base-station tower and is then transferred through wired links to the digital pipes of the telephone network, and then, near its destination, converted back into a wireless signal to traverse the final leg, from tower to handset. In the wired portion of its journey, a file of such infinitesimal size is inconsequential. Srinivasan Keshav, a professor of computer science at the University of Waterloo, in Ontario, said: “Messages are small. Even though a trillion seems like a lot to carry, it isn’t.”

    Perhaps the costs for the wireless portion at either end are high — spectrum is finite, after all, and carriers pay dearly for the rights to use it. But text messages are not just tiny; they are also free riders, tucked into what’s called a control channel, space reserved for operation of the wireless network.

    That’s why a message is so limited in length: it must not exceed the length of the message used for internal communication between tower and handset to set up a call. The channel uses space whether or not a text message is inserted.

    Professor Keshav said that once a carrier invests in the centralized storage equipment — storing a terabyte now costs only $100 and is dropping — and the staff to maintain it, its costs are basically covered. “Operating costs are relatively insensitive to volume,” he said. “It doesn’t cost the carrier much more to transmit a hundred million messages than a million.” …

    In other words, the ‘marginal cost’ is zero. Time for the ACCC to crack some tel-co skulls I think.

  50. Nick K
    January 3rd, 2009 at 16:54 | #50

    Alanna, it is true that markets often produce less than optimal outcomes due to imperfect information. This, in turn, can facilitate many of the anti-social features you talk about.

    But many of the features that produce less than optimal outcomes in the market (such as imperfect information) are actually worse in the case of government. The average person spends far less time analysing matters of public policy than they do weighing up major purchasing decisions. Yet this is the typical voter that policies must be pitched to.

    Political systems tend to suffer to an even greater extent from ‘rational ignorance’ among voters and the disproportionate influence of interest groups. But a further problem with government is that government policy relies on coercion while the market relies on consent. That is, governments can use state power to enforce regulations, taxes etc. that redistribute resources without the consent of those paying.

    The difference between the free market and government is that, generally, in a market anyone wanting to profit unfairly at the expense of others must con them into accepting a bad deal. With government, those with influence can simply use state power to redistribute resources from someone else without their consent. If the free market is personified by a sleazy salesman selling snake oil, then government is more like a bank robber or a sleazy salesman with a gun.

    This is not to deny that there are some situations where government intervention or regulation will produce better outcomes than a completely free market. But there is always a high risk that regulation and intervention will go well past that which generates optimal outcomes.

    The whole notion that free market equals selfishness and excessive individualism, while government intervention equals social responsibility and the greater good is something of a false mutual exclusivity. In practice, government policies are just as likely to create an accumulation of interest groups selfishly defending their narrow self-interest at the expense of others and the greater good of society.

  51. January 3rd, 2009 at 17:23 | #51

    Well said, Nick K.

  52. gerard
    January 3rd, 2009 at 17:24 | #52

    does it matter that the outcomes generated by the market are determined by the existing distribution of wealth (and obviously the political regime that upholds this distribution). surely it’s meaningless to talk about ‘market’ outcomes in the abstract when they depend entirely on the given parameters.

  53. gerard
    January 3rd, 2009 at 17:34 | #53

    What I was trying to say was said better by Amartya Sen: “the market mechanism is only as good as the company it keeps.”

    the use of the market economy is consistent with many different ownership patterns, resource availabilities, social opportunities, rules of operation (such as patent laws, anti-trust
    regulations, etc.). And depending on these conditions, the market economy itself would generate different prices, terms of trades, income
    distributions, and more generally diverse overall outcomes. The arrangements for social security and other public interventions can make further modifications to the outcomes of the market processes. Together they can radically alter the prevailing levels of inequality and poverty. All this does not require a demolition of the market economy, but does demand alterations of the economic and social conditions that help to determine what market solutions would emerge.


  54. January 3rd, 2009 at 18:05 | #54

    Whereas the government mechanism is only as good as … what?

  55. gerard
    January 3rd, 2009 at 18:27 | #55

    since the entire system of private property depends on the ‘government mechanism’ for its existence, I wouldn’t postulate it as something counterposed

  56. January 3rd, 2009 at 19:04 | #56

    Yet you try to counterpose it with (I presume) government using a quote from Amartya Sen. Odd.

  57. gerard
    January 3rd, 2009 at 19:23 | #57

    No. The point is that ‘market outcomes’ depend entirely on the parameters of the environment in which the market exists, and it is meaningless to talk about them in the abstract. Do you get it, or do you need it dumbed down a bit more?

  58. TerjeP (say tay-a)
    January 3rd, 2009 at 20:35 | #58

    I quite like Nicks enquiry about the “Efficient Government Hypothesis”. The reality is that the well considered, appropriately implemented and properly scope and time limited government intervention, whilst brilliant in theory, is in practice such a rare bird that we usually end up with some Cookoo alternative. It would be better to never enjoy the benefit of this rare and precious bird if it also means we can be rid of all the Cookoos that fly in when some government loving nutters open the damn window.

  59. Jeff M
    January 3rd, 2009 at 22:34 | #59

    Great article by Dean Baker that seems relevant to this discussion:

    I wonder if those arguing that government involvement is always bad would apply that same argument to its granting patents, copyrights and corporate charters? I’ll bet not.

  60. Ubiquity
    January 3rd, 2009 at 22:59 | #60

    EMH is a simplistic equilibrium model of no relevance in real life situations.

    A free market is more like a “Diffusion-limited aggregation”


    Refute EMH all you want, as long as there is no implication that it refutes the benefits of a free market with “limited government”.

  61. Nick K
    January 3rd, 2009 at 23:03 | #61

    Terje, great analogy about chasing a rare bird and ending up with a whole lot of Cookoos instead.

    The argument that markets are imperfect but not as prone to failure as government is never going to be popular. That is because many people want to believe that there is some more benevolent force we can turn to in order to solve things.

    Jeff, I haven’t actually argued that government involvement is always bad. As for copyright and patent laws, I support them but I think they have been taken too far. Copyright and patent laws are necessary to some extent to create incentives to produce new material. But if taken too far, they are open to abuse and excessive rent-seeking and anti-competitive behaviour. For example, I believe one corporation has the exclusive right to produce champagne with orange labels. Ridiculous.

  62. January 3rd, 2009 at 23:52 | #62


    The quote about the casino is not ‘alleged’. It’s in Chapter 12 of the General Theory.

    “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. “

  63. Mike
    January 3rd, 2009 at 23:55 | #63


    Very interesting and keep up the good work.

    The events that are unfolding has reminded me of the presentation by John R. Saul in 1999. I looked it up on the ABC site and found…

    “it had a quarter of a century, a quarter of a century is a long time in economic experiment, two and a half times the time Napoleon had, quite a long time. Five times the length of a World War, very few people get 25 years to do what they want in this world. And to be in a major crisis at the end of 25 years is sort of a sign that you’ve blown it! And you should step a side.”

    Well, he was out by about 10 years… but we certainly are in a crisis.

    On the next page..

    “Now it’s quite interesting, I noticed the other day in the Japan Times the following about the crisis in Korea – “the state prosecution is studying whether to punish the nation’s former or current top economists for their role in triggering the economic crisis”. It’s quite an interesting idea. They are the ones who say they’re social scientists who have the truth, they’re the ones who say they’re professionals like doctors, so why shouldn’t they be sued for malpractice?”

    Lets see if they (the economists and their boses who should have seen this coming) are, but I won’t hold my breath.

  64. Alanna
    January 4th, 2009 at 00:03 | #64

    Gerard at 51# . Agree re Australian Telco service. Its a shocker.

    “There is a good case to be made that the GFC was caused mainly by government and regulatory distortions of the market for a few reasons:
    – central banks kept interest rates too low for too long, encouraging excessive debt and inflating asset prices
    – government policies such as more favourable tax treatment for real estate compared to other investments fuelled asset bubbles which eventually burst”

    I see the low interest rates followed by the US and mirrored here in Australia as lack of intervention by conservative Treasurers – and reflecting Greenspans overriding belief that the markets would provide a solution (it did and its not pretty). Greenspan and other similarly inclined Treasurers let the boom have its head – and furthermore spent most of the past decade congratulating themselves for the successful low interest rate low inflation business environment.
    What is now the greatest embarrassment for the free market theory is that some of the finest institutions held up as evidence of the success of Greenspans policies (with CEOs that often mimicked free market speak) that paraded their wealth ostentatiously during the boom are now the same institutions running cap in hand not to the market, but to governments to help them with bailouts. Even the once mighty market scions arent immune to wanting government benevolence.

  65. Alanna
    January 4th, 2009 at 00:36 | #65

    Nick # 52
    “That is, governments can use state power to enforce regulations, taxes etc. that redistribute resources without the consent of those paying.”

    I dont see that the consent of those paying is at all necessary if a greater benefit is conferred on the majority. That is precisely what governments should see as a prime responsibility – redistribution to ensure that that the majority are living in the body of an economy and are not dragging on growth by residing its tail end. When we have had executives loading up on debt to make risky buys at inflated prices because the bigger the deal, the bigger their bonuses – that is not good corporate stewardship – its theft of shareholder equity. If it takes taxes or regulation to bring management ethics back to management and banish casino style self interested partying (and flying in and out with the loot like WOW raiders) then the sooner the better.

    Yet I agree with your comment “But there is always a high risk that regulation and intervention will go well past that which generates optimal outcomes. ”

    That is a known fault of government (that and self interested politicians that line their own pockets or their mates pockets) – once processes become set in the machinery of government bureaucracy there is a tendency for the process to continue past its useful date and in so doing create problems such eg the extension of protection to unviable industries (that were never going to be viable without subsidies in the 1920s).

    Neither the market nor government is perfect and what we do need is economic history and historical economic analysis (something quite recently the coalition government attempted to erase as a legitimate field of research).

    It is not adequate to set a government process in stone and then leave it there until it causes its own distortions. What can overcome that? Only analysis.

    I suggest nothing more than a bit of balance and maybe the employment of a few more economists and a few less political writers.

  66. Nick K
    January 4th, 2009 at 01:15 | #66

    Alanna, the point about interest rates is that where central banks set interest rates at a level clearly lower than what the market would set them in the absence of central bank control, this is essentially a regulatory distortion of the market. And this is more likely to encourage people to take on excessive levels of debt.

    Markets rely on effective price signals to influence behaviour and allocate resources. So when price signals are distorted in this manner so as to not truly reflect the supply and demand for credit, it is not surprising that the result is excessive borrowing and a credit crunch.

    In one sense, free market-leaning economists are implicated in this to a degree. That is because central bankers that were still influenced by monetarist thinking were focused too much on simply maintaining inflation targets, while ignoring the emerging problem of excessive borrowing and inflated asset values.

  67. Nick K
    January 4th, 2009 at 01:43 | #67

    Alanna, regarding the argument about governments using state power and coercion to redistribute resources through taxes and regulations without obtaining the consent of those who have to pay for it, there are a couple of points.

    It’s true that, up to a point, state-enforced redistribution of resources and compulsory taxation is socially beneficial and necessary. For example, it would be completely stupid to fund things like defence forces, police, basic infrastructure through voluntary contributions rather than compulsory taxation. To a point, it is necessary to compel people who can afford it to contribute towards the basic requirements of maintaining a workable society.

    The problem is that the compulsory taxing and other redistributive powers of the state (like regulations and litigation) are wide open to abuse. It is very easy for various interest groups to simply use their political influence to push for measures designed to enable them to profit at the expense of others, instead of engaging in more productive activities. The system can encourage rampant rent-seeking and economic parasitism.

  68. January 4th, 2009 at 04:27 | #68

    John, you write that “…it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example).”

    This reads like a comparative claim but you appear to base it on analysis of only one of the two institutional structures you are comparing (markets & governments). What are you using as a reference model to anticipate the outcomes of government actions?

    So far as I can tell, the major distinction between markets and governments is that participants in a market do not have the option of using violence to make people provide buy what they are selling, whereas participants in a government do. I’m sure there are cases where outcomes might be improved when some subset of society has a special option to use violence, but I don’t think it likely that such outcomes would actually be realized.

    If, for example, my upstairs neighbors were exempted from the laws concerning extortion and theft, it’s entirely possible that they might use such powers to provide health care to everyone. But that’s not a reason to trust them with such powers. I’m not sure why I should consider the people in a government any more trustworthy than my neighbors.

  69. gerard
    January 4th, 2009 at 07:47 | #69

    “So far as I can tell, the major distinction between markets and governments is that participants in a market do not have the option of using violence to make people provide buy what they are selling, whereas participants in a government do.”

    That overlooks a pretty basic fact. Unless you are prepared to defend everything that you own by yourself, and basically live in a Somalia-type society, you are depending on a government monopoly of violence for the maintenance of your private property. The question is not whether government should intervene in the market – it is whether the government has any role other than the protection of private wealth. In a society where wealth is inequitably distributed, it is unlikely that a government whose only role is to use its monopoly of violence to uphold this inequitable distribution can survive the democratic process. It is a program that might have more success in a Latin American style military dictatorship.

    You’ve heard the old saying that property is nine-tenths of the law. The libertarian argument is basically that it should be ten tenths.

  70. Jeff M
    January 4th, 2009 at 07:50 | #70

    Nick K said: “Copyright and patent laws are necessary to some extent to create incentives to produce new material.”

    Ah, but they are not necessary. Yet we accept them as natural laws that can’t be altered. This is very convenient for those who benefit from those laws.

    There are other ways to create incentives that are as effective and possibly more efficient. As Baker points out, the real debate is really about different regulatory structures rather than more or less regulation.

  71. Alanna
    January 4th, 2009 at 11:41 | #71

    “Markets rely on effective price signals to influence behaviour and allocate resources. So when price signals are distorted in this manner so as to not truly reflect the supply and demand for credit, it is not surprising that the result is excessive borrowing and a credit crunch. ”

    Nick – each and every firm seeks to have some control over their prices. It is not only the government that has the power to distort prices. It is only in competitive markets where there is no price control that the price mechanism works effectively and far less so in industries like oligopolies who eg may have the resources to avoid the need to borrow and / or can continue to maintain prices by reducing labour and operating undercapacity in the event of a downturn. Only when unemployment is sufficiently high enough will such industries be brought to heel by lower demand (and less so in response to competitive price strategies taken by rivals – of which there wont be any). I agree markets respond to price signals, but if competition has (been permitted) to fail in many industries (such that those with resources and the ability to purchase government or media influence can serve their own interests at the expense of competition then they will seek to do so), then the price mechanism will also fail and the market can no longer be called a market in any genuine sense of the word. It really is time we stopped carrying this burden of perfectly competitive markets around with us and boring students silly with a dry one track approach to economics (in textbooks, in discussion and in theory).

    Will we still be discussing market theory, perfectly competitive markets and a lovely responsive price mechanism when we all work for wages in some enormous corporation and small business is shrivelled to nothing?. I dont believe the price mechanism is perfect either. The more price control firms have the less it works. I buy groceries – I watch the exchange rate change – I see no change in prices of imported foods. We have a drought and a semi recovery – I only see a steady rise in prices year after year – some very nasty rises. I wish we had legislation to get out the scissors and separate the large players but apparently we dont even have as good anti trust legislation as they do in the U.S. or Europe and apparently we actually cant do that here in Australia.

    In my view that is sadly lacking effective (competition) regulation, rather than too much.

  72. gerard
    January 4th, 2009 at 13:51 | #72

    A corporation is a rent seeker by definition.

  73. derrida derider
    January 4th, 2009 at 18:34 | #73

    But doesn’t the weak form of the EMH sorta imply the semi-strong form? If prices, and hence the value of investments, cannot be predicted from past history then no central planner can use past history as a guide to value either.

    Plus, without going overboard about it, the public choice theorists have a point. Real-life central planners are not merely as ignorant on average as private investors, they will also often be biased. Put simply, the squeaky axle always gets the grease whether or not it is the axle that can best use it.

    In 2008 we saw plenty of examples in Australia alone – from the travesty of greenhouse policy to the massive malinvestment of taxpayer’s money in making cars nobody wants.

  74. jquiggin
    January 4th, 2009 at 20:49 | #74

    #77 The weak form says prices cannot be predicted from their own past history. If we say that “history”=”publicly available information”, the proposition that prices can’t be predicted from history is the semi-strong form.

    On your other point, if we combined the failure of EMH with the assumption that governments are infallible, we’d get a case for universal public ownership. Since, in reality, both governments and markets are fallible, we need to look on a case by case basis at which is better/worse. Hence my final para about the mixed economy.

  75. January 5th, 2009 at 03:28 | #75

    I am currently from Chicago and my school says: the market is like a human body where every cell has a mind of its own and covets what all the other cells have — not the magical efficiency world the Chicago Boys fantasize.

    Timely example? A dozen years ago, I paid $500 for a root canal in a prime location office — about $750 in today’s money. Now the country wide price (I checked in hopes of lower) is $1400 — almost double. Mmm. Over that time period medical insurance at least doubled (while doctors are doing three times as much — so much they cannot even charge us enough to cover it all?). Could dentists have wondered if they could get away with doubling their fees for doing the same thing and possibly get away with it because they would just seem to be to be going with the ever higher price medical flow?

    A special Chicago Boys disconnection with reality is the labor market. Everybody understands that when more want to sell than buy it is a buyers market. The Chicago Boys don’t at all get the need to virtually reduce the overwhelming number of sellers in the labor market via effective unionization (effective in the era of the race to the bottom can only mean sector-wide) and/or as high as practicable a minimum wage so that the share of the pie gotten by most people is based on their genuine utility, not powerless desperation. Let’s at least say the Chicago Boys don’t differentiate between the efficiency of utility and desperation.

  76. January 5th, 2009 at 07:20 | #76


    I appreaciate the response. However, your are mistaken in your claim that “Unless you are prepared to defend everything that you own by yourself, and basically live in a Somalia-type society, you are depending on a government monopoly of violence for the maintenance of your private property.”

    This is certainly false. I rely on a variety of means to secure my property from private aggressors and I’m certainly not not naive enough to rely on the government’s monopoly of violence to protect my property from aggression by the government. In any case, if you think my options for protecting my property are limited to total dependence on the state and doing it on my own, you are simply mistaken.

    Anyway, I’m not sure why you wanted to change the subject. Even if my chosen response to my present circumstances is to rely solely on a government monopoly of violence to protect my property, that doesn’t begin to answer the question I had put to our host. Recall: I had asked why should I expect outcomes to be improved when one subset of society has a special exemption from the norms concerning property rights.

  77. Pat Connelan
    January 5th, 2009 at 08:15 | #77

    The EMH remains entirely relevant as a trading philosophy, even more so after the events of the past year.

    It does not say that prices are perfect. It says that markets are very good in assimilating new information into prices extremely quickly.

    This makes it difficult for individuals to “beat” the market with any consistency or to forecast prices with any great degree of accuracy.

    While many here have understandable reservations about the consequences of the unregulated market capitalism of the last quarter century, they should reflect on the fact that much of the financial services industry does not really adhere to the EMH.

    Indeed, it makes its money by peddling the myth to people that it is worth them paying fat fees to intermediaries to beat the market. The convenient assumption underpinning the actions of the product sellers is that markets are “inefficient”. They need them to be because that’s how they make their living.

    As Nick K observes above, no-one is saying that markets are perfect. But you would have to say that after a long period of under-pricing risk, they have corrected in an extremely efficient way in the past year.

    The bigger question, in my view, is the adequacy of the inflation targeting regimes of the central banks. After keeping monetary policy too lax for too long early this decade, surely they will now consider the effects of asset price bubbles in their consideration.

  78. Nick K
    January 5th, 2009 at 09:31 | #78

    Alanna @ 74, the only point I would add is that whether or not markets are competitive should not stop price signals from continuing to operate.

    If there is an industry that is not sufficiently competitive, this will be reflected in higher prices and higher profit margins. This creates more incentive for new players to enter the market.

    Of course, the market does not always operate to generate this sort of equilibrium for the usual reasons. Sometimes there are barriers to entry, imperfect information, and because people do not live solely according to economic incentives.

    Even though price signals don’t generate perfect outcomes, they are still useful in influencing behaviour. The fact that price signals aren’t perfect doesn’t mean that governments or regulators can interfere with them without ever generating perverse consequences or unintended costs.

  79. Nick K
    January 5th, 2009 at 09:55 | #79

    Gerard, I am not sure if I agree entirely with the claim that the existence of the market and attendant outcomes is entirely dependent on the state using its legal monopoly on the use of force to guarantee property rights.

    There are plenty of examples of markets that operate pretty much outside the realm of legal enforcement, like the underground economy or criminal transactions. I don’t think those who profit from (say) the drug trade, organised prostitution (where illegal) or earnings undeclared for tax purposes are relying on the state to protect their wealth. Indeed, if the state finds out what they are doing they will often lose their wealth.

    Moreover, most people take care to protect valuables rather than rely solely on the state to protect their property rights.

    So the existence of unequal outcomes generated by markets is hardly dependent on the state enforcing property rights.

    Also, once taxes and other regulations become sufficiently high the benefit people gain from continuing to fund the state merely in order to protect property rights diminishes. If given a choice between paying more than half your earnings to the government, or paying nothing but running a risk of getting rumbled and having no legal recourse, a rational individual might choose to take their chances.

  80. Alanna
    January 5th, 2009 at 18:47 | #80

    Its not just root canal therapy – its the average filling. It used to only have one side to it – not four (the trouble is – too few dentists – and too many fillings).


  81. Smiley
    January 5th, 2009 at 22:01 | #81

    Whilst markets are not perfectly efficient the commercial world is better able to judge reality than government officials (for evidence refer back to the comment by Alan Greenspan that he was shocked that the market did not act as he thought they should)

    Well that’s just great rog because someone was trying to tell me a few months back that Alan Greenspan was the head of a group of private banks called the Federal Reserve. And when Greenspan disputed the existence of the bubble in property markets he was just protecting the interests of the private banks and not the general public.

    It sound to me that while he might have been a publicly appointed official (like Henry Paulson), his actions have not been completely in the public interest.

    Cronyism has become synonymous with Bush and you could easily say that it has corrupted the ability of his government to operate efficiently. It’s impossible for me to ignore the fact that it was a conservative government that produced such inefficiency.

    So really it’s crony corporate capitalist governments that are inefficient not well governed markets as seems to be the suggestion of some.

  82. Alanna
    January 5th, 2009 at 23:47 | #82

    Nick #82
    “Alanna @ 74, the only point I would add is that whether or not markets are competitive should not stop price signals from continuing to operate.”

    Nick, I do not agree with this comment and I think that is part of the problem with those who believe markets operating freely generate efficiency. Price signals only occur when price is able to respond to competition in markets – both from buyers and rivals. Those with monopoly pricing power (or monopsony pricing power) may not generate any price signals. Firms seek to, can and do escape market forces. In a market of only two sellers, the consumer is trapped, has little ability to substitute, and prices hence respond sluggishly, if at all. Scarcity can also be contrived as De Beers proved so well. Concentration of market power destroys price signals and this is precisely what those who believe in the efficiency of free markets and the importance of price signals are increasingly failing to recognise. They have this view of markets that applies more to last century than this one. The point of government intervention is to maintain competition (and protect the ability of price signals to work) – and the market cannot do that alone – if it is impaired. I do not want to buy only from a market of highly concentrated sellers (and I avoid doing so if I can because instinctively we know when we are being gouged – yet the ability to substitute is becoming more and more difficult to a in many sectors).

    Given unsustainable speculative (unproductive) activity, the only thing that is likely to lower prices in many sectors is higher unemployment leading to lower demand. That should not be the only way to pull back the excess profit taking of firms because it is harsh on the ordinary person who was not responsible, did not contribute, and simply wants to work.

    People and the economy need protection from Monopolistic power. The market has shown time and time again through history – it cannot correct for an excess of market power and influence except through economic catastrophe (and yes economists who initiate failed policies should be held accountable).

    If the market works fine it doesnt need intervention (and in that case it should be left alone) but it would be totally unrealistic to look about us now and suggest that all is well in the markets because it clearly is not. The GFC will impact thousands of productive workers yet those who gambled at the top and paid themselves extraordinary bonuses (whilst running companies into walls) will remain relatively unaffected. Even of they lost some wealth, they are likely to still retain large reserves of savings rendering them immune to any depression, and may now possibly be busy laying off thousands.

    I dont even call that a market. I call it a globally monumental scam that was allowed to happen because the economists who drove policy (over two decades) simply did a very very bad job. They based many of their actions predominantly on a single untested belief (free market efficiency), used the economy as an experiment and looked forward to a long run utopia instead of backward to assess and judge actual outcomes.

  83. Pat Connelan
    January 12th, 2009 at 07:58 | #83

    FYI: EMH originator Fama has now started up his own blog, in association with his research partner Ken French. This allows them to comment on some of the issues being thrown up by the GFC:


  84. January 12th, 2009 at 09:49 | #84

    “If the market works fine it doesnt need intervention”

    You appear to have a strange idea of how the market works. I should say markets, since there are too many to count, all with varying characteristics, but let’s stick with the abstract concept.

    Markets ‘work’ great at their central role – allocating resources to their most productive use. This is NOT to say they are perfect, or never fail, or don’t have bad outcomes for certain people or groups at times. It IS to say that they do better than the opposite of free markets, pure central planning. It follows that there is a point (or possibly several) in that spectrum where a balance is reached where the relative benefits of each approach is maximised, and the costs minimised.

    What’s up for debate is where that point is (usually because of disagreement about costs and benefits). What’s not up for debate, except amongst the delusional, is whether markets ‘work’ or not. Which leads me to your statement “a single untested belief (free market efficiency)”. The efficiency of markets relative to other arrangements is beyond dispute – I present all of history as an empirical example :-), and the standard left-wing complaint (that markets are too efficient and therefore diminish equality) as proof that even the opponents of markets acknowledge reality.

  85. Alanna
    January 18th, 2009 at 17:23 | #85

    We are arguing exactly the same point.Markets ‘work’ great at their central role -allocating resources to their most productive use. This is NOT to say they are perfect, or never fail, or don’t have bad outcomes for certain people or groups at times. It IS to say that they do better than the opposite of free markets, pure central planning.

    Of course they do it better than a command economy. But they also do it better when markets are controlled not left to laissez faire.

    Laissez faire is an extreme. Command systems are an extreme. We have been heading too far towards laissez faire. That is my point. I would be complaining just as loudly if we were going too far towards a command economy. I dont like extremes Jarrah, and nor I suspect, do you. It is a question of balance and the ability to analyse actual outcomes of policy not ideology.

  86. Alanna
    January 18th, 2009 at 17:27 | #86

    Jarrah#88 Note I did not drop any words to the effect of left wing or right wing into my argument. I dont see things that way. I prefer ideology doesnt interfere with the actual analysis of outcomes of economic policy interventions or non intervention. Id like to be confident that our economic analysists are actually examining whether something worked or not (whether it is an intervention or a non intervention), rather than whether the policy was consistent with a particular ideological or theoretical model and therefore “should have worked.” There is a difference. Its called the ability to question.

  87. drbiker
    February 3rd, 2009 at 02:28 | #87

    Many interesting comments about EMH, but as one who was earning their Econ PhD at the time & was inundated with the concept, please remember EMH was primarily intended as a framework for exposing the inefficiencies in the financial sector, primarily the limitations of technical & fundamental analysis, excess brokerage fees, and market limitations. Moreover, review of the literature at the time will point out that many carefully differentiated between the concept & the mathematical application. Much as Muth’s rational expectations was a reasonable concept (a priori) with serious implementation flaws (ex post), EMH was designed to provide a “relative” standard to judge investment behaviour and financial markets.

    And this goes to the heart of the issue – no matter what the eventual replacement for or modification of EMH, the financial markets will bastardize the message to sell their products.

    The real disappointment to me, 40 years on, results from the economic and financial researchers failure to improve the outmoded components, like the mean and standard deviation of prices, reflect risk and return. Fama at least had the excuse that he worked with punch cards on an IBM 360 where, with special approval, he could get 32k of RAM.

    The real challenge should be to develop a replacement concept “better” suited to 2009 and beyond, not 1969. As a tool for changing the financial community 40 years ago, it worked quite well. As a tool for improving future economic performance, your antigue phonograph player has as much relevance.

    Forum’s such as this would really benefit everyone by asking if creating relative standards for evaluating markets is beneficial, and, if so, what form should it take.

  88. Kevin Cox
    February 3rd, 2009 at 05:48 | #88

    Markets are efficient if they are stable and predictable. That is, if a market place – say of Adam Smith’s buttons – operates without any external shocks for a period of time the price of buttons will stabilise around its “true value”. This is the price people are prepared to buy and people prepared to sell.

    Efficient markets are those with this characteristic. That is the market is self correcting and seeks a stable state.

    Markets will move from one stable state to another provided there are no internal mechanisms that provide uncontrolled positive feedback and provided the internal mechanisms assist the system reach a stable state. That is the system has servo mechanisms.

    In a market the servo controls are the ability of the players in the market place to react so that the system will reach a stable state. This is the law of supply and demand. If the demand increases the supply increases. If demand decreases supply will decrease. In a market place price can be thought of as the other servo mechanism. If demand increases but supply cannot then price increases dampens demand. If supply increases but demand does not then price will decrease and so increase demand. Thus price is a servo mechanism.

    Markets that operate this way stabilise around a price in the absence of external effects. The graph of prices in such market should look like a step function. We would have prices stabilising around a given value until an external event caused the market to seek a new equilibrium. We should also be able to recognise the external event(s) that caused the market to move from one stable state to another.

    The fact that we cannot model this for asset markets tells our servo mechanisms exhibit positive not negative feedback.

    The positive feedback in the money market is caused by linking debt with money through the way we create money by issuing credit even though it is not backed by an asset. The more debt we create the more money we create and the more debt we are able to create. At the same time the increase in the price of money means it is more attractive to create new money particularly as we get interest on new money immediately. The feedback loop of price over demand is positive. One the way down the less debt we have the less money we have which means the less debt we can create. The price of money drops which means there is less incentive to create debt.

    Systems with positive internal feedback exhibit chaotic behaviour. We cannot predict their states because the internal mechanisms dominate system behaviour. This was well described by Maxwell in 1868 in his paper “on governors”. When we see a market where we cannot explain the graph of prices then it is likely we have a positive feedback loop rather than the state changes being caused by external events. One way to overcome this problem is to try to put in place a regulator that works against the positive feedback. With money markets we use the price of new money as the regulator – that is the price the Reserve Bank puts on new money. This method has proved to be ineffective and only partially works when the supply of debt is increasing.

    The other method is to remove the positive feedback effects. With money markets there are two things we can do. We can separate the creation of money from the creation of debt and we can remove interest payments on new money until interest represents rent on an asset. That is there is an asset backing new money before it can earn rent. Do these two things and money markets will stabilise.

  89. BenP
    February 3rd, 2009 at 05:55 | #89

    Behined every ‘market’ are people planning production, how could it be otherwise. The point is who is doing the planning and who sanctioned them so to do.

    Re EMH – weak or strong -leads us to yet another ‘wreckage of the greater part of economic theory’.

  90. February 4th, 2009 at 05:05 | #90

    “On the other hand, a number of studies have suggested that the volatility of asset prices is greater than is predicted by semi-strong and strong forms of the hypothesis (note to readers – can anyone recommend a good literature survey on this point).”

    Robert Shiller’s book _Market Volatility_ is largely about this topic and nothing else and contains plenty of references and the sort of thing you’d expect from a literature survey. It is dated (1989) but, honestly, nothing has changed since then except the excuses.

  91. Kevin Cox
    February 4th, 2009 at 06:25 | #91

    Shiller describes the positive feedback mechanisms that cause market volatility. I do not understand why we have not taken the next step.

    Can we remove positive feedback from the market and so make it efficient?

    Here is a suggestion for an individual stock to remove the positive feedback of an increase in price causing an increase in demand without a corresponding increase in supply.

    As soon as the stock climbs to what the company considers fair value plus a percentage then the company issues more stock and sells it on the market. We would have to experiment to see whether this should be known or unknown to the market and whether the fair value and percentages are known or unknown. My guess is that it should be announced but the fair value and percentage should be secret but fixed until there is a material change.

    When the price increased so the supply would increase and the market would stabilise around what the rest of the market thought was fair value. It would be fascinating to see the graph and to see if the company variations in its estimates changed the rest of the markets estimates.

    It would be an easy enough experiment for a listed company to try and perhaps there is a company out there that wants to make the market in its shares efficient. Of course when prices go down the company must buy if the market does not represent in its opinion fair value minus another percentage. This approach could be a protection for a company against “market manipulators” that attempt to force prices up or down. Perhaps the fact that a company had these mechanisms in place would be protection enough?

  92. Gerard MacDonell
    February 4th, 2009 at 11:15 | #92

    I come to this blog by way of Grasping Reality. I like the attack on the EMH, the earlier acceptance of which I think reflected as much a methodological error as ideology.

    The error is to confuse a failure to reject an established hypothesis as evidence that the hypothesis is correct. I am sorry if this thought is obvious to you and tedious but I think it is quite relevant here.

    A bunch of people who do not know how financial markets work, many never having seen one, posit a highly reductionist model set up to fail in predicting an excess return in some market. Observing that their model does not generate a profit, they conclude grandly in favor of the EMH. To someone not fully indoctrinated in the mumbo-jumbo of neoclassical economics, it is amusingly childish.

    I always thought an analogy could be drawn to a pre-Kepler astronomer failing to predict the location of the stars. Rather than concede his ignorance, he suggests that the stars are moved around by God in a way intended by Him to foil human efforts at prediction. More crazily, he claims to have conducted a “test” of this nonsense, which was “passed.”

    I bet you agree with this criticism. And I bet if you read your excellent post with this in mind, you might slightly change how you expressed yourself in a couple spots. Thank you.

  93. February 4th, 2009 at 14:17 | #93

    Gerald I think you have hit the nail on the head “The error is to confuse a failure to reject an established hypothesis as evidence that the hypothesis is correct.”

    Prices that are fairly unpredictable maybe so for a wide range of scenarios that are not compatible with “markets working well”. For example prices may be unpredictable because:
    1. Prices are generated in an unpredictable “irrational way” i.e. Keynes animal spirits.
    2. The process for generating prices maybe “chaotic” and so the standard linear tests are not relevant.
    3. The process the produces prices may change over time. i.e. history matters.
    4. The process maybe predictable but we haven’t put enough effort into understanding it yet.
    5. Any combination of the above 4 points – which seems the most likely to me.

    The real tragedy of the EHM is that economists simply run deductive models and screen these models against prices rather than actually looking at interesting questions about how and how well financial markets work and what can be done to help them function better.
    For example questions about:
    1. Do bubbles exist and if so how can we define them and take actions to reduce their size and/or impact.
    2. How well do people allocate their own capital.
    3. Are capital raising’s allocated to the highest return areas or do they occur when there are bubbles in certain industries resulting in over investment in the wrong place at the wrong time?
    4. How accurate are people expectations about the future (individually and in aggregate) and how do they form them? etc.

    If economists tried to answer these sorts of questions we’d have a much better chance of avoiding financial crisis. Instead we’ve got the EMH which provided some interesting results up til about 1975 but is a complete dead end. Refuted – depends what you take it to mean. Useful – not very.

  94. February 4th, 2009 at 23:53 | #94

    “The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century.”

    1) There were no “laissez faire” economies in the 20th century to test this against!

    2) The dot-com bubble certainly did not take place in a laissez faire environment.

  95. February 4th, 2009 at 23:58 | #95

    “The point of government intervention is to maintain competition…”

    That’s hilarious!

  96. Ken
    February 5th, 2009 at 03:28 | #96

    “Markets ‘work’ great at their central role – allocating resources to their most productive use.”

    For a suitable definition of “productive.” Depending on how the incentive system for the market participants is set up, this market productivity may have little or no relation to any other sense of the word. Unfortunately, many people conflate all senses, and assume that because a market is involved the outcome will be optimal with respect to those non-market measures of productivity.

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