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!
John Quiggin 
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!
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.
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.
“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”.
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?
Classic evidence on the EMH here.
More evidence here.
Steve Keen had what I thought was a very good discussion of the EMH in his Debunking Economics book.
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.
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.
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.
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.
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
http://en.wikipedia.org/wiki/Jari_project
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.
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.
#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?
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.”
#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.
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.
How so Rog? The cause of the GFC is government? Please elaborate. I rather thought it was lack of government myself.
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.
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.
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”?
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.
As EMH is a hypothesis it has yet to be properly tested.
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.
“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.
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.
http://www.firstcapital.com/blogs/mark_sunshine/?p=115
http://www.ft.com/cms/s/0/46db7d1e-bcec-11dd-af5a-0000779fd18c.html
And my blog site http://www.firstcapital.com/blogs/mark_sunshine/
(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).
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.
[…] Refuted economic doctrines #1: The efficient markets hypothesis John Quiggin […]
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.
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.
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.)
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…
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.
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)
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 )
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.
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.
Does anyone have a view on the website “Financial Rankings” I just found. Is the information reliable? It is at:
http://financialranks.com/?p=76
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.
[…] long term it’s a weighing machine. This article does a pretty good job of marking the passing end of the EMH (at least in the near […]
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.
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.
could have alerted people to the impossibility of Madoff’s consistent gains over good times and bad.
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.
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.”
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?
Ayn-Randroid alert!
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.
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.
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.