I got more very useful comments on my section on the rise of the Efficient Markets Hypothesis, and I will get down to editing it before long. In the meantime, here’s my draft section on Implications of the EMH

At least in the draft, I’m following a standard structure: One chapter per dead/zombie idea, with sections on Beginnings, Implications, Failure and What Next? It seems to go OK for EMH, and we’ll see how it works for the others.

As before, comments of all kinds, and particularly pointers to (putative) errors, are most welcome.

The EMH: Implications

Although Paul Samuelson and Eugene Fama were jointly responsible for the formulation of EMH, they had very different views of how it should be interpreted.

Samuelson maintained the distinction, characteristic of the Keynesian-neoclassical synthesis between microeconomics, where a standard competitive market analysis was applicable, and macroeconomics, where a Keynesian analysis was needed. He argued that while tests of the EMH showed that financial markets were micro-efficient, the experience of bubbles and busts showed that they were ‘macro-inefficient’.That is, the efficient markets hypothesis works much better for individual stocks than it does for the aggregate stock market.

Samuelson’s position means, for example, that is difficult, if not impossible to outperform the stock market by examining the price history of individual stocks, or by poring over company reports. But it is possible to identify bubbles in the stock market as a whole, and to propose policies to stabilise asset markets. Writing in 1998, as the dotcom bubble was approaching its peak, Samuelson called for increased interest rates to deal with the ‘quasi-bubble’ on Wall Street. And, repeating Keynes response to the idea that rational speculators would always prevent such bubbles getting out of hand, Samuelson wrote

‘We have no theory of the putative duration of a bubble. It can always go as long again as it has already gone. You cannot make money on correcting macro inefficiencies in the price level of the stock market.’

But by the 1990s, Samuelson was in the minority, and his view that the EMH was consistent with macro-inefficiency commanded little support. The alternative interpretation, more logically consistent (if less consistent with reality), that the financial market price of an asset was not merely the best estimate of its value relative to other assets of the same kind, but was the best possible estimate, given available information.

This maximal interpretation of the EMH was espoused in academic works by Fama and his many students and followers and by the 1990s, accepted by most finance theorists, and nearly all policymakers. It was popularised by such writers as Thomas Friedman, whose The Lexus and the Olive Tree warned governments that the could not possibly hope to resist the collective financial wisdom embodied in the ‘Electronic Herd’ of global financial traders.1

The implications of the efficient markets hypothesis go well beyond financial markets. The EMH provides a case against public investment in infrastructure, and implies the macroeconomic imbalances, such as trade and current account deficits should not be regarded with concern and, provided they arise from private sector financial transactions, are actually both beneficial and desirable.


1 The term is an allusion to the ‘Thundering Herd’ a nickname for the iconic Wall Street investment bank, Merrill Lynch. In October 2008, Merrill Lynch was rescued from imminent collapse through a takeover by Bank of America, which was in turned bailed out to the tune of billions of dollars by the US government.

Asset bubbles and imbalances

The efficient markets hypothesis implies, in essence, that there can be no such thing as a bubble in the prices of assets such as stocks or houses. Such a claim, seeming as it does to fly in the face of centuries of experience, requires a fair bit of faith in the analysis underlying the EMH. But, in the euphoric atmosphere of the 1990s, such faith was in abundant supply.

The argument begins with the claim that, if a bubble in stock prices were indeed observable, speculators would sell the asset in question and go on to sell it short (that is, sell assets they did not hold in the expectation of being able to buy them later at a lower price). This would ensure that the price returned rapidly to the true market value.

But as Keynes had pointed out decades earlier, this argument only stands up if bubbles are short-lived, so that speculators are quickly vindicated. As Keynes said

“He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how thc crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. “ Ch12 p140

More succinctly, in words widely (though apparently apocryphally) attributed to Keynes himself ‘the markets can stay irrational longer than you can stay solvent’. Lots of investors, from small-scale individual speculators to billion-dollar fund managers like Julian Robertson of Tiger Investments bet against the stockmarket bubble of the 1990s and lost.

A second argument is that, even if bubbles are real, there is little nothing policymakers can or should do to burst them. This was the conclusion reached by a number of central bankers who, unlike Greenspan, saw irrational exuberance in stockmarkets and property markets as a likely source of future trouble. A study by Borio and Lowe of the Reserve Bank of Australia pointed out the dangers of asset bubbles. However, in a policy environment where the only way of restraining speculation was to raise interest rates, they concluded that central banks could do little more than issue warnings.

It is worth noting, that although Australia experienced a serious land price bubble, lending standards were held to much stricter levels than in the US or other markets. It may be that the warnings of the Reserve Bank had some influence on the policy decisions of prudential regulators.

Finally, some supporters of the EMH argued, along lines first popularised by Austrian economist Joseph Schumpeter,, that even if bubbles lead to massively wasteful investment, they generate innovations that are beneficial in the long run (the phrase ‘creative destruction’ was widely used in this context).

Supporters of the EMH also engaged in a fair amount of historical revisionism to argue that famous historical examples of bubbles, from the Dutch tulip mania to the Roaring Twenties and beyond, were actually rational responses to new market conditions, often exaggerated in subsequent retellings. The Dutch tulip mania saw the price of a contract for a single tulip bulb exceed 10 times the annual income of a skilled craftsman Economist Peter Garber argued that these contracts were never fulfilled, and were little more than “bar bets”, and hence did not violate the EMH. Earl Thompson also defends the EMH, but argues that the prices were in fact rational in the light of the market rules prevailing at the time.

Implicit in all of these arguments was the conclusion that, in a well-developed modern market, with transparent dealing and with all parties subject to the scrutiny of auditors and ratings agencies, an irrational bubble could not possibly develop or be sustained. This conclusion formed the basis of financial policy in the decade leading up to the Global Financial Crisis of 2008.

The growth of the financial sector

In most of the simple models from which the Efficient Markets Hypothesis was derived, the financial sector did not exist as an industry. Financial markets were assumed to set the price of assets without any cost to the economy. As we have seen, the question of how those with information or forecasting skills could gain the returns they needed to justify their efforts was a significant theoretical problem for strong forms of the EMH.

Although no truly satisfactory analysis of the role of financial institutions in efficient markets was ever produced, advocates of the EMH came to accept that the cost of financial market transactions was equal to the value of the information they incorporated in asset prices. It followed that, as financial transactions were liberalised and the economy became ever more sophisticated, it was economically and socially desirable that the financial sector should grow.

And grow it did. In simple economic terms, the growth of the financial sector since the mid-1970s has been staggering. The financial services industry’s share of corporate profits in the United States rose from around 10% in the early 1980s to 40% in 2007 (Már Gudmundsson,, at a time when the profit share of national income was also growing strongly.

Volumes of financial activity grew at rates that defy any simple interpretation. The Bank for International Settlements has estimated the global volume of futures market transactions in 2007 at $1.6 quadrillion dollars, or about 30 times total world output. Notional volumes of outstanding derivative contracts are similarly massive. In the normal course of events, most of these transactions net out to zero, but even a small mismatch can produce losses (or gains) of many billions.

Along with all this, the income and wealth of those working in the financial sector grew massively. The salaries of financial sector executives reached four times the level prevailing in other industries, at a time when executive salaries in general massively outpaced growth in the incomes of ordinary workers. Such massive accumulations of wealth translate naturally into political power. Particularly in the United States, both major political parties were heavily influenced by Wall Street firms.

But the political power of the finance sector does not depend solely on command over economic resources. After the economic dislocation of the 1970s, the financial sector became, in perception and to some extent in reality, the most important guarantor of economic stability and prosperity. Governments sought desperately to gain and maintain the AAA ratings issued by agencies such as Moodys and Standard & Poors.

Private and public investment

Casual observation suggests that both the private and public sectors have difficulty in managing investments. Public sector investments, from the time of the Pharoahs onwards, have included plenty of boondoggles, white elephants and outright failures. But the private sector has not obviously done better. Waves of extreme optimism, leading to massive investment in particular sectors, have been followed by slumps in which the assets built at great expense in the boom lie unfinished or idle for years on end.

The EMH supports the first of these observations, but suggests that the second must be mistaken. Since public investments are not subject to the disciplines of financial markets, there is no reason to expect their allocation to be efficient.

By contrast, according to the EMH, private investment decisions are the product of an information system that is automatically self-correcting. The value given by the stock market to any given asset, such as a corporation, is the best possible estimate. If the managers of a given corporation make bad investment decisions, the value of shares will decline to the point where the corporation is subject to takeover by better managers.

The EMH, which enshrines the market price of assets as the summary of all relevant information, is inconsistent with any idea that managers should pursue the long-term interests of corporations, disregarding short term fluctuations in share prices. On the EMH view, the short-term share price is the best possible estimate of the long-term share price and therefore of the long-term interests of the corporation.

If the EMH is accepted, public investment decisions may be improved through the use of formal evaluation procedures like benefit-cost analysis, but the only really satisfactory solution is to turn the business over to the private sector. In the 1980s and 1990s this reasoning fitted neatly with the global push for privatisation, discussed in Chapter …

The EMH implies that governments can never outperform well-informed financial markets, except in cases where mistaken government policies, or a failure to adequately define property rights, leads to distorted market outcomes. If governments are better informed than private market participants they should make this information public rather than using superior government information as a substitute for public policy.

To sum up, the EMH implies that private enterprise will always outperform government, and that governments should confine their activities to the correction of market failures, and to whatever income redistribution is needed to offset the inequality of market outcomes.

Macroeconomic implications

There are also important implications for macroeconomic variables such as the balance of international trade. From a traditional Keynesian perspective, large imbalances in trade are a sign of trouble to come, since they will inevitably produce an unsustainable buildup of debt. Economists like Nouriel Roubini and Brad Setser were particularly vocal in warning of the trouble ahead for the US economy. I made the same point in an article published in the Economist’s Voice, with the self-explanatory title ‘The Unsustainability of the US Trade Deficit’.

By contrast, the EMH leads to the conclusion that economic analysis should be focused on asset values rather than on income flows. Observations of current income flows are informative only about the present, whereas asset values capture all relevant information about current and future income flows. An increase in asset values implies an increase in the present value of future income and therefore in the optimal level of consumption.

Once the EMH is accepted, there is no need to worry about imbalances in savings and consumption. International capital movements can be seen as the aggregate of a large number of transactions between ‘consenting adults’, buying and selling financial assets in markets which, according to the EMH, have already taken into account all available information about future risks. If a national government has better information, the appropriate response is not to act on it, but to release the information to the markets.

On the traditional, income-based view, by contrast, asset-based arguments are misleading and dangerous. By the time sentiment shifts in asset markets, the opportunity for an orderly adjustment will already have been lost. Advocates of the traditional view pointed to episodes of contagious panic in financial markets, most recently the Asian financial crisis of 1997.

The traditional response to macroeconomic imbalances such as trade deficits was the adoption of contractionary monetary and fiscal policies aimed at reducing demand for imports and at forcing domestic producers to seek export markets as a response to lower demand at home. The resulting ‘stop-go’ policies caused substantial suffering and economic dislocation.

Once it is realised that sustained macroeconomic imbalances ultimately reflect financial market failures, this response can be seen to be inappropriate, as can the benign neglect associated with the consenting adults view. The appropriate response is to intervene in financial markets to restrict the unsound lending practices that drive the growth of such imbalances.

46 thoughts on “Bookblogging

  1. @Chris Joye
    Trying out the reply tool here. Chris, I’ve followed earlier rounds of the debate within the central banking community. I entirely agree that interest rates are the wrong tool, but it’s also clear that moral suasion is not enough. In my 2006 paper with Stephen Bell, I conclude that the only solution is a return to restrictive financial regulation.

  2. Email is down, would you believe. John: I generally agree. One smart proposal is Phil Lowe et al’s notion of “automatic stabilisers” in prudential supervision/capital adequacy requirements etc.

  3. I wonder who the book is aimed at. This is the most readable offering for the lay reader. The earlier offering seemed to be aimed more at the specialist.

  4. It’s intriguing that John Quiggin refers to “restrictive financial regulation”, but I wonder what that really means, a return to the pre-deregulation model? I would have thought that in this day and age there were more sophisticated ways to moderate the risks inherent in the roller coaster world of banking. I wonder if anyone has any ideas..

  5. “In this day and age” the central banks caused the biggest stuff up in the world economy since the Great Depression. If anything we have regressed.

    I support 1950s style regulation or the abolition of legal tender laws and free banking. One or the other.

    This “in between” has castrated the economy, where banks privitise profits on the way up and socialise losses on the way down.

    Even nationalisation of the banking system would be better than what we have.

  6. ABOM, my guess would be that the wholesale changes you suggest would damage the economy significantly, in the short term, and add very little protection when it was really needed. Regulation of the 1950s (and 1960s and 1970s!) style would bring the economy to its knees very quickly. And laissez-faire? Sure, if you want lots more sub-prime type scenarios. Throwing the baby out with the bathwater is not the answer. For all the apparently informed comment here there is a dearth of really creative ideas. I think Alice was close with one comment but did not expand – probably didn’t realize that she was “warm”.

    In a world where government intervention will be required, albeit very rarely, to ensure the survival of the payments system, and other broad reaching parts of the financial markets, there should be some type of structure within which ADIs (and other financiers) operate to ensure that really crazy things can’t happen. That structure has to be a lot smarter then the present Australian system, and I don’t mean smarter in the context of yet more “models”.

  7. Damien, are you saying another catastrophic GFC is preferable to either re-regulation or complete deregulation? You’re too cautious, assuming the current system is a “wise” accumulation of knowledge over the years. It’s not. It’s insane. Free banking and heavy regulation have both been around longer than the current mutant financial system that has only been around since 1971 (or really since Glass-Steagall was removed in the 1990s).

    The baby was thrown out years ago. It’s head was cut off and the blood is all around us. The UK is having the biggest contraction in economic activity since the Great Depression and the US is still the midst of crisis, with the biggest budget deficit in history and debt as a propotion of GDP being at levels unprecedented in world history.

    This is not the time to be worrying about the baby. The baby is already dead.

  8. The Bank sector needs stronger Controls over what and how much they can lend, the fraction kept in reserves needs to go right up, where they can go (and whether they should in fact go anywhere at all). Why do we need global banks anyway? – if they want to globalise goods and services fine but you dont globalise the means of transacting (your financial system) and you carve banks into banks for savings by regulations and banks for investment and never the twain shall meet. And someone needs to regulate the creative financial derivative markets badly.

    In short there is no other way except to hog tie the bastards and cut off their air supply and start growing real industries instead of an obscenely fattened financial sector and obscenely rewarded executives (on much misery of others). We have lost the plot. We have given the banks a license to destroy the capitalist system as we know it.

  9. @ABOM
    ABOM – dont make me choose….I dont mind the sweet gentle Rothbard who clearly had good intentions….but Mises?

    Never underestimate the power of a woman ABOM!

    One of my husbands was deeply blue when I met him (a long desecndant of sweet country folk…Doug Anthony’s followers and their children – politics you dont discuss and nor do you change your vote come hell or high water).
    Fortunately I was able to resuscitate him just in time and it was long before he started to turn green (a decade or so) and no – the green shade wasnt due to oleander in his tea!

    ABOM – how can you possibly ask me to choose…Mises or Keynes?
    I might concede a little on Rothbard…but lets save the rest for all those uinteresting arguments to come!

  10. Alice, I admit Mises was a strange dude (apparently a wife-beater, which I was deeply disturbed by – women are everything to me) but please focus on the ideas. I’m asking you not about Mises, but about a very specific entry on Do you agree with this particular entry?

    The back massage will have to wait…

  11. Pr Q: perhaps some information on how the EMH has been tested, and the results of those test, might be a nice addition?

    Mandelbrot’s self-promotion aside, in his book “The (Mis)Behaviour of Markets” (2005), he lays out the data for the empirical distribution of stock price changes and compares it against the predictions of EMH (any version). Clearly the empirical distribution has fatter tails than the normal distribution implied by EMH. To quote from page 13:
    “In fact, the bell curve fits reality really poorly. From 1916 to 2003, the daily index movements of the Dow Jones Industrial Average do not spread out on graph paper like a simple bell curve. The far edges flare too high: too many big changes. Theory suggests that over that time, there should be fifty-eight days when the Dow moved more than 3.4 percent; in fact, there were 1,001. Theory predicts six days of index swings beyond 4.5 percent; in fact, there were 366. And index swings of more than 7 percent should come once every 300,000 years; in fact, the twentieth century saw forty-eight such days. Truly, a calamitous era that insists on flaunting all predictions. Or, perhaps, our assumptions are wrong.”


    Donald Oats

  12. @Freelander
    I think you raise a valid point, Most tests of the EMH are afflicted with the “joint hypothesis” problem. The joint hypothesis problem is really an identification problem: is the hypothesis you are testing a test of the EMH, or a test of the pricing model you are using (e.g. CAPM, ICAPM, etc)?

    This problem plagues micro-tests of the EMH, since the focus here is on whether the stock is efficiently priced relative to some benchmark (model) price. In order to get around this joint hypothesis problem, one really needs to conduct macro-tests of the EMH, which can really only be done by comparing whether asset prices are consistent with economic fundamentals.

  13. @ABOM
    I admit I havent really had a string of husbands I turned green with oleander…only one and the best I could do with him was a few green shoots which threaten to wither easily…bit like the economy.
    However, I have serious concerns now about this dude Mises….a wife beater eh? ABOM maybe thats why there isnt a lot of women in his blogs – they can detect it even through the internet. Yet, as you say if we get rid of fed intervention in banks exactly how will that solve the problem of frb and excessive risky “malinvestments”. There needs to be some form of practical regulation to enforce more control over their behaviours and what about Glass Steagall repeal…didnt that contribute to the growth of the ugly financial institutions (and didnt some free marketers advise against this strongly???).

  14. Ugh. You’re losing me.

    Please read this, from the great Murray Rothbard:

    “Given this dismal monetary and banking situation, given a 39:1 pyramiding of checkable deposits and currency on top of gold, given a Fed unchecked and out of control, given a world of fiat moneys, how can we possibly return to a sound noninflationary market money? The objectives, after the discussion in this work, should be clear: (a) to return to a gold standard, a commodity standard unhampered by government intervention; (b) to abolish the Federal Reserve System and return to a system of free and competitive banking; (c) to separate the government from money; and (d) either to enforce 100 percent reserve banking on the commercial banks, or at least to arrive at a system where any bank, at the slightest hint of nonpayment of its demand liabilities, is forced quickly into bankruptcy and liquidation. While the outlawing of fractional reserve as fraud would be preferable if it could be enforced, the problems of enforcement, especially where banks can continually innovate in forms of credit, make free banking an attractive alternative.”

    No Austrian supported the repeal of Glass-Steagall (Ron Paul didn’t, I didn’t – we all knew it was going to be a disaster). Landis predicted disaster in 2004:

    As I’ve said many times before: Either have free banking and repeal legal tender laws. Or heavily regulate banking (perhaps even nationalise).

    I’ve said this before so I’m getting a little worried about you. I had you on side earlier. Now I’m not so sure….

  15. And just how many husbands have you had, Alice?? I’ve nearly destroyed my second marriage, so I cannnot believe anyone would marry a third time after being put through the wringer twice…

  16. Only one….ABOM….Im so tight I hate the thought of the wringer…its a real deterrent but hubby had two before me and got put through the wringer really badly only once (big time and we spent years paying that one off…grrr) ..wife number two wasnt any trouble – it was the shortest marriage in history – less than a year – and as for me ? I have actually refused to marry him – he is jinxed (I reckon three strikes and you are out – so that really means I have had no hubby at all!!!!).

    Looks like a hubby, acts like one, been around long enough to act like one, but in all the technicalities Ive never been married ABOM (absolute truth).

    So ABOM – how could you nearly have destroyed your second marriage. I dont believe it!

  17. I can barely keep myself alive, so I was “vigorously” against producing another life-form to suffer consciousness. My wife had a different view, enthusiastically embracing the idea of creating another “me”. She did not comprehend what a disaster creating another “me” would have been.

    “I am myself indifferent honest; but yet I could accuse me of such things that it were better my mother had not borne me. I am very proud, revengeful, ambitious; with more offences at my beck than I have thoughts to put them in, imagination to give them shape, or time to act them in. What should such fellows as I do crawling between earth and heaven? We are arrant knaves all; believe none of us.”

  18. ABOM- Im on side still..there is merit in what you say …just let me mull it over…some suggestions I think may certainly work better than what we have now (which is a mess despitte any turnaround)…just which parts is the question…….

  19. It sounds like Samuelson thinks that bubbles are predominantly a macro phenomenea. My limited observations suggest that the are a scale invariant phonemeneaa. They can occur in the whole economy (such as the GFC), or they can just occur in the price of a single stock. They also seem time-scale invariant to a certain extent.

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