Don’t blame the effi cient
market hypothesis
BY: DAVID SMITH
S
o many personal reputations have back to using forecasts. This is for the instinct and the tendency of markets to
been lost during this crisis that it very good reason that they are an overshoot meant that prices could diverge
seems almost unnecessary to start important part of the information fl ow from equilibrium values for long periods.
bashing economic theory, particularly that business and the fi nancial markets On a slightly different point, it
when it has so few defenders. To take rely on. argued that many of the fi nancial market
one line of attack, the fact that most That neatly brings me on to my main innovations of recent years, such as the
economists did not see this coming point – the apparent burying by the markets in complex structured credit
must render all their models and crisis of one particular set of theories, the derivatives, conferred little economic
methods redundant. effi cient market hypothesis. The Turner benefi t, even if they had not resulted in
Well, up to a point. It is true that the Review, published by the Financial such an enormous economic cost.
majority of economists did not see this Services Authority, was typical. It is quite a charge sheet, implying
coming until it started happening, and “The predominant assumption that anybody who thinks there is any
did not see the prospect of a serious behind fi nancial market regulation – in merit in the effi cient market hypothesis
global recession until after the collapse of the US, the UK and increasingly across is either sadly deluded or in the grip of
Lehman Brothers and the near- the world – has been that fi nancial market fundamentalism. I hope I am
meltdown of the world’s banking system markets are capable of being both neither, so let me have a try.
last September. effi cient and rational and that a key goal The fi rst point to make is that the
It is also true that, just as regulators of fi nancial market regulation is to effi cient market hypothesis has not had
failed to take a ‘macro-prudential’ view remove the impediments which might it all to itself in recent years. Anybody
of the activities of the banks, so produce ineffi cient and illiquid who witnessed the dotcom boom and
economists did not pay enough attention markets,” it said. bust needed no lessons from this crisis in
to what was happening in the banking If there was a sentence designed to be the tendency of fi nancial bubbles to
and fi nancial system. followed by a ‘But’, this was it, and the blow up and burst.
Economists did, however, warn long Turner Review had a series of reasons
and hard about the unsustainability of why, in fact, markets had in practice THE ALTERNATIVE HYPOTHESIS
large global economic imbalances. Like been far from effi cient. They included Indeed, criticisms of effi cient market
the boy who cried wolf, however, such the importance of distinguishing theory may have got it entirely the
warnings lost impact with repetition, between market effi ciency and market wrong way round. What led to the
particularly when they came to nothing rationality. “The fact that prices move as global fi nancial crisis? It was caused by
for so long. Similarly, there were plenty random walks and cannot be predicted the belief that it was possible for the
of warnings about the overvaluation of from prior movements in no way denies majority of investors to beat the market,
property. the possibility of self-reinforcing herd in a risk-free way, even in an era of
effects and of prices overshooting ultra-low, long-term real interest rates.
IMPROVEMENT, NOT rational equilibrium levels,” it said. This alternative hypothesis, which
ABANDONMENT Individual rationality is not the same certainly had nothing to do with
So economic models need improving, as collective rationality, the review went effi cient market theory, drove everything
and they certainly need better specifi ed on to say, and even individual rationality from structured credit products to the
fi nancial sector equations. But they do can be called into question. Investors do decision by enough banks and
not need to be thrown out. Every time not always operate in a rational ‘front of investment advisers to put their wealthy
there is a recession economic forecasters brain’ way but are more instinctive in clients into Bernard Madoff’s high-
are castigated for their uselessness. But, their behaviour. The FSA was also taken return funds.
while economics is better at explanation with Robert Shiller’s work on ‘irrational’ An effi cient market hypothesist would
than prediction, the world soon goes exuberance, accepting that the herd tell you that those who claim to be able
4 SUMMER 2009
0404 comment.indd 4comment.indd 4 1/6/091/6/09 11:19:0111:19:01Professional Investor Summer 09.6 6 4/6/09 15:40:42
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