Joe Nocera of the New York Times penned an interesting column yesterday about the death of an economic theory called the “efficient market hypothesis”.
You know what the efficient market hypothesis is, don’t you? It’s a theory that grew out of the University of Chicago’s finance department, and long held sway in academic circles, that the stock market can’t be beaten on any consistent basis because all available information is already built into stock prices. The stock market, in other words, is rational.
In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.
This reminds me a bit of the nature-nurture debate. Only a specialist could arrive at any conclusion other than that it’s a bit of both. Similarly, no one but an expert could maintain that the stock market is wholly rational. Anyone with knowledge of history knows that, in the short term, markets can be far from rational. If they were, then bubbles would be impossible, but bubbles have been with us almost as long as there have been tulips in Holland. In the long run, of course (in which time, as Keynes famously observed, we’ll all be dead), prices find their level. As one of Nocera’s sources points out, one of the ironic things about the “efficient market hypothesis” is that for those who accepted it as gospel, it proved to be true. If, on the other hand, one posited that the market was neither efficient or rational in the short term, one could bet against the bubble and beat the market, though of course one needs to be extremely perceptive to do so.
If this were only an academic issue it would be interesting, but not terribly important. After all, regardless of whether nature or nurture is winning the day in academic circles, in the political world we go on assuming that the two are intertwined, and public policy doesn’t suffer much. And it’s not very important that anyone be able to beat the market consistently. But the corollaries to the theory are what has helped bring us low. For if markets are efficient in real time, it follows as the night the day that we should simply let them do their magic, and avoid governmental interference. Which is precisely what we have done for the past too many years.
Whenever someone posits a theory that seems to fly in the face of both common sense and historical experience, we must suspect that they are working backwards: starting at a desired point and selectively gathering data to support that point. (See comic below) It’s a little like the creationists that engage in logical contortions to reach their illogical conclusions. In fact, the belief in the wisdom of free markets espoused by so many approaches religious faith in both its fervor and its reliance on faith above reason and experience.
The University of Chicago, from which this theory emanated, has been dominated by conservative economists. The theory supports the anti-regulation, free market ideology of that school, and of the conservative ideology generally. Unlike psychological theory, it has been adopted by people with real power to affect our economy, and we are now living with the results.
