Whither the EMH?

The following comes from the BNZ Annual Lecture given by Professor Glenn Boyle, Department of Economics and Finance, University of Canterbury, under the title "Whither Economics?", delivered in Christchurch on 1 July 2010. EMH means "efficient market hypothesis".

But what specifically are the failings of the EMH that lead to such damning criticism?

Four appear to be central:

• Financial economists didn’t predict the crisis, thereby ‘proving’ that markets can’t be efficient in the way that economists believe.
• The collapse occurred too quickly for markets to be efficient.
• There was an obvious asset price bubble, which is incompatible with an efficient market.
• Belief in the EMH by traders and regulators created a false sense of security thatallowed the crisis to occur.

Those who argue that a failure to predict the crisis disproves the EMH are simply confused, since a central insight of the EMH is that such events should be unpredictable. In a market where prices already reflect all existing information, only new information can change prices. But new information, by definition, is unpredictable, both in content and in timing. Ergo, price changes must also occur unpredictably – implying that no investor can consistently earn above-average returns, net of the costs of acquiring information. If financial economists as a group had announced in December 2007 that financial markets would collapse in nine months time, and that they had sold all their securities and taken on as many short positions as possible, and then the collapse had occurred just as predicted in September 2008, that would have constituted strong evidence against the EMH. But what actually happened was entirely consistent with the EMH.

Similarly, prices should respond quickly in a market that processes information efficiently – when a fire breaks out in the theatre, it’s perfectly rational for everybody to head for the exits at once. A slow and gradual downturn – which is what the critics seem to think should happen in an efficient market – would in fact have been a strong indicator of market inefficiency.

The EMH does not imply that security prices are always ‘right’ in some fundamental sense, only that it’s impossible to tell whether prices are right or wrong. If all available information is incorporated in prices, there cannot be any information left to determine whether prices are ‘right’ or ‘wrong’. Any new information could confirm that prices are ‘right’ or indicate that they are ‘wrong’, but because this information is unpredictable it’s impossible to tell which is the case ex ante. Consequently, the formation of so-called asset price ‘bubbles’ is inconsistent with the EMH only to the extent that these are identifiable at the time they occur. While there were a number of commentators who regularly ‘cried wolf’ over many years prior to the 2008 crisis, few, if any, seem to have withdrawn from securities markets altogether – which, as Ray Ball points out, is the only reliable test of predictability. As Robert Lucas (Economist, 8 August 2009) notes, a central lesson of the crisis is the futility of attempting to find central bankers and regulators who can identify bubbles – since such people are unlikely to exist in the first place, and would be unaffordable if they did.

The most serious charge against the EMH is that it helped cause the crisis. Did financial market traders load up on risk and debt in the belief that an efficient market would give them early warning if they went too far? Did regulators sit on their hands secure in the knowledge that they could rely on an efficient market to do their job for them?

The answer to both questions is surely ‘no’ – if anything, the behaviour of both traders and regulators exhibited a lack of belief in the EMH. Traders have never subscribed to the EMH – after all, their principal raison d’etre is to out-perform the market. And in the years leading up to the 2008 crisis, some loaded up on risk and leverage in a selfdefeating attempt to attain this objective. Nor did regulators behave as if they had even the remotest belief in the EMH. If they had, they would have looked very closely at the suspiciously good performance of Freddie Mac and Fannie Mae and at the leverage of Lehman and Bear Sterns. They would certainly have been crawling all over Bernie Madoff. But instead they behaved as though they believed consistently high, above market returns were nothing at all to be sceptical about.

So the critics have got it the wrong way round. To the extent that there was indeed a link between the emergence of the crisis and belief in the EMH, the problem was too little belief, not too much. If traders had believed more in the EMH, they would have given up trying to beat the market and reduced their risk. If regulators had believed more in the EMH, they would have spotted, and taken action against, the high-risk and fraudulent strategies staring them in the face.

A nice brief readable summary of the issues to do with the EMH and the recent financial crisis.

The overriding lesson to take from this may well be,

Ultimately, economists must take a large share of the blame for the demise of sensible commentary on economics. Too many seem all too happy to offer up regular forecasts of financial market variables such as exchange rates and short-term interest rates, despite a huge research literature indicating that changes in such variables are not predictable. Such economists need to learn some humility. Too many others seem all too happy to advocate significant government intervention in financial markets on the slightest pretence, despite a huge research literature indicating that such action inevitably has unintended consequences. Such economists need to learn some economics.