So I’m supposed to go speak at Columbia Business School tonight on the topic, “Should finance professors take the blame for the financial crisis?” I just realized a little while ago that I’d better start, um, figuring out an answer. Happily, Jeremy Siegel and Martin Wolf have taken to the pages of the WSJ and FT, respectively, this morning to help me out by giving their takes on finance professors and that most famous of finance professor theories, the efficient market hypothesis.
The answer I glean from Siegel, who coincidentally happens to be a finance professor, is no way:
Regulators wrongly believed that financial firms were offsetting their credit risks, while the banks and credit rating agencies were fooled by faulty models that underestimated the risk in real estate. … Neither the rating agencies’ mistakes nor the overleveraging by the financial firms in the subprime securities is the fault of the Efficient Market Hypothesis.
[F]irst, asset markets are only “imperfectly efficient”; second, it is possible to value markets; third, huge positive deviations from fair value – bubbles – are economically devastating, particularly if associated with credit surges and underpricing of liquidity; and, finally, central banks should try to prick such bubbles.
The argument here is that because the folks at the Federal Reserve believed enough in the efficient market hypothesis so as to convince them that there was no point in trying to identify or rein in asset bubbles, we got ever bigger asset bubbles.
Interestingly, Siegel blames the Fed too:
As home prices continued to climb and subprime mortgages proliferated, Mr. Greenspan and current Fed Chairman Ben Bernanke were perhaps the only ones influential enough to sound an alarm and soften the oncoming crisis. But they did not.
He apparently sees no connection, though, between this and anything ever taught in finance class.
So here’s where I currently stand:
1) There were financial crises before there were finance professors, so the professors can’t be entirely to blame for the problems (the same goes for the argument that the very existence of the Fed causes financial crises, by the way).
2) It’s possible that we’re overstating the importance of academic theories here. If either Greenspan or Bernanke had tried to crack down on the housing boom in serious way, they would have encountered massive political resistance. Ideas matter, but politics matters too.
3) Even as narrowly defined by Siegel, the efficient market hypothesis does appear to be wrong. Here’s his definition:
The hypothesis does not claim that the market price is always right. On the contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is not at all easy to say whether they are too high or too low.
But Smithers argues that you can identify when a financial market is in bubble territory—if perhaps not with great precision. And here’s the thing: Jeremy Siegel believes this too. He wrote an op-ed for the WSJ in March 2000 arguing that tech-stock valuations had gotten way out of hand and were due for a big-time correction (which began that very month). He has significantly tweaked his “stocks for the long run” advice in recent years to emphasize that cheap stocks are more likely to pay off than expensive ones.
4) Siegel’s narrow definition of the efficient market is not the one that emanated from the finance faculties at the University of Chicago, MIT and other campuses in the 1960s through 1980s. In those days an efficient market was widely understood to be a market that got prices right, and followed the rules of risk and return laid out in the Capital Asset Pricing Model. Now it’s true that even orthodox finance scholars (UCLA’s Richard Roll in particular deserves several gold stars here) began poking holes in this elegant structure almost immediately, but the basic message that continued to be conveyed to MBA students, CFA candidates and the outside world in general was something along the lines of EMH+CAPM=Rational Markets 4ever. So I think it’s a copout when a finance professor says, “All we ever meant was that markets are hard to outsmart.” The finance professors should be asking, “I wonder why so many people think an efficient market is a market that gets prices right and whose risks are easy to estimate? And I wonder if we played a role in making them think that?”
I’ll need to come up with more than that for tonight, but this blog post is already long enough. One thing I should add, though, is that Siegel begins his op-ed with a quote from “a piece for the Washington Post” by Roger Lowenstein. It wasn’t just “a piece,” it was a review of my Myth of the Rational Market, one that was generally favorable but criticized me for being too nice to the finance professors. Then Siegel quotes efficient-market basher Jeremy Grantham, with whom I shared the spotlight in a Joe Nocera column back in June. But no mention of me or my book.
Clearly, my mild-mannered, not-all-that-far-from-the-middle-of-the-road approach is doing me no favors. So that’s it: No more Mr. Nice Guy. This crisis wasn’t just the financial professors’ fault. It was all Jeremy Siegel’s fault!
(I’m kidding, professor. Although if you want to write an angry response in the WSJ that mentions me and my book several times, I’m certainly not going to stop you.)