Titan of academic finance Gene Fama writes in his blog:
The premise of the Fox book is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH), which posits that market prices reflect all available information. The claim is that the world’s investors and their advisors in the financial industry bought into this model. Because they ceased to investigate the true value of assets, we have been hit with “bubbles” in asset prices. The most recent is the rise and sharp decline in real estate prices which froze financial markets and led to the worst recession since the Great Depression of the 1930s.
The book is fun reading, but its main premise is fantasy. Most investing is done by active managers who don’t believe markets are efficient. …
I really didn’t think this was the main premise of my book. I wrote 95% of the thing before the financial crisis, and I certainly didn’t predict the disaster that ensued. So it would have been hard for me to set out to prove “that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis.” I was basically just out to recount some intellectual history that I thought was really interesting, and maybe important too.
That said, the premise of a book is in the eye of the reader, and I’m sure a lot of the people forking over good money to buy my book do so because they think I’m arguing that Fama’s efficient market hypothesis is the cause of all our troubles. So I can’t run too far away from that argument.
Yet … I completely agree with Fama that most investing is done by active managers who don’t believe markets are efficient. Also, investors were blowing bubbles long before Fama starting writing about “efficient markets” in the 1960s. So investor behavior during the tech stock and real estate bubbles really can’t convincingly be attributed to the teachings of Fama and other finance professors.
But I don’t think that’s the main point that fiercer efficient-markets critics than I like George Cooper and George Soros are making. They’re saying that the big problem was that regulators and central bankers drank the efficient market Kool-Aid. Adair Turner, chairman of the British Financial Services Authority, put it well in that famous interview that Prospect published back in September (subscribers only, I’m afraid; I happen to work with a subscriber):
[W]e have had a very fundamental shock to the “efficient market hypothesis” which has been in the DNA of the FSA and securities and banking regulators throughout the world. The idea that more complete markets and more liquid markets are definitionally good and the more of them we have the more stable the system will be, that was asserted with great confidence up to three years ago.
What Fama might say in response is, “Well, I never asserted that.” He’s probably be right. But as I wrote in my previous post on the topic, what Turner describes was the key message that emanated from academic finance and economics into the Wall Street and government-policy mainstream over the past few decades. Interestingly, some of the most interesting financial-economic research of the past decade-and-a-half has been about market failures. But the transmission of such knowledge into mainstream thinking occurs with long and variable lags—and Fama certainly wasn’t one of the people out there waving their hands and saying, “Hey, watch out! Financial markets can burn you!”
I guess that’s what’s kind of disappointing to me about Fama’s post. I’m thrilled that he’s read my book, and is saying halfway nice things about it in public. In general, I’m a big Fama fan—his willingness to keep testing his theories against the evidence, and to support the work of students and younger professors whose research undermined those theories, is hugely admirable. But he and a lot of other people in academic finance just don’t seem interested in directly engaging in many of the most interesting questions raised by the financial crisis. Such as: Can the financial sector get too big, and if so how can we tell? Can derivatives markets concentrate risk as well as spread it? Is financial innovation fundamentally different and more dangerous than innovation in other fields, and if so what should we do about it? Should central banks and financial regulators try to snuff out asset-price bubbles, and if so how should they go about determining when we’re in bubble territory? Is Hyman Minsky right that good times inevitably breed crises?
Of course most investors don’t believe in the efficient market hypothesis, and most of them would probably be better off if they did. Point taken. Now can we move on to the more interesting stuff?