‘No Free Lunch’ vs. ‘The Price is Right’

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Economist Dick Thaler has a new FT opinion piece that says nice things about (and quotes extensively from) The Myth of the Rational Market. (Thanks, Dick!) In it, he makes the case that the efficient market hypothesis consists of two main ideas, “No Free Lunch” and “The Price is Right,” that have met very different fates over the past decade or so. After running through the history, he concludes:

What lessons should we draw from this? On the free lunch component there are two. The first is that many investments have risks that are more correlated than they appear. The second is that high returns based on high leverage may be a mirage. … On the price is right, if we include the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and, in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be “right”, then these bubbles would not occur. But they have, so what are we to do?

While imperfect, financial markets are still the best way to allocate capital. Even so, knowing that prices can be wrong suggests that governments could usefully adopt automatic stabilising activity, such as linking the down-payment for mortgages to a measure of real estate frothiness or ensuring that bank reserve requirements are set dynamically according to market conditions. After all, the market price is not always right.

That sounds about right. I’ve been making similar arguments this week in a debate with Eric Falkenstein at CBS MoneyWatch.com. But I think Thaler says it more convincingly than I do. I guess he does have a lot more practice.