One of the great snow jobs of the past thirty years is the assertion that "efficient markets" equals "free markets" equals "capitalism and democracy" and mom and apple pie. For its proponents, to criticize the Efficient Market Hypothesis (EMH) is akin to attempting to clone Lenin from his Kremlin mausoleum. But EMH is not about free markets, it is merely a conjecture about 'information' and how investors SHOULD use information to participate in financial markets.
EMH is covered in immense detail on immeasurably Internet sites so it is unnecessary to describe in detail here, other than to note that in its 'strong-form' the hypothesis states that investors cannot consistently earn 'excess returns' over a long period of time.
Pity nobody told the schmucks on Wall Street, before they gambled our pensions in the credit crunch casino!
Another way to state the EMH hypothesis is that the market will right itself eventually. According to the theory, 'rational' investors, who have the same information, will arrive at the same price for a traded asset guided, no doubt, by the invisible hand of Adam Smith.
Like Voltaire's comic hero Candide, Alan Greenspan (Emperor of EMH) is the eternal optimist, believing that all he had to do was tweak the Fed interest rate and, markets being efficient, everyone would naturally behave sensibly.
In his recent testimony to the US Congress, Dr. Greenspan said he was in a "state of shocked disbelief" at what happened in the US credit markets. Note he was not shocked at the millions of people thrown out of work as a result of his beliefs, but, as he whined, that the "self interest of lending institutions failed".
I have news for Dr. Greenspan, every Wall Street firm did have all the market information they needed to make rational investment decisions, since they were busily reporting record profits based on the crazy asset prices that everyone was turning a blind eye to. The efficient marketers knew well that the bonus bus was racing out of control down the mountain but wanted to be the last one off just before it went over the cliff.
The impact of the dominance of EMH in financial market theory on approaches to financial regulation cannot be denied.
If EMH is right then, since the market will right itself naturally, there is little need for regulation - why try to second-guess the all-powerful market? In this financial Utopia, all regulators have to do is to ensure that market information is made as widely available as possible and, hey presto, as Candide would say 'all is for the best in this best of all possible worlds'.
In this parallel universe, markets don't have to be regulated, they will, since they can do no other, regulate themselves. As a consequence, over time, self-regulation has become the name of the game and financial regulators around the world have fallen over themselves trying to get out of the way of self-regulators, happy to receive advice from the banks themselves on how they should be regulated. Basel II is just one such example of pandering to self-regulation.
But what if EMH is wrong, or at least not always right? It is but a mere hypothesis after all and one that has been severely tested, as Milton Friedman would say, by experience (not least in our pockets). The beauty of EMH however is not that it has never been proven correct (except by definition) but that it cannot be proven wrong since any counter example is considered by its adherents to be merely a statistical outlier. So one individual (say, for argument's sake, Warren Buffett) may make outrageous profits over a prolonged period, but not everyone did, QED - EMH must be true!
Debate has raged for years about whether EMH has any validity, not least between the efficient marketers and the proponents of Behavioral Finance. Behavioral Finance, which has achieved respectability since one of it originator - Daniel Kahneman - received a Nobel Prize in 2002, states basically that far from being 'rational', people are sometimes stupid, very stupid. And there is a growing body of experimental and real-world evidence that Dr. Kahneman may not be too far off the truth. People may not always 'beggar thy neighbor' in the zero-sum game of the efficient market, but instead often tend to 'follow thy neighbor', even if it is down a financial blind alley.
But what if both theories were, at least in part, correct. Investors may indeed tend to make rational economic decisions if there is an abundance of 'good' market information, but where information may be lacking they may do something 'economically irrational'.
It is worth posing the question: what should regulators do if Behavioral Finance is in fact correct, even if only in certain conditions? In such a situation, regulators, and their political masters, just cannot stand on the sidelines since 'irrational' or 'human' behavior (depending on which theory one subscribes to) can have very serious consequences, as we have witnessed in 2008. Regulators just have to wake up and realize that some people sometimes do idiotic things. Regulators have to regulate, a forgotten notion but still useful nevertheless.
What this means is that regulators, instead of letting banks do their own thing, have to again begin to ask tough questions, such as 'tell me once more why you are lending money to people who cannot pay it back'? The answer that 'everyone else is doing it' is of course no longer valid, but should instead warrant the rejoinder - well stop it or you are grounded! The regulator as parent rather than friend.
Following the precautionary principle, regulators should always remain skeptical about economic theories, as they come and go like any other fashion. However, human behavior remains constant, and regulation is as much a social science as a mathematical one. Maybe the Fed should be hiring psychologists as well as rocket scientists?
Regulation is often characterized as a pendulum, swinging one way then back again. But in this age of the digital watch, does anyone in Generations X or Y know what a pendulum is? I prefer instead to envisage the beautiful parabolic arc of the executioner's axe - at one end benign, at the other deadly. Regulators are now at the cutting edge of regulation and they had better get sharp about what exactly they are going to do to intransigent bankers. If they don't, they will be on the chopping block themselves.
But efficient marketers are nothing if not optimistic, as Dr Greenspan assured Congress "This crisis will pass, and America will reemerge with a far sounder financial system". Candide's mentor, Pangloss, expressed EMH more lyrically when he said 'private misfortunes make the public good, so that the more private misfortunes there are, the more everything is well'. In other words, even though you may have lost your job, your home and your pension, treat it as a learning experience.
So as you queue patiently in the line for the soup kitchen, please take the opportunity to discuss the finer points of Modern Portfolio Theory with your neighbor, the ex-regulator.
Footnote
The author has begun work on a bridging theory, a 'grand theory' if you like, which is tentatively called the Inefficient Behavior Supposition (IBS) that in lay terms states, "If people don't know where they are going, they won't get there".
In more technical terms the IBS theory postulates that
E (RD | I(In)) = 0
or the Expectation of a Rational Decision (RD) given Incomplete (I) Information (In) is zero where I is a monotonic Incompleteness function, bounded on the interval [0,1].
Basically, this says that without good data we are as likely to get any decision wrong as right! Unfortunately, we can never know when we have all the information that we need?
