Bedtime for market efficiency
It’s time for introductory economics courses to give up on one of their favourite fairy stories
As a result of that big financial crisis we once had, people have been calling on the economics profession to make some fairly serious revisions to the way the subject is taught. While there’s decent room for debate over how extensive changes need to be, and a lot of room for scepticism about the kind of people who want to use the crisis as a reason to chuck everything away and rebuild the science around their own personal hobby horses, I think there’s one thing that really can’t be denied; when this particular phoenix rises from the flames, it ought to leave the Efficient Markets Hypothesis back in the ash pit.
The theory of efficient markets gets a chapter of its own in John Quiggin’s “Zombie Economics” as an idea that won’t go away, no matter how thoroughly it’s refuted. So it’s worth setting this out in black and white, in so many words — this idea, once referred to by Michael Jensen as “the best established fact in all of social sciences”, is actually close to being one of the most decisively refuted.
The temptation will be to try and avoid going “cold turkey” on efficient markets, by reducing the overarching claims, but hanging on to the general story that markets are “broadly efficient”. This won’t do either. Even with respect to some of the most liquid markets in the world (S&P500 equities) and with respect to the weakest possible version of the hypothesis (so-called “weak form” — the hypothesis that there is no information in the past history of share prices which can be used to predict the future), it doesn’t work. This has been known to specialist financial econometricians for about twenty years now (“A Non-Random Walk Down Wall Street” by Lo & McKinlay was first published in 1999, summarising literature that had been in existence since the early 90s). Momentum effects exist and can’t be rationalised away as statistical noise; fund companies like AQR have been offering funds based on them, and generally outperforming, for ages.
And when you get to anything stronger than the very-weak form versions, the performance is really quite embarrassing. Robert Shiller’s share of the Nobel Prize was for noticing that securities prices are, in general, much too volatile to make sense as forecasts of anything in the real world. DeLong, Summers, Shleifer & Waldmann have shown that there is no real theoretical basis to the idea that “traders competing against each other make markets efficient” — it’s just as likely that they create meaningless volatility. Market prices aren’t totally informative, as they are in some sense a weighted average of the views of a large group of well-resourced and intelligent people with an incentive to get things right. But nobody would build a theory of politics around the infallibility of opinion polls — business schools certainly wouldn’t let any other department get away with claiming that it’s definitionally impossible to improve on the current state of affairs.
All that’s really left of market efficiency is a sort of woolly idea that “it’s difficult to make money in the stock market”. Which it is, but it’s pretty difficult to make money in any other way too, a fact which has fewer implications for fundamental economic truth than you’d think. Efficient markets theories have the advantage for economics academics that they provide a useful response to an often-asked question by class smart-alecs (“If you’re so smart, why aren’t you rich?”), and they can provide the occasion for the dispersal of some generally sensible advice for personal finance (tracker funds). But this really isn’t a reason to keep them on the syllabus.