The Inefficient Market Hypothesis

Nancy Folbre is professor emerita of economics at the University of Massachusetts, Amherst.

Either it was a partisan compromise, or the Nobel Memorial Prize in Economic Science committee simply hedged its bets, bestowing its annual prize on three economists, two of whom represent divergent views. One Financial Times blogger compared it to a joint celebration of Milton Friedman and John Maynard Keynes.

John Kay, also writing in The Financial Times, put it more sharply, as “awarding the physics prize jointly to Ptolemy for his theory that the Earth is the center of the universe and to Copernicus for showing it is not.”

Eugene Fama of the University of Chicago represents Ptolemy, asserting that economics revolves around efficient markets. Robert Shiller of Yale University represents Copernicus, contending that efficient markets currently represent a smaller, less significant portion of the universe. (The third winner was Lars Peter Hansen, also of the University of Chicago.)

Many of those siding with Professor Fama engineered the financial deregulation that set the stage for the Great Recession. At least some of those siding with Professor Shiller worry that the new regulations put into place with the Dodd-Frank Wall Street Reform and Consumer Protection Act will not be strong enough to avert another crisis.

Yet the differences between these two prize winners are smaller than they have been portrayed, especially compared with a darker theory of financial crisis based on the work of John Maynard Keynes and Hyman Minsky.

While Professor Shiller carefully observes market malfunctions, he remains reliably upbeat. His most famous book, “Irrational Exuberance,” playing on a term popularized by Alan Greenspan in 1996, correctly predicted that the housing bubble would soon burst. Yet his tone, both then and now, has a patrician undertone, as in “Calm down, gentlemen, you mustn’t get carried away.”

In his 2012 book “Finance and the Good Society,” he worries more about the behavior of people than those abstract entities called markets (see Page 177). Like many proponents of behavioral finance he emphasizes the extent to which individual investors may misperceive and overreact to information. While Professor Shiller warns of “some unfortunate incentives to sleaziness inherent in finance” (the title of Chapter 24), he also believes that new financial instruments informed by his research (and his values) can save the day.

He disputes Professor Fama’s leap from evidence that individual investors cannot outperform stock market averages (sometimes termed the “random walk” theory) to the so-called efficient market hypothesis. But this hypothesis is not as grand as it sounds. It relies on a very narrow definition of efficiency: that market prices immediately adjust to all available information.

This is rather like telling a patient that the hospital immediately adjusts to all the information about your disease that can be provided by diagnostic tests. It says nothing about its probable success in improving your health.

In its simplest form, the debate between traditional and behavioral finance comes down to the difference between two sets of investment recommendations: if you believe the efficient market hypothesis, don’t try to beat the market by picking individual stocks, just invest in index funds. If you don’t believe it, try to anticipate the kinds of mistakes other investors are likely to make and take advantage of them (a strategy closely associated with the behavioral economist Richard Thaler, who was considered a likely candidate for the Nobel this year).

Tragically, however, both investment strategies fail in the event of a major financial collapse, which drives many businesses into bankruptcy and many workers into unemployment. Minor departures from informational efficiency can’t explain the experience of the United States economy in the 21st century.

Theories based on the Keynes/Minsky view of the business cycle focus not on the imperfect rationality of individual investors, but on the institutional dynamics of financial profit maximization under conditions of uncertainty. Banks face temptations to overextend and overleverage themselves during booms and to develop inherently opaque securities like derivatives that offer them enormous profits.

In the absence of effective regulation, they are able to hold other economic actors hostage to bail out on the grounds that they are too big to fail.

From this perspective the assertion that markets are efficient serves as an ideological justification for deregulation, while the acknowledgement that individuals sometimes act irrationally merely distracts attention from the larger problem.

Most Americans continue to fear another financial crisis. Nearly 8 in 10 say that not enough bankers and employees of financial institutions were prosecuted for their roles in the last one.

In other words, they seem to favor the inefficient market hypothesis, even though no one has yet won a Nobel Memorial Prize in Economic Science for it.