Readers have requested a summary of the Efficient Market Hypothesis, which is in the news again as a result of the ‘Nobel’ Prize award to Professor Eugene Fama – see this instant reaction on the matter). In what follows the reader can peruse very brief presentations of the triad of toxic theories that undermined macroeconomic logic and helped legitimise the practices that contributed no end to the Crash of 2008. They are: the Rational Expectations Hypothesis, Eugene Fama’s Efficient Market Hypothesis and the so-called Real Business Cycle Theory…
[The desciription below is an extract from Chapter 1 of my Global Minoatur]
The type of economics which dominated the thinking of influential people (in the banking sector, the hedge funds, the Fed, the ECB, everywhere) was no more than a thinly veiled form of intellectual fraud which provided the ‘scientific’ fig leaf behind which Wall Street tried to hide the truth about its ‘financial innovations’. They came with impressive names such as the Efficient Market Hypothesis (EMH), the Rational Expectations Hypothesis (REH), Real Business Cycle Theory (RBCT). In truth, they were no more than impressively marketed theories whose mathematical complexity succeeded for too long in hiding their feebleness.
Three toxic theories underpinning pre-2008 Establishment Thinking
EMH: No one can systematically make money by second-guessing the market. Why? Because financial markets contrive to ensure that current prices reveal all the privately known information that there is. Some market players overreact to new information, others under-react. Thus, even when everyone errs, the market gets it ‘right’. A pure Panglossian theory!
REH: No one should expect a theory of human action to predict well in the long run if it presupposes that humans systematically misunderstand that very theory. No doubt, this sounds radically anti-patronising. It assumes that not much light can be shed on society by theorists who believe they understand its ways better than Joe Blog. But note the sting in the tail: For REH to hold, it must be true that people’s errors (when they predict some economic variable, e.g. inflation, wheat prices, the price of some derivative or share) must always be random; i.e. un-patterned, uncorrelated, untheorisable. It only takes a moment’s reflection to see that the espousal of REH, especially when taken together with EMH, is tantamount to never expecting recessions, let alone crises. Why? Because recessions are, by definition, systematic, patterned events. However surprising when they hit, they unfold in a patterned manner, each of its phases being highly correlated with what preceded it. So, how does a believer in EMH-REH respond when her eyes and ears scream to her brain: Recession, Crash, Meltdown? The answer is: By turning to RBCT for a comforting explanation.
RBCT: Taking EMH and REH as its starting point, the theory portrays capitalism like a well-functioning Gaia. Left alone, it will remain harmonious and never go into a spasm (like that of 2008). However, it may well be ‘attacked’ by some ‘exogenous’ shock (coming from a meddling government, a wayward Fed, heinous trades unions, Arab oil producers, aliens, etc.) to which it must respond and adapt. Like a benevolent Gaia reacting to a large meteor crashing into it, capitalism reacts efficiently to exogenous shocks. It may take a while for the shockwaves to be absorbed, and there may be many victims in the process but, nonetheless, the best way of handling the crisis is by letting capitalism get on with it, without being subjected to new shocks administered by self-interested government officials and their fellow travellers (who pretend to be standing up for the common good in order to further their own agendas).
To sum up, toxic derivatives were underpinned by toxic economics which, in turn, were no more than motivated delusions in search of theoretical justification; fundamentalist tracts that acknowledged facts only when they could be accommodated to the demands of the lucrative faith. Despite their highly impressive labels and technical appearance, economic models were merely mathematised versions of the touching superstition that markets know best, both at times of tranquillity and in periods of tumult.