There are plenty of good theories about how we found ourselves in the mess we’re in. But one of them is not that the efficient market theory did it. This is one of more outlandish claims, since so much of what got financial institutiions in trouble was predicated on the idea that they could beat average market returns. Then they dug themselves in even deeper by claiming the markets were dislocated and that their guesses about the pricing of collateralized debt securities were more accurate than those of the market.
None the less, this ridiculous idea has gained a lot of traction. Pablo Triana’s article in the Financial Times today should hopefully put this to rest.
Espousers of the “efficient market theory did it” camp seem to argue that, by providing unmitigated faith in the soundness of quoted market prices, the notion that everything is behaving rationally, and that no dangerous bubbles can take shape, the analytical machination made investors and policymakers complacent and careless, allowing the (very real, very irrational) housing-related blow-up to happen.
This line of reasoning suffers from an obvious drawback: can we really assume that all professionals are basing their actions all the time on the dictates of the efficient market hypothesis? That they are even aware of the existence of such theory?
Of course not. I mean, it’s not as if the Merrill Lynch traders who gorged on subprime credit default obligations did so because they religiously abided by Prof Fama’s (earlier, at least) pontifications. Or that regulators allowed the insane leverage to take place because their brains repeatedly flashed out the “markets are efficient, markets are efficient!” signal.
Efficient market theory is an ideology a few may share, but it is not a mechanism for direct action-taking. As such, and unlike the theories that truly caused the crisis, it cannot lead to activities by professionals that may cause trouble.
There is also the point that the efficient market hypothesis says markets cannot be beaten, and yet the current nightmare was created by those who very much wanted to outperform.
Had Wall Street and the City abided by the theory, they would have gorged on index funds rather than on subprime CDOs. They would have tried to make money by boringly replicating the index, not by selling optionality though credit default swaps.
Rather than being followed, the efficient market theory was scorned.
He goes on to say that we should probably be worrying more about things like value at risk and the way compliance with capital requirements is calculated. Those are very clearly not based on effecient market theory.
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