The Inefficient Market Hypothesis By Nancy Folbre October 21, 2013 – The New York Times

Either it was a partisan compromise, or the that the housing bubble would soon burst. Yet Nobel Memorial Prize in Economic Science his tone, both then and now, has a patrician committee simply hedged its bets, bestowing undertone, as in “Calm down, gentlemen, you its annual prize on three economists, two of mustn’t get carried away.” whom represent divergent views. One In his 2012 book “Finance and the Good Financial Times blogger compared it to a joint Society,” he worries more about the behavior celebration of Milton Friedman and John of people than those abstract entities called Maynard Keynes. markets (see Page 177). Like many proponents John Kay, also writing in The Financial Times, of behavioral finance he emphasizes the extent put it more sharply, as “awarding the physics to which individual investors may misperceive prize jointly to Ptolemy for his theory that the and overreact to information. While Professor Earth is the center of the universe and to Shiller warns of “some unfortunate incentives Copernicus for showing it is not.” to sleaziness inherent in finance” (the title of Chapter 24), he also believes that new financial Eugene Fama of the University of Chicago instruments informed by his research (and his represents Ptolemy, asserting that economics values) can save the day. revolves around efficient markets. Robert Shiller of Yale University represents He disputes Professor Fama’s leap from Copernicus, contending that efficient markets evidence that individual investors cannot currently represent a smaller, less significant outperform stock market averages (sometimes portion of the universe. (The third winner was termed the “random walk” theory) to the so- Lars Peter Hansen, also of the University of called efficient market hypothesis. But this Chicago.) hypothesis is not as grand as it sounds. It relies on a very narrow definition of efficiency: that Many of those siding with Professor Fama market prices immediately adjust to all engineered the financial deregulation that set available information. the stage for the Great Recession. At least some of those siding with Professor Shiller worry This is rather like telling a patient that the that the new regulations put into place with the hospital immediately adjusts to all the Dodd-Frank Wall Street Reform and Consumer information about your disease that can be Protection Act will not be strong enough to provided by diagnostic tests. It says nothing avert another crisis. about its probable success in improving your health. Yet the differences between these two prize winners are smaller than they have been In its simplest form, the debate between portrayed, especially compared with a darker traditional and behavioral finance comes down theory of financial crisis based on the work of to the difference between two sets of John Maynard Keynes and Hyman Minsky. investment recommendations: if you believe the efficient market hypothesis, don’t try to While Professor Shiller carefully observes beat the market by picking individual stocks, market malfunctions, he remains reliably just invest in index funds. If you don’t believe upbeat. His most famous book, “Irrational it, try to anticipate the kinds of mistakes other Exuberance,” playing on a term popularized by investors are likely to make and take advantage Alan Greenspan in 1996, correctly predicted of them (a strategy closely associated with the In the absence of effective regulation, they are behavioral economist Richard Thaler, who was able to hold other economic actors hostage to considered a likely candidate for the Nobel this bail out on the grounds that they are too big to year). fail. Tragically, however, both investment strategies From this perspective the assertion that markets fail in the event of a major financial collapse, are efficient serves as an ideological which drives many businesses into bankruptcy justification for deregulation, while the and many workers into unemployment. Minor acknowledgement that individuals sometimes departures from informational efficiency can’t act irrationally merely distracts attention from explain the experience of the United States the larger problem. economy in the 21st century. Most Americans continue to fear another Theories based on the Keynes/Minsky view of financial crisis. Nearly 8 in 10 say that not the business cycle focus not on the imperfect enough bankers and employees of financial rationality of individual investors, but on the institutions were prosecuted for their roles in institutional dynamics of financial profit the last one. maximization under conditions of uncertainty. In other words, they seem to favor the Banks face temptations to overextend and inefficient market hypothesis, even though no overleverage themselves during booms and to one has yet won a Nobel Memorial Prize in develop inherently opaque securities like Economic Science for it. derivatives that offer them enormous profits. Nancy Folbre is professor emerita of economics at the University of Massachusetts, Amherst.