For the past few decades, the field of economics has embraced the
“efficient-market hypothesis” which claims that financial markets price assets
at their intrinsic worth given all publicly available information. For
example, the price of a company’s stock always accurately reflects the
company’s value given the information available on the company’s earnings, its
business prospects and so on.
Lawrence Kudlow, Jerry Bowyers and other popular pseudo-economists
have promulgated the theory to the general public and continue to embrace the
theory to this day. They argue that the minds of millions of investors,
all acting in their own best interests, are smarter than the minds of a handful
of economists and government officials. Therefore, the pricing of the
market is accurate. They consider the performance of the markets to be the
most reliable economic indicators.
The theory is so infused into economists’ minds that few pay
attention to dissent. Alan Greenspan himself rejected recommendations to
rein in subprime lending or address the housing bubble on the belief of this
theory. In the late 00s, suggestions that the financial system was
taking on potentially dangerous levels of risk were mocked and considered
misguided.
This theory was so universally accepted that when the housing
bubble burst, an oft-used phrase became “nobody could have predicted it.”
But it was, however, predicted. Case In Point: The Housing
Bubble. Among others, Dean Baker of the Center for Economic Policy
Research predicted the housing bubble years before it collapsed. But he was
ignored.
The main limitation of the theory is “paper
speculation”. Many investors are investing, not in a business or real
estate, but in the potential profit they anticipate receiving from reselling
the security in the future. The basis for the selling price is not the
intrinsic value of the business or property but the price that the speculator
thinks he can get at some future date. This theory explains the stock
market bubble of the 90s as well as the housing bubble of the 00s.
Another limitation is withheld information. Insiders may
have information that would cause the price of a security to decline, but they
intentionally withhold this information. This took place in the Enron
scandal, the housing bubble (mortgage brokers granting loans to borrowers who
were unable to repay and then selling the loans to unknowing investors) and
most recently Greece trying to cover up the extent of its debt.
If the economics profession is to redeem itself, it will have to
abandon the assumption that everyone is rational and markets work perfectly.
