The Efficient Market Hypothesis

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.