John Cassidy: The Inefficiency of the Market Isn't an Open Question:
In an article on the front page of Tuesday’s Times, Binyamin Appelbaum did a nice job of highlighting the difference in views between Robert Shiller and Eugene Fama…. But there’s a danger that some readers may come away… with the impression that the issue of whether financial markets are efficient remains unsettled. It isn’t…. Financial markets are sometimes chronically inefficient. The only outstanding question is how far this inefficiency extends….
Part of the problem is how financial economists define efficiency. In most areas of economics, efficiency is defined in terms of how well markets allocate resources…. Since the nineteen-sixties, when Fama got his start, financial market efficiency has been defined rather differently… a financial market is 'weak-form efficient' if prices reflect all the past information that is relevant to the market… 'semi-strong-form efficient' if it reflects all past and current public information… 'strong-form efficient' if it reflects all the public and private information…. It was clear from the very beginning that this notion of efficiency is problematic…. As Joseph Stiglitz and Sanford Grossman pointed out way back in 1975, a perfectly efficient market is an impossibility.
On a more practical level, too, this notion of efficiency is problematic. If prices in financial markets already reflect all the pertinent information, they should move only in reaction to news…. Thus prices should move randomly—not predictably. Very many empirical studies, including some carried out by Fama in his later years, suggest that they don’t….
Moving from individual securities to the over-all market, how does efficiency hold up? Not very well. In many markets, not just the stock market, prices tend to overshoot in one direction or another and, eventually, revert to the mean. Occasionally, this phenomena takes on extreme forms…. Speculative bubbles represent glaring violations of informational efficiency, and they also violate allocative efficiency, which is much more important. The ultimate purpose of financial markets is to share risk, finance productive investment, and help the economy grow. But in recent years, we have seen instances where the markets have amplified risk, financed a ton of unproductive investment—such as empty housing developments in Florida, Ireland, and Spain—and helped bring on the deepest recession since the nineteen-thirties. Looked at it in this context, the proposition that markets are efficient can seem like a poor joke….
Fama and some of his fellow efficient-markets believers reacted to these events in a way that combined denial with elaborate rationalization. In a 2010 interview with me, Fama refused to accept that the markets went loopy, and he even questioned whether there was such a thing as a bubble. In recounting extreme movements in the market, he pointed to sharp but unexplained (and unobservable) shifts in investors’ risk tolerance as an explanation that was consistent with efficiency. His second defense was to fall back on the difficulty in predicting market movements…. But just because it is tough to tell what a market is going to do doesn’t mean it is efficient in any meaningful sense….
In early 2000, when 3Com floated its Palm computing subsidiary on the Nasdaq, the market put such a high price on the new issue that it implied that the parent company, which retained a big stake in Palm, had a negative stock-market valuation. Was it really a big stretch to conclude that this was a bubble? Was it so tough in 2005, when house prices had virtually tripled in ten years, to say we were in a real-estate bubble? Shiller got both calls right, and so did quite a few others. It’s not unreasonable to expect policymakers to identify bubbles, at least in their later stages.
And, on a broader level, what’s so difficult about the concept that developments in the financial sector, and, in particular, the rate at which banks create credit, has important implications for the over-all stability of the economy? From Adam Smith to Knut Wicksell to Hyman Minsky, many great economists have appreciated the perils of rampant credit growth, and unhinged finance generally. During the past few decades, though, all too many economists overlooked these dangers, or purposely sought to downplay them. Over time, these omissions helped to produce an intellectual environment in which policymakers from both major parties could pursue policies that proved disastrous.
One of the reasons for this failure in the market for economic analysis was the hegemony of the efficient-markets hypothesis, and the sunny view of finance it embodied. In choosing to honor Shiller and Fama at the same time, the Nobel committee has, wittingly or unwittingly, obfuscated this history. To prevent another policy disaster in the future, it needs telling and retelling.