The Price Isn't Always Right

The efficient market hypothesis dreamed up by Eugene Fama at Chicago in the late 1960s envisioned a market in which "security prices at any time 'fully reflect' all available information." This theory gained tremendous power over scholars and regulators. For decades, most academic research into financial markets began with the assumption that security prices did reflect all available information, that they couldn't be gamed, and that they weren't subject to bubbles or panics. But it was a theory that failed to explain some pretty important market realities, and left our nation singularly unprepared for the events of the past half-decade.

The Markets Knows Best?
There are those who argue that efficient market theory is largely to blame for our current troubles. Three such blamers who spring immediately to mind are hedge fund investor George Soros, market strategist Jeremy Grantham, and author George Cooper. Lulled into the belief that financial markets knew best, the reasoning goes, investors and regulators failed to do anything to rein in an out-of-control housing market bubble-and now we're all still suffering from the consequences.

I wouldn't go quite that far. In my view, there were clearly other factors at work over the past decade-massive capital flows from China and a homeownership fetish in Washington, to name two. Also, as I explain in my book, The Myth of the Rational Market, the world experienced financial crises long before anybody at the University of Chicago thought to string the words "efficient" and "market" together. Finally, if all one means by "efficient market" is a market that's hard to beat, that's not such a wrongheaded idea at all (I'm sure Eric Falkenstein and I will spend more time discussing such personal-investing lessons in our subsequent Blog War posts).

What Goes Up...
A few years ago, Yale economist Robert Shiller -- a long-time critic of the efficient market hypothesis -- cobbled together an inflation-adjusted index of U.S. real estate prices going back to 1890 and found that (a) in the past, prices had declined for decades on end and (b) the rise in real home prices since 1997 was by far the sharpest on record. From these two pieces of data he drew the common-sense conclusion that the rise in housing prices wouldn't go on forever and was likely to be followed by a sharp fall. But real estate economists and regulators tended to resist his account (it seemed so unscientific), opting instead for explanations that started with the assumption that prices wouldn't have risen like that without good reason. In doing so, they missed the bubble.

Could real estate economists and regulators have stopped the bubble? Perhaps not. Imagine what would have happened if Alan Greenspan had, in 2004, suddenly decided it was time for a regulatory crackdown on over-easy mortgage lending standards. Congress would have eaten him alive!

So, no, the financial crisis wasn't all efficient market theory's fault. But it sure didn't help.

Follow Blog War on the efficiency of markets:

• Justin Fox, Aug. 3: The Price Isn't Always Right
• Eric Falkenstein, Aug. 4: In Defense of Efficient Markets
• Justin Fox, Aug. 5: Markets Can Do Many Things Well, But Not Everything