In Defense of Efficient Markets

Justin, let me first note that in your book, which I very much enjoyed, you make many gracious acknowledgements to the efficient markets hypothesis (EMH), such as the basic implication that it is very, very difficult to outperform the market. To outperform the market is incredibly hard, as evidenced by data not merely on retail investors who trade too much and tend to get into the market at exactly the wrong time, but professionals too, as mutual fund managers underperform their passive investment alternatives like night follows day. This is not a minor acknowledgment, but basically is the EMH theory.

Yet you call efficient markets a "myth" and say the theory "deluded" investors. "Efficient markets" appears to be a loaded phrase, with lots of baggage unrelated to the original definition presented by Eugene Fama back in 1965, which is that current market price is the best predictor of future price.

I think this distaste for efficient markets comes from two sources. First, many people distrust the "invisible hand." They do not think markets are fair games that reward virtue and promote social welfare. Secondly, there are critics (stockbrokers, talking heads on CNBC, financial journalists) whose livelihood depends on markets being wrong; otherwise their special insight as to why one should be in telecoms, or bonds, would have no value.

Government fails more often than markets do
By definition, an efficient outcome is one that cannot be improved upon. I am no anarcho-capitalist. I think a collective must have rules, even government. Yet I think government power should be minimized, because government failure is far more common than market failure, as the I.Q. of a group is diminished by centralized interaction. Not only do government bureaucrats suffer from the same cognitive and emotional limitations as consumers and investors, they are politically motivated rather than merely self-interested.

Justin, you mention in your post that Robert Shiller noted that housing was on an unprecedented tear in 2004. But Shiller did not predict an aggregate housing decline; instead, he merely stated the recent increase in home prices was unlikely to continue. In the 2005 edition of Irrational Exuberance, he wrote that in some cities "the price increases may start to slow down, and then to fall. At the same time, it is likely the boom will continue for quite a while in other cities."

Now, compare this modest warning by a lone economist to the forces promoting home lending from all directions. It was not just a Wall Street phenomenon, but one pushed by our government, legislators, regulators, and even academics (for evidence, see Stan Liebowitz's "Anatomy of a Train Wreck").

In 2002, President Bush bragged in a speech about how Freddie Mac had began a program to "help deserving families who have bad credit histories to qualify for homeownership loans." Bank acquisitions were evaluated in part by their Community Reinvestment Act record, which necessitated lowering underwriting criteria on homes. Furthermore, the Federal Housing Administration was, and is, offering loans with only three percent down, and during the boom, the Department of Housing and Urban Development promoted a program where even this minor investment could be paid for by the homebuilder, allowing a homebuyer to purchase an overpriced house with no money down. As the Republicans discovered in 2004 when they tried to add more oversight to Fannie Mae, there was little legislative appetite for anything close to more stringent lending standards during the boom.

The market diagnosed the bubble
In light of this governmental housing exuberance, I doubt that a more powerful government would have mitigated the boom -- rather, it would have made this crisis worse. Indeed, it was only the collapse of the subprime market at the beginning of 2007 as reflected by the ABX-HE subprime housing index that alerted people to the severity of this problem, and shut off financing by mid-2007, six months later. Market prices, not legislators, instigated the end of the insanity. How quickly are failed governmental initiatives usually stopped, once identified?

No one thinks markets are perfect, and EMH never says this. The proof that markets are efficient is that it is so improbable one can generate alpha -- something you, like most EMH critics, concede. But the implications do not seem obvious. That you were able to find one person in 2004 and turn his measured warning into something that would have drastically reversed the regulatory emphasis on weakening underwriting standards is classic hindsight wisdom.

The nice thing is that markets rely on decentralized self-interest to keep prices in line, which is surely more dependable than legislators building patronage systems and pandering to their base with other people's money. Letting markets, as opposed to bureaucrats, signal people how to get paid and how to invest, is simply better than the undefined alternative.

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