Last week I gave what was basically a ridiculously brief and shallow overview of some of the issues and debates around the Efficient Market Hypothesis, and I want to pull you back to why this is relevant to this section of the blog.
The theme I have been exploring is:
If saving is not channelled to investment the value of all our savings falls. But this fall in value is not necessarily reflected in financial markets – financial assets can be overvalued.
The statement that financial assets can be overvalued implies that market prices are wrong, that they do not reflect fundamental values. This assertion flies directly in the face of the Efficient Market Hypothesis, so you can see why I wanted to spend at least a bit of time exploring this theory that has been the subject of rich study for over 50 years.
Justin Fox’s excellent book The Myth of the Rational Market gives a brilliant account of that history – I found it compelling and unputdownable and would thoroughly recommend it. But even this book, I feel, does not do full justice to this subject – I already knew many of the authors, ideas and papers to which this book refers, and found it fascinating seeing it all pieced together into a coherent history, but I’m not recommending it as “all you need to know” on the subject. Similarly, the discussion on this blog can only be superficial, but ignoring the EMH altogether was out of the question.
One point that struck me from this book is is that no-one who actually works in this specific field of financial economics really believes in the EMH any more. Even before the financial crash most of those specialising in this field were coming to the conclusion that prices in financial markets certainly don’t reflect fundamental values, and don’t even reflect the best prices based on available information.
However, the EMH remains a powerful idea. This is partly because those outside this field don’t realise where the evidence has ended up – they just remember what they learnt about EMH in the past. This includes full-time economists (most of whom pay very little attention to finance). I’ve read so many defences of the EMH since the crash that until I read Fox’s book I hadn’t realised the extent to which it is recognised to have failed within financial economics – it was still passionately defended at the turn of the century, but since then it has quietly receded, without news of its demise being widely shared!
And the EMH holds power precisely because it supports what is arguably the dominating idea in economics – that the market is always right, or at the very least is better than any other option. A mainstream economics education is effectively a form of conditioning to always believe in the power of the market. Any mainstream economist with a basic awareness of the EMH is likely to assume that this theory must be correct and backed up by the evidence, because this is their orthodox doctrine.
And this leads to the most important point about the EMH: because the theory states that it is impossible to beat the market, that no-one can understand the underlying information and see where the market is going wrong, the implication is that there is no way for governments and regulators to improve market outcomes. Even if we accept markets are wrong, there is no way to make them right.
And hence, the EMH has given an air of academic legitimacy to the ideologically driven desire of the last 40 years to deregulate financial markets to the greatest extent possible. Rather than say “we need to understand these markets”, economists and politicians have simply said “we can’t”, and left these markets unregulated and unchecked, trusting in their “efficiency” and “rationality”.
In the next section of the blog (starting in 3 weeks) we are going to look at the seismic shifts in financial markets that have occurred in this century – preceding the crash and continuing apace since, largely unnoticed by economists. In 2 weeks I’m going to summarise everything we’ve covered in this section on Productivity (all the posts in the last 12 weeks are under this category and accessed by clicking “Productivity” in the menu bar). Everything in this section is purely to help you understand the significance of what is going on in financial markets, so it seems sensible to summarise it before we start.
But first we need to look next week at one aspect of saving in forensic detail – business sector saving, or undistributed profits. This may not sound interesting, but it is vital to understanding the specific dynamics in financial markets at this time.