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A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.

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A Critique of Pure Financial Reason
Did Efficient Market Hypothesis destroy the economy?
25 September 2009

The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street, by Justin Fox (HarperBusiness, 400 pp., $27.99)

Among this recession’s casualties—lost jobs, foreclosed homes, bankrupt companies—one might include the economic theory known as Efficient Market Hypothesis (EMH). The notions that all available information is already reflected in fluctuating asset prices, that inefficiencies (if they exist) are fleeting, and that people are cool calculators of optimal utility have all come under attack as having either caused, or substantially contributed to, the financial crisis and recession.

That charge is accurate, says Justin Fox, a columnist for Time who runs the Curious Capitalist blog. The notion of a rational market “is a myth of great power—one that, much of the time, explains reality pretty well. But it is nonetheless a myth, an oversimplification that, when taken too literally, can lead to all sorts of trouble.” As EMH came to dominate economics, academic finance, and Wall Street trading desks, its “elegant” mathematical models warped all interpretations of reality. On one estimate, asset bubbles have occurred once every three years since 1925—yet because of EMH, most economists excluded them from their theories and textbooks. The unhappy results of EMH included an enormous housing bubble and devastating mistakes made by our best and brightest, the keepers of the models.

Fox’s book deftly weaves together a century of intellectual history and market developments to unearth the deep roots of EMH. The stock-market crash of 1929 and the ensuing Depression did much to dampen enthusiasm for capitalism and investing, he writes, but gradually the economy recovered, and stock markets soared to new heights in the 1950s and 1960s. A new generation of mathematical economists, shaped by a desire to find order amid chaos and aided by new tools such as mainframe computers, propagated new ideas to explain economic reality. One that took particular hold was that of the efficient market. As Eugene Fama, its most famous proponent, described it: “In an efficient market, the actions of the many competing participants should cause the actual price of a security to wander randomly about its intrinsic value.” Stock prices clearly fluctuated, but only within a standard bell-curve distribution, meaning that they could easily be modeled. These fluctuations, moreover, were random, so no discernible patterns could be found and no one could beat the market.

In business schools during the same period, dissatisfaction with the way corporate finance was taught led to the creation of the capital asset pricing model (CAPM). Frustration with the insufficiently theoretical manner of stock-market analysis inspired new tools like “beta,” a measure not of an individual security’s absolute price variance but of its relationship to the overall market’s behavior. Slowly but steadily, investing became professionalized, theorized, and democratized. For professors and money managers on the front lines, the 1960s through the 1990s were a thrilling age of discovery.

Fox chronicles, in near-conspiratorial terms, the “conquest of Wall Street” in the 1970s and 1980s by CAPM- and beta-inspired index funds, performance measurement, and a market for corporate takeovers. Yet he also tells the story of the backlash against EMH that began in the 1970s and gained steam in the 1980s, led by economists like Larry Summers, Robert Shiller, and Nobel laureates Joseph Stiglitz, Daniel Kahneman, Vernon Smith, and Ken Arrow.

Fox notes that in the spread of any idea, much nuance is lost in being transmitted from its originators to its second- and third-generation adopters. In the 1990s, a deformed, ahistorical version of EMH permeated trading floors—and, via CNBC talking heads, the public consciousness—even as it lost favor among academics. The combination of blinkered academics, profit motives on Wall Street, and shortsighted mathematical models produced self-evident absurdity: for instance, the CFO of Goldman Sachs apparently arguing that an event that occurred “should only occur every hundred thousand years. . . . A better explanation may be that his risk models weren’t very good,” Fox writes wryly.

But Fox’s criticisms often go too far. Disparaging economics for its overemphasis on rationality is too easy. Real-time rationality and retrospective rationality can be quite different things, and given the disparate incentives facing economic actors, it shouldn’t be too surprising that a series of seemingly rational decisions can occasionally amount to mass irrationality. Toward the end of the book, Fox throws his support to behavioral theories, which stress the shortcomings of human decision-making: “I have become convinced that behavioral finance is more than just a collection of curiosities,” he writes. Fox is far from alone in this. But what’s often forgotten in the rush toward theories of irrationality is that leading behavioralists, such as Richard Thaler, gladly leave room for rationality in their theories. What’s needed is a rebalancing, not a complete excising of rationality. Science, after all, must sometimes drill into the abstracted essence of behavior, using simplified assumptions to gain understanding.

As for the current recession, a narrative focused only on misguided theories of market efficiency is glib. The book opens with Alan Greenspan’s much-mocked congressional testimony in the fall of 2008, in which the former Fed chairman confessed that his faith in efficient markets had failed—after 40 years. Yet isn’t it rational to adhere to a worldview that seemed to depict reality for so long? Members of Congress, smugly pleased at Greenspan’s contrition, certainly seemed happy during the boom years to reap the windfall from Wall Street’s excesses. Too much faith in the theory that markets couldn’t be other than efficient clearly helped cause the financial crisis and recession; beyond that, there is no way to prove conclusively how great a role EMH played.

Until academic scholars figure out how to exclude human beings from market activity, a capitalist system, with the well-developed financial markets that are essential to innovation, will not operate smoothly or predictably. Capitalism is messy, unpredictable, and “spasmodic,” as an economist in the 1830s pointed out. Let’s hope that the policy response to the current recession does not stifle future messiness, which despite its obvious downsides is essential to improving living standards.

Dane Stangler is a senior analyst at the Ewing Marion Kauffman Foundation in Kansas City, Missouri.

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