This is fascinating. Finance Professor and creator of the Efficient Markets Hypothesis Eugene Fama:
The premise of the Fox book [“The Myth of the Rational Market”] is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH)…
The book is fun reading, but its main premise is fantasy. Most investing is done by active managers who don’t believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. The recent problems of commercial and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finally, MBA students who aspire to high paying positions in the financial industry have a tough time finding a job if they accept the EMH.
I continue to believe the EMH is a solid view of the world for almost all practical purposes. But it’s pretty clear I’m in the minority. If the EMH took over the investment world, I missed it.
This gets to something like the Grossman-Stiglitz paradox, which is if markets reflect all information, where’s the incentive to get the information needed to keep markets efficient? The “keeping” part is key there, since the real economy is always changing, someone needs to do something to “keep” the financial markets forecasting capital needs efficiently. It’s a weird theoretical place to end up.
But he’s right. Most market participants don’t think markets are so efficient that they can’t get some alpha out of it. So who does believe in market efficiency? Is there a group of people who believe it significantly more than Fama believes people that participate in markets believe it? Yes: Our regulators and our government.
You can see it in Judge Easterbrook’s statement on mutual fund fees, where since “It won’t do to reply that most investors are unsophisticated and don’t compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest” any observed difference between institutional and individual investor fees has to be the result of costs, as opposed to bargaining. It’s easy to read that differential the other way, that institutional investors have clout and individuals are getting squeezed, but since we take efficient markets to be true we start from the ideological other stance.
You also hear it in the background in other places. Let’s look at July 30, 1998 RR-2616, Treasury Deputy Secretary Lawrence Summers testimony before a Senate Committee on the CFTC Concept Release. As a reminder, the CFTC, under Brooksley Born, wanted authority to regulate OTC derivatives. The Treasury (Rubin and Summers), SEC (Arthur Levitt) and The Federal Reserve (Alan Greenspan) wanted to stop this, and did. Born resigned and was replaced by one of Rubin’s assistants.
(By the way, there’s an excellent Frontline episode about this clusterfuck that is worth your time. My favorite is the gendered language here: “I didn’t know Brooksley Born,” says former SEC Chairman Arthur Levitt, a member of President Clinton’s powerful Working Group on Financial Markets. “I was told that she was irascible, difficult, stubborn, unreasonable.”
I can only assume this is Ivy League-speak for “What? You believe a random firm could take on such a CDS position in the OTC market that their counterparty risk would destabilize the entire system? Why don’t you talk reasonably with us in a few days when you are off the rag.”)
Anyway, the testimony (my underline):
Summers: Mr Chairman, thank you for giving me the opportunity to discuss issues raised recently regarding the regulation of the OTC derivatives market — notably, the concept release issued last May by the Commodity Futures Trading Commission (“CFTC”)…
Once again, it is legitimate and valuable for Congress to consider whether it is necessary to make changes to the regulation of the entire OTC derivatives market. But I would note that it is not immediately obvious how either of these rationales applies in the case of the vast majority of OTC derivatives:
* first, the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies and most of which are already subject to basic safety and soundness regulation under existing banking and securities laws;
Ah, the late 1990s. “Yes there are some noise traders sloshing around out there but the idea that the financial sector wouldn’t get counterparty solvency risk perfect is outside the terms of reasonable debate.” There’s a lot of stuff going on there, hubris, subsequent cushy jobs at hedge funds and large banks, not rocking the boat, etc. But underlining this, for regulators, members of Congress, officials more generally, is the idea that markets will simply get this correct. And they did not.
Justice Holmes once famously dissented that it’s a form of judicial activism to base our courts on “an economic theory which a large part of the country does not entertain.” It seems like the same should be said for our government and our regulatory bodies, especially as they try and figure out how to fix the mess that is the financial markets. And it’s worth noting that the founder of this economic theory, The Efficient Markets Hypothesis, doesn’t even believe that people actually in the financial markets entertain it.