Titan of academic finance Gene Fama writes in his blog:
The premise of the Fox book is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH), which posits that market prices reflect all available information. The claim is that the world's investors and their advisors in the financial industry bought into this model. Because they ceased to investigate the true value of assets, we have been hit with "bubbles" in asset prices. The most recent is the rise and sharp decline in real estate prices which froze financial markets and led to the worst recession since the Great Depression of the 1930s.
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. ...
I really didn't think this was the main premise of my book. I wrote 95% of the thing before the financial crisis, and I certainly didn't predict the disaster that ensued. So it would have been hard for me to set out to prove "that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis." I was basically just out to recount some intellectual history that I thought was really interesting, and maybe important too.
That said, the premise of a book is in the eye of the reader, and I'm sure a lot of the people forking over good money to buy my book do so because they think I'm arguing that Fama's efficient market hypothesis is the cause of all our troubles. So I can't run too far away from that argument.
Yet ... I completely agree with Fama that most investing is done by active managers who don't believe markets are efficient. Also, investors were blowing bubbles long before Fama starting writing about "efficient markets" in the 1960s. So investor behavior during the tech stock and real estate bubbles really can't convincingly be attributed to the teachings of Fama and other finance professors.
But I don't think that's the main point that fiercer efficient-markets critics than I like George Cooper and George Soros are making. They're saying that the big problem was that regulators and central bankers drank the efficient market Kool-Aid. Adair Turner, chairman of the British Financial Services Authority, put it well in that famous interview that Prospect published back in September (subscribers only, I'm afraid; I happen to work with a subscriber):
[W]e have had a very fundamental shock to the "efficient market hypothesis" which has been in the DNA of the FSA and securities and banking regulators throughout the world. The idea that more complete markets and more liquid markets are definitionally good and the more of them we have the more stable the system will be, that was asserted with great confidence up to three years ago.
What Fama might say in response is, "Well, I never asserted that." He's probably be right. But as I wrote in my previous post on the topic, what Turner describes was the key message that emanated from academic finance and economics into the Wall Street and government-policy mainstream over the past few decades. Interestingly, some of the most interesting financial-economic research of the past decade-and-a-half has been about market failures. But the transmission of such knowledge into mainstream thinking occurs with long and variable lags"”and Fama certainly wasn't one of the people out there waving their hands and saying, "Hey, watch out! Financial markets can burn you!"
I guess that's what's kind of disappointing to me about Fama's post. I'm thrilled that he's read my book, and is saying halfway nice things about it in public. In general, I'm a big Fama fan"”his willingness to keep testing his theories against the evidence, and to support the work of students and younger professors whose research undermined those theories, is hugely admirable. But he and a lot of other people in academic finance just don't seem interested in directly engaging in many of the most interesting questions raised by the financial crisis. Such as: Can the financial sector get too big, and if so how can we tell? Can derivatives markets concentrate risk as well as spread it? Is financial innovation fundamentally different and more dangerous than innovation in other fields, and if so what should we do about it? Should central banks and financial regulators try to snuff out asset-price bubbles, and if so how should they go about determining when we're in bubble territory? Is Hyman Minsky right that good times inevitably breed crises?
Of course most investors don't believe in the efficient market hypothesis, and most of them would probably be better off if they did. Point taken. Now can we move on to the more interesting stuff?
[...] Fama vs. Fox on the role of the efficient markets hypothesis in the credit crisis. (Curious Capitalist) [...]
Mr. Fox, It is disapointing to hear Dr.. Fama use the word "Fantasy" when referring to your book. That is disrespectful, and I respectfully submit wrong.
You are right that "the premise of a book is in the eye of the reader".
In my eye you did a good job of stating the fact. Current economic theories could not explain the size and frequency of crashes. It has been a case of "well, it is the best we can do...."
My understanding is that EMH relies on Nash's theory of equilibrium. Unfortunately there is plenty of evidence of non-equilibrium behavior in the market, and the theories don't account for biology (us). We humans are "bursty" in nature. (Lazlo-Notre-Dame) Current theory is not Full Process.
I believe that Dr. Fama will come around. Bob Klapetzky http://www.alphaadder.blogspot.com
Justin, I haven't read your book yet but I promise I will.
I find that a great deal of the discussion of EM theory is befuddled because the discussors don't distinguish clearly between different but related statements:
1. You can't know whether the price is right. and 2. The price is right
or
1. Individuals are rational actors and 2. In aggregate, individuals' actions effect the market as if they were all rational actors.
Another thought:
While all (or enough) first-order information might be "in the market" to set prices "efficiently," what about the potentially more profound effects of second-order information: "I believe that you believe"? Or even more, "I believe that you *will* believe." (See "Greater Fool.")
This information obviously cannot be known, or known with any accuracy or certainty. And it is arguably far more powerful--at least in the short term--than first-order information.
And yet another thought, re: herd behavior. It's been shown that groups of individual actors, with each actor operating under very simple algorithms, can create very complex (and generally unpredictable) behavior by the whole group.
So each bird in a flock operates with rules like "if I'm on the outside of the flock (no bird on one side of me) and the bird next to me moves away, move towards that bird."
The result is the quite remarkably cohesive behavior of bird flocks.
Now, assume that our investing algorithms are based largely on our (inherently unreliable) second-order beliefs. Life gets very, very complicated...
Mr.Roth,
I empathize with your comment " I find that a great deal of the discussion of EM theory is befuddled because the discussors don't distinguish clearly between different but related statements:
1. You can't know whether the price is right. and 2. The price is right
or
1. Individuals are rational actors and 2. In aggregate, individuals' actions effect the market as if they were all rational actors."
People do not behave in a random manner.
Warren Buffet has been frequently quoted that he is simply trying to buy a future dollar discounted, with an eye on traditional underlying economic variables to make buy/sell decisions. He is considered the quintessential "rational optimizer". Many people extrapolate this thought to mean that momentum "noise traders" are not trying to do the same thing. This is incorrect. A noise trader is trying to do the same thing, except his underlying economic variable is price movement. Humans with the emotional self-discipline to consistently and effectively be "rational optimizers" is rare, whereas a noise trader's barrier to entry is much less. Seeds are planted by "rational optimizers", but bubbles and crashes are created by "noise traders", and their market driven perception of their stored value within the market.
Their perceived priority is driven by greed or fear.
Stocks are a temporary store of value.
Stocks value is a PERCEIVED value; local, temporal and transitional based on market dynamics.
Greed drives the market up and out of control of the "rational optimizers", and attracting ever more "noise traders"
A complex dynamic system self organizing towards criticality. At criticality, events that during "rational optimizers" time in charge would be uncorrelated, become highly correlated.
The complex dynamic system self organizing is not the market.
The market is a derivative of what is self organizing; the noise traders and their greed/fear.
So essentially you have a time period where the price is right. When rational optimizers make up the majority of the market. A time when most people won't touch it with a ten foot pole. Or a time where noise traders take over, until they panic in a hysteresis like phenomena. So there are phases. When rational optimizers are in charge, so are traditional value metrics. They are right. When the noise traders are in charge, it is the "greater fool theory". Then they are right, until they are very, very wrong.
Bob Klapetzky http://www.alphaadder.blogspot.com
[...] Fox, author of The Myth of the Rational Market, is in an interesting interchange with Eugene Fama, patriarch of efficient-market [...]
There's always been a curious disconnect between the daily work of fund managers, who seem pretty capable of agreeing there are market inefficencies in the market, and the way they discuss the market in theory, where a stricter version of EMH comes into play.
I think if there's a charge about EMH, and the state of macroeconomics in general, is that there has been a growing disconnect between modeling and reality. When you build models to prove a negative, when you purposfully ignore historical bubbles that your calculations can't predict, than you've left your science open to some pretty basic attacks.
No model and theory has to be perfect. But when challenged, real science adjusts to fit reality. Economists at large seem more inclined to challenge the validity of reality itself.
I agree with Roth. I keep bringing up the commodity bubbles of 2007-2008, and the primary cause of that was herd mentality. The winners were the people who could most accurately predict which direction the herd would move. In the case of GS and Morgan Stanley, they kept firing gun shots to stampede the herd in a particular direction.
There is a small difference between this and betting on horse races, the difference being that some bettors can influence the outcome of the race.
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