The efficient markets hypothesis: dead and buried?

On Wednesday, a cadre of high-profile academics and commentators gathered in London to deliver a series of talks based on a book that they have co-authored on "The Future of Finance and the Theory that Underpins it".

Among the once sacred cows that was not so much challenged as vilified was the efficient markets hypothesis. Economists could no doubt argue until the cows (sacred or otherwise) come home, about what is meant by the efficient markets hypothesis, so it would help to explain first what precisely was the theory that many of them sought to condemn.

Paul Wooley, a London School of Economics academic and former fund manager who, with Lord Richard Layard, brought together the group of authors, described it as a hypothesis "grounded in the belief that competition among profit-seeking market participants will ensure that asset prices continuously adjust to reflect all publicly available information." Prices would, therefore, equate to the consensus of investors' expectations about the discounted value of future attributable capital flows.

As Wooley noted, the hypothesis provided the intellectual cornerstone for much of the monetary and regulatory policy that preceded the crisis, making it responsible for the many policy mistakes made in the decades leading up to the summer of 2007. The view of the financial sector as the epitome of competitive perfection had, he said, "beguiled central bankers into believing that market prices could be trusted and that bubbles either did not exist, were positively beneficial for growth, or could not be spotted." Regulators too were "faithful disciples", which explained why they were content with light-touch regulation.

His sentiments were broadly shared by others, including Sushil Wadhwani, Adair Turner and Sir Andrew Large.

Commentator Andrew Smithers went further, condemning the economics profession for holding the doctrine so dear for so long (it is 40 years since Eugene Fama's breakthrough paper ‘Efficient Capital Markets: A Review of Theory and Empirical Work'). "The efficient markets hypothesis is a disgrace because it's a failure of the whole economics profession. It is amazing that the hypothesis has been taken so seriously for so long. It's not bad maths, it's bad understanding of how science works," Smithers said. "The efficient markets hypothesis in its original form was testable. But in its new form it is not. It therefore falls the wrong side between Karl Popper's demarcation of what is a science and pseudo-science. If they're not testable, then they're not hypotheses."

Quite which economic theory would stand up to the full rigours of empiricism, it is hard to see. And not all agreed with the criticisms. Smithers' comments provoked one member of the audience to protest that the hypothesis was not the cause of the crisis, a response that Smithers in turn tried to rebut. Charles Goodhart, who also contributed a chapter, agreed that a failure of ideas was at the root of the crisis, but identified a different set of ideas as the culprit. He blamed "all of us" for being captured by the ideas - also pushed by academic economists - that adequately capitalised banks could always access wholesale funding markets: it was all a cock-up, not a conspiracy.

Still given the pummelling that it received from others it would seem that this particular sacred cow will be hard pressed to survive.

Yet perhaps not.

Wooley acknowledged that in the forty years that have passed since the publication of Fama's paper, the hypothesis had been "extended and modified to form an elegant, comprehensive framework for understanding asset pricing and risk." However, there is a consensus among policymakers and academics alike that a mispricing of risk was one of the key factors in causing the crisis.

Another paper presented at the event, co-written by Andy Haldane, the executive director for financial stability at the Bank of England, which examined banks' performance using existing measures of gross value added and growth accounting, found that neither took into account that banks' business models had become inherently riskier. The two measures therefore failed to accurately reflect the industry's true value.

As one member of the audience asked, if - and it's a big if - risk could be adequately priced, could this not spark a rebirth of a new, "improved" efficient markets hypothesis?

Wooley's criticism of the efficient market hypothesis suggests one reason why it should not. His argument centres on the fact that most end investors invest through fund managers, which gives rise to problems of asymmetric information, and that these investors in turn choose fund managers "obsessed with short-term strategies" at the expense of long-term stability.

During the technology bubble, he noted: "Technology stocks received an initial boost. Funds invested in the unglamourous ‘value' sectors languished, prompting investors to lose confidence in the ability of their underperforming value managers, and to switch funds to the newly successful growth managers, a response that gave a further boost to growth stocks." Added impetus to growth stocks came when fund managers switched from value to growth to avoid being fired. In Wooley's words, this "battle between fair value and momentum" meant a fund manager could be "dead right in the long-run, but nearly dead in the short-run." Technology stocks, then, rose to a level that no longer represented fair value not because risk was mispriced, but because, in a climate hooked on high returns, greed was good.

However, the alternative to a new, "improved" hypothesis would be a return, at least to an extent, to a model of finance where the public sector could again play a role in credit allocation. The spectre of such government interference may prove ultimately too depressing to contemplate. As Wadhwani said: "Economists have long understood that market failure does not, of itself, justify government intervention." For now, the efficient markets hypothesis is one sacred cow that is likely to survive.

Claire Jones is the editor of CentralBanking.com