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Efficient markets, bamboozled journalists and stupid regulators

Posted by Graeme in Business & Investment,Market failure,Wrong at 8:03 am on Monday, 9 November 2009

The media seems to have reached a consensus that the efficient markets hypothesis (EMH) has been discredited by the financial crises. I have been somewhat bemused by this, as I could not see the connection.

I did rather wonder if I was being stupid, and missing something that all these journalists, and a scattering of academics out to get efficient markets, all knew. I was. I did not realise how stupid regulators were. It is less surprising that journalists have been conflating a number of related concepts: the efficient markets hypothesis, rationality, related bits of financial theory, and, most of all, market efficiency in the micro-economic sense (economic efficiency)

The main problem has been with the last of these: it is the justification for laissez-faire neo-liberal politics, which has become dominant. It is the basis on which

A related problem is that both the EHM and economic efficiency have been treated as absolutely true, not normative. They are a normal state of affairs to which correctly functioning markets tend, but the deviations from the normal state are what regulators and market participants should be focused on.

What the efficient markets hypothesis says is that securities prices reflect all available information. This also implies that you cannot predict futures movements in prices from past movements (i.e. technical analysis does not work). This is entirely different from economic efficiency that is the state in which markets in products and services function optimally.

Markets may function optimally without external intervention (as is the case for a market in perfect competition, with all consumers having full information and if no externalities or public goods (side effects on people other than a buyer and a seller) ) — then they do not need intervention. How well this reflects the market in financial services, especially given the existence of government guarantees against bank failure, you can decide for yourself.

The assumption that regulator made was the lassez-faire one, that the market in financial services (not the market in securities) would function correctly without much regulatory intervention. One reason this failed is that banks have both explicit and implicit state guarantees (they are “too big to fail” because of systemic risk)

The biggest single mistake made was to allow banks to use their own risk models for capital adequacy purposes. This was particularly stupid given that one reason for the reforms was that banks had been manipulating the previous system. Imagine you are running a bank and you are making a choice of different risk models. One says that you need to raise a lot more capital, and shut down some of your most profitable businesses (because they need so much capital raised that it would be uneconomic to do so). Another model says everything is fine. Which to you choose? If each model was devised by a different quant, who do you give a big bonus to?

Obviously, that is a gross oversimplification of how banks choose risk models: the process would involve many people, and there would be a lot of scrutiny: but everyone doing the scrutiny would have the same sort of bias.

This has absolutely nothing to do with the EMH. The only assumptions the risk models took from the EMH was that securities prices are unpredictable, and that is right. The financial theory, and the data, to do better risk models existed: fat tails, in particular, had been discussed extensively for decades before the financial crisis ()they were certainly a mainstream part of the syllabus when I did my MSc a decade ago).

Where regulators may have actually relied on EMH is in assuming that asset prices were always correct, so no unexpected nasty surprises would emerge. Even here they were really relying on rationality, not efficient markets: during a bubble prices reflect all available information, but the assessment of the information is systematically incorrect. Of course it means that the regulators did not believe bubbles happen: how did they come to that conclusion.

Now we have dealt with the stupidity of regulators, now back to the journalists. To be fair, the mis-reporting is not entirely their fault. A number of academics and other critics of the EMH have taken the chance of blame the EMH for everything that went wrong, and journalists have swallowed a line fed to them by experts.

Another reason for blaming the EMH, is to avoid admitting that the way markets have been allowed to function does not lead to economically efficient outcomes. It is a bizarre mixture of tight regulation and light touch, that largely favours big business. The problem here, is that this does not only apply to financial markets, but the whole economy, and there is little appetite among politicians, or journalists, or businesses, or anyone else that matters, for so fundamental a challenge.

Comments (8)


Comment by Richard Beddard at 10:50 am on 9 November 2009 at

Hi Graeme, your argument is highly nuanced. Sometimes the market is efficient, sometimes its inefficient. When it’s inefficient it’s still relecting all available information, just wrongly.

I think most people who are repelled by the EMH would agree with you.

On the extent to which it’s to blame for the financial crisis, I don’t know anything about risk models but suspect we put too much faith in them. That’s not to say the maths is wrong, but that it doesn’t apply all the time. Just like EMH.

There is complexity in markets that is not captured by the current breed of mathematical models, however elegant they are.

It seems to me there are three possible ways to cope:

1. Build a margin of error into the models
2. Make the existing models better
3. Develop new models

Comment by Graeme at 10:59 am on 9 November 2009 at

One point I want to make is that EMH is being blamed for the conclusions drawn from related theories.

The thing about the risk models is that banks could have used much better risk models, but did not.

Risk models will never be perfect, so we definitely do need large margins for error. In that case the advantages of sophisticated models disappear, so we might as well go back to simple regulation, such as risk weighted capital.

The other thing that happened with risk models was that VaR, which was developed to deal with short term risk from proprietary trading an similar activities, was applied to everything.

Comment by Richard Beddard at 5:37 pm on 9 November 2009 at

Still professing a lack of knowledge about risk models it may be that what links VaR to EMH is the use of price variability as a proxy for risk. Under ‘normal’ conditions past variations in price might be a reasonable indicator of future variations, but in extreme circumstances (rather like the EMH) it doesn’t work. I think the reason why a lot of these models break down is they share similar assumptions.

It’s the assumptions we’re attacking, and their applicability to the real world (or at least, how rigidly they should be applied).

Comment by Graeme at 6:34 pm on 9 November 2009 at

The link I can see is that risk models assume efficient markets (they assume that the current price plus a normal return is the best estimate of future prices, and that you cannot predict future prices from past prices).

However, although risk models depend on EMH, the EMH does not depend on the other theories behind the risk models. Discrediting the risk models, does not discredit EMH. This is especially true as many of the predictions of EMH have proved correct. You recently linked to a study showing that technical analysis does not work very well, that is one example.

When you say variability, do you mean volatility? Then the real question is: what distribution of future returns are you assuming? If you let banks use their own risk models, they will be tempted to use distributions that are not fat-tailed enough – i.e. they will be tempted to under-estimate the risk of catastrophe and hope they get their bonuses before anything goes wrong. It is a pretty good bet for the bankers, as it is depositors, investors and governments that will take losses if things go wrong.

That said, I suspect most bankers were wishful thinkers, deluding themselves as well, rather than cynical exploiters. No-one ever wants to believe the good times might end.

Comment by Value Investing: Tools and Techniques for Intelligent Investment : Interactive Investor Blog at 12:12 pm on 11 November 2009 at

[…] the Efficient Market Hypothesis to blame for the financial crisis? Only a little bit, says […]

Comment by Monevator at 10:26 am on 12 November 2009 at

I’ll happily admit to being intellectually outgunned on this subject, but I do think your initial post pointing the finger at regulators and journalists is a little wide of the mark.

Financial professionals were among the lead rank in equating all good to the efficiency of markets. They even suggested their crazy bonuses (let’s forget the ones being paid now, just pre-2008 payouts) were a manifestation of this – if (/as) the market was efficient, their bonuses must be entirely rational, and beyond debate.

In your own post you castigate regulators and journalists, but you don’t seem to consider the financial professionals who also conflated various models of risk and value. (I see you do in the comments).

I’m a bit fed up with financial agents themselves getting blame only as an afterthought (not so much here as in the wider financial media).

If a chef who doesn’t wash his hands gives his customers food poisoning, an extended inquiry might eventually look at wider standards of inspection and enforcement, but the blame wouldn’t be so swiftly directed away from the chef.

Comment by Graeme at 11:46 am on 12 November 2009 at

As far as justifying bonuses goes, the theory they were using was “economic efficiency”, not EMH, which is what I am defending here. I agree with the rest of your comment and I am quite happy to castigate the professionals too — they were greedy, reckless, and put bonuses before their duty to customers and shareholders. Is that enough castigation for the moment?

Comment by Monevator at 7:38 pm on 12 November 2009 at

That’ll do nicely Graeme!

Sorry, comments are closed