Published Opinion and the Efficient Market Hypothesis (amv)

Fg and I have written a little defense of economic and financial theories for a magazine, especially a defense of the EMH. This is necessary, since published opinion makes the profession's believe in EMH at least partly responsible for the Great Recession. As soon as our article is published, we'll post it. Until then, I post in full some remarks by Sam Wylie on Core Economics pointing to the same direction:

"Before the GFC [Geat Financial Crisis] journalists and columnists seldomly mentioned financial market efficiency. Not only was the efficient markets hypothesis (EMH) not a hot topic, but I think that journalists realised that the market efficiency has a precise definition and without a complete understanding of that definition they might come unstuck by discussing the EMH. But now it is trendy, almost compulsory in some quarters, to mention the EMH as a primary cause of the GFC and disparage it wherever possible. Here are some examples of discussion of the EMH.

1. From the FT on 27 October 2009 “… and a belief in efficient markets proved wrong. These beliefs must be abandoned.” This is an example of the common usage of the EMH as a straw-man. Nobody believes that financial markets are perfectly efficient. Grossman and Stiglitz proved in 1982 the impossibility of perfectly efficient markets. All financial markets are inefficient to a greater or lessor degree. [I may add that the EMH points to equilibria, conditional on all information available (public and private) and conditional on the structural believes of economic agents. Thus EMH describes 1) temporary equilibria and 2) these equilibria are only as good as the underlying information and the expectations derived from it. Financial markets trade future values! According to the EMH, finacial markets are informationally efficient, not necessarily allocatively efficient! (See the Lucas-quote here.) It says: The best predictor is the market! But the best approximation may not be the right price! (see fg's post) No economist has ever denied that expectations can fail. That's why for EMH it is sufficient that markets are temporary equilibria and not Rational Expectations Equilibria: theory tells us that RE equilibria require superhuman information processing skills. For real-world traders EMH simply means that they shouldn't believe in vodoo! The only systematic way to exploit above-average returns is either by having new private information, a better economic understanding, or - the most important case - at the cost of above-average risk. There are no secret rules to beat the market; amv]
2. John Quiggin writing in the AFR on 5 Nov 2009. “With the spectacular failure of the efficient markets hypothesis over the last two years, it is no longer possible to put any faith in general claims about the superiority of the private sector”. This example shows that “failure” of the EMH can now be used to explain anything.
3. Brian Toohey in the AFR on 14 November 2009 quoting Jeremy Grantham “… it is worth noting that every valued job created by financial complexity is paid for by the rest of the real economy, and talent is displaced from real production, as symbolised by all the nuclear physicists on proprietary trading desks.” This quote is an example of the desire to talk about market efficiency leading respected columnists a long way from their area of expertise.
4. The Economist on 12 December 2009 in the Economic Focus column “If markets were truly efficient, carry trades ought not to be profitable because the extra interest earned should be exactly offset by a fall in the target currency”. This example makes my point that journalists used to be reluctant to discuss market efficiency for fear of demonstrating that they don’t understand basic finance concepts. But now even newspapers of the quality of the Economist are happy to publish anything that discusses market efficiency, regardless of how uninformed the commentary is." [Carry trades are perfectly compatible with EMH, since in the real world many exchange rates are pegged (think of the so-called Peso problem and the carry trades prior to the Asian crisis 1998). In such a case, the involved monetary authorities themselves provide a free lunch to the financial market. Second, carry trade exploiting the term structure is perfectly compatible with the EMH: higher long-run returns come at additional risk. This is the core prediction of the EMH; amv].