Although Paul Samuelson and Eugene Fama were jointly responsible for the formulation of EMH, they had very different views of how it should be interpreted.

Samuelson maintained the distinction, characteristic of the Keynesian-neoclassical synthesis between microeconomics, where a standard competitive market analysis was applicable, and macroeconomics, where a Keynesian analysis was needed. He argued that while tests of the EMH showed that financial markets were micro-efficient, the experience of bubbles and busts showed that they were ‘macro-inefficient’.That is, the efficient markets hypothesis works much better for individual stocks than it does for the aggregate stock market.

Samuelson’s position means, for example, that is difficult, if not impossible to outperform the stock market by examining the price history of individual stocks, or by poring over company reports. But it is possible to identify bubbles in the stock market as a whole, and to propose policies to stabilise asset markets. Writing in 1998, as the dotcom bubble was approaching its peak, Samuelson called for increased interest rates to deal with the ‘quasi-bubble’ on Wall Street. And, repeating Keynes response to the idea that rational speculators would always prevent such bubbles getting out of hand, Samuelson wrote
‘We have no theory of the putative duration of a bubble. It can always go as long again as it has already gone. You cannot make money on correcting macro inefficiencies in the price level of the stock market.’

But by the 1990s, Samuelson was in the minority, and his view that the EMH was consistent with macro-inefficiency commanded little support. The alternative interpretation, more logically consistent (if less consistent with reality), that the financial market price of an asset was not merely the best estimate of its value relative to other assets of the same kind, but was the best possible estimate, given available information.

This maximal interpretation of the EMH was espoused in academic works by Fama and his many students and followers and by the 1990s, accepted by most finance theorists, and nearly all policymakers. It was popularised by such writers as Thomas Friedman, whose The Lexus and the Olive Tree warned governments that the could not possibly hope to resist the collective financial wisdom embodied in the ‘Electronic Herd’ of global financial traders.[1]
The implications of the efficient markets hypothesis go well beyond financial markets. The EMH provides a case against public investment in infrastructure, and implies the macroeconomic imbalances, such as trade and current account deficits should not be regarded with concern and, provided they arise from private sector financial transactions, are actually both beneficial and desirable.

The right price

The EMH implies that the prices generated by stockmarkets and other asset markets are the best possible estimate of the ‘right’ price for the assets concerned. But what does it mean to say ‘The Price is Right’? From the point of view of an investor, the value of an asset is determined by the flow of income it generates over the period for which it is held and the disposal value (if any) at the end of the period. This stream of payments can be converted into a current value by a discounting procedure (the opposite of working out a future value using compound interest): the problem is to choose the ‘right’ risk adjusted discount rate.

Given efficient markets, economic analysis suggests that the discount rate should be determined by the socially efficient allocation of the aggregate risk for the economy as a whole among individual consumers. This gives rise to a model of the determination of the prices of capital assets called (perhaps unsurprisingly) the Capital Asset Pricing Model, or CAPM. Economists who want to stress the point that the asset prices are ultimately determined by the preferences of consumers sometimes make this explicit and refer to CCAPM, the Consumption-based Capital Asset Pricing Model. The difficulties of CCAPM will be discussed in Chapter …, but for the moment it is sufficient to note that the model depends critically on the efficient markets hypothesis.

If a stock price is indeed the best possible estimate of the risk-adjusted value of future dividends and resale values, then individual investors (at least those without inside information according to the semi-strong EMH) can do no better than to buy a portfolio of stocks and other asset prices that matches their risk preferences, without worrying about attempting to make their own estimates of the value of individual assets. In this sense, the price is right for them.
But there is a stronger, and more important sense in which the EMH implies that market asset prices are the right prices. Given any possible set of investments companies might make in new products or processes, market participants can estimate the value of those investments by considering the likely immediate impact on the stock prices of the companies concerned, or the likely return in an Initial Public Offering (IPO). Capital markets will fund the subset of investments with the highest market value. If there are no relevant market failures outside capital markets, the EMH says that these will also be the most socially valuable investments.

The qualification about market failures requires some clarification. Suppose a company is considering an investment that will be highly profitable but environmentally damaging. Then stock markets will value the company on the basis of the profits, and will fund the investment, even though it may be less socially valuable than an alternative, more environmentally friendly choice. In this case, the financial market price is not the ‘right’ price.

But, an EMH advocate will say, the answer is not to try and change financial markets, for example by promoting socially responsible investments. Rather the correct response is to address the market failure directly by ‘getting prices right’ in the relevant market, for example by taxing pollution or (if that isn’t feasible) by imposing tighter environmental regulations. In fact, a sufficiently strong EMH advocate will argue, even the prospect of such regulations will depress the value of the company, and this will lead markets to kill socially damaging projects even before governments have got around to responding to them. Given the EMH, all is for the best in the best of all possible worlds (provided “possible” is defined carefully enough).

Asset bubbles and imbalances

The efficient markets hypothesis implies, in essence, that there can be no such thing as a bubble in the prices of assets such as stocks or houses. Such a claim, seeming as it does to fly in the face of centuries of experience, requires a fair bit of faith in the analysis underlying the EMH. But, in the euphoric atmosphere of the 1990s, such faith was in abundant supply.

The argument begins with the claim that, if a bubble in stock prices were indeed observable, speculators would sell the asset in question and go on to sell it short (that is, sell assets they did not hold in the expectation of being able to buy them later at a lower price). This would ensure that the price returned rapidly to the true market value.

But as Keynes had pointed out decades earlier, this argument only stands up if bubbles are short-lived, so that speculators are quickly vindicated. As Keynes said

“He who attempts it [speculating on the bursting of a bubble] must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. “ Ch12 p140

More succinctly, in words widely (though apparently apocryphally) attributed to Keynes himself ‘the markets can stay irrational longer than you can stay solvent’. Lots of investors, from small-scale individual speculators to billion-dollar fund managers like Julian Robertson of Tiger Investments bet against the stockmarket bubble of the 1990s and lost.

A second argument is that, even if bubbles are real, there is little nothing policymakers can or should do to burst them. This was the conclusion reached by a number of central bankers who, unlike Greenspan, saw irrational exuberance in stockmarkets and property markets as a likely source of future trouble. A study by Borio and Lowe of the Reserve Bank of Australia pointed out the dangers of asset bubbles. However, in a policy environment where the only way of restraining speculation was to raise interest rates, they concluded that central banks could do little more than issue warnings.

It is worth noting, that although Australia experienced a serious land price bubble, lending standards were held to much stricter levels than in the US or other markets. It may be that the warnings of the Reserve Bank had some influence on the policy decisions of prudential regulators.

Finally, some supporters of the EMH argued, along lines first popularised by Austrian economist Joseph Schumpeter,, that even if bubbles lead to massively wasteful investment, they generate innovations that are beneficial in the long run (the phrase ‘creative destruction’ was widely used in this context).
Supporters of the EMH also engaged in a fair amount of historical revisionism to argue that famous historical examples of bubbles, from the Dutch tulip mania to the Roaring Twenties and beyond, were actually rational responses to new market conditions, often exaggerated in subsequent retellings. The Dutch tulip mania saw the price of a contract for a single tulip bulb exceed 10 times the annual income of a skilled craftsman Economist Peter Garber argued that these contracts were never fulfilled, and were little more than “bar bets”, and hence did not violate the EMH. Earl Thompson also defends the EMH, but argues that the prices were in fact rational in the light of the market rules prevailing at the time.

Implicit in all of these arguments was the conclusion that, in a well-developed modern market, with transparent dealing and with all parties subject to the scrutiny of auditors and ratings agencies, an irrational bubble could not possibly develop or be sustained. This conclusion formed the basis of financial policy in the decade leading up to the Global Financial Crisis of 2008.

The growth of the financial sector

In most of the simple models from which the Efficient Markets Hypothesis was derived, the financial sector did not exist as an industry. Financial markets were assumed to set the price of assets without any cost to the economy. As we have seen, the question of how those with information or forecasting skills could gain the returns they needed to justify their efforts was a significant theoretical problem for strong forms of the EMH.

Although no truly satisfactory analysis of the role of financial institutions in efficient markets was ever produced, advocates of the EMH came to accept that the cost of financial market transactions was equal to the value of the information they incorporated in asset prices. It followed that, as financial transactions were liberalised and the economy became ever more sophisticated, it was economically and socially desirable that the financial sector should grow.

And grow it did. In simple economic terms, the growth of the financial sector since the mid-1970s has been staggering. The financial services industry's share of corporate profits in the United States rose from around 10% in the early 1980s to 40% in 2007 (Már Gudmundsson,, at a time when the profit share of national income was also growing strongly.

Volumes of financial activity grew at rates that defy any simple interpretation. The Bank for International Settlements has estimated the global volume of futures market transactions in 2007 at $1.6 quadrillion dollars, or about 30 times the total value of all stocks traded on share markets. Notional volumes of outstanding derivative contracts are similarly massive. In the normal course of events, most of these transactions net out to zero, but even a small mismatch can produce losses (or gains) of many billions.

Along with all this, the income and wealth of those working in the financial sector grew massively. The salaries of financial sector executives outstiripped those prevailing in other industries, at a time when executive salaries in general rose to huge multiples of the incomes of ordinary workers. Such massive accumulations of wealth translate naturally into political power. Particularly in the United States, both major political parties were heavily influenced by generous donations from Wall Street firms.

But the political power of the finance sector does not depend solely on command over economic resources. After the economic dislocation of the 1970s, the financial sector became, in perception and to some extent in reality, the most important guarantor of economic stability and prosperity. Governments sought desperately to gain and maintain the AAA ratings issued by agencies such as Moodys and Standard & Poors. The alternative was the political disgrace of a downgrading and the ultimate threat of capital flight, as occurred when the Mitterand government in France attempted to introduce an expansionist macroeconomic policy in the early 1980s.

Private and public investment

Casual observation suggests that both the private and public sectors have difficulty in managing investments. Public sector investments, from the time of the Pharoahs onwards, have included plenty of boondoggles, white elephants and outright failures. But the private sector has not obviously done better. Waves of extreme optimism, leading to massive investment in particular sectors, have been followed by slumps in which the assets built at great expense in the boom lie unfinished or idle for years on end.

The EMH supports the first of these observations, but suggests that the second must be mistaken. Since public investments are not subject to the disciplines of financial markets, there is no reason to expect their allocation to be efficient.

By contrast, according to the EMH, private investment decisions are the product of an information system that is automatically self-correcting. The value given by the stock market to any given asset, such as a corporation, is the best possible estimate … If the managers of a given corporation make bad investment decisions, the value of shares will decline to the point where the corporation is subject to takeover by better managers.

The EMH, which enshrines the market price of assets as the summary of all relevant information, is inconsistent with any idea that managers should pursue the long-term interests of corporations, disregarding short term fluctuations in share prices. On the EMH view, the short-term share price is the best possible estimate of the long-term share price and therefore of the long-term interests of the corporation.

If the EMH is accepted, public investment decisions may be improved through the use of formal evaluation procedures like benefit-cost analysis, but the only really satisfactory solution is to turn the business over to the private sector. In the 1980s and 1990s this reasoning fitted neatly with the global push for privatisation, discussed in Chapter .

The EMH implies that governments can never outperform well-informed financial markets, except in cases where mistaken government policies, or a failure to adequately define property rights, leads to distorted market outcomes. If governments are better informed than private market participants they should make this information public rather than using superior government information as a substitute for public policy.

To sum up, the EMH implies that private enterprise will always outperform government, and that governments should confine their activities to the correction of market failures, and to whatever income redistribution is needed to offset the inequality of market outcomes (in the view of most EMH proponents, not very much).

Macroeconomic implications

There are also important implications for macroeconomic variables such as the balance of international trade. From a traditional Keynesian perspective, large imbalances in trade are a sign of trouble to come, since they will inevitably produce an unsustainable buildup of debt. Economists like Nouriel Roubini and Brad Setser were particularly vocal in warning of the trouble ahead for the US economy. I made the same point in an article published in the Economist’s Voice, with the self-explanatory title ‘The Unsustainability of the US Trade Deficit’.

By contrast, the EMH leads to the conclusion that economic analysis should be focused on asset values rather than on income flows. Observations of current income flows are informative only about the present, whereas asset values capture all relevant information about current and future income flows. An increase in asset values implies an increase in the present value of future income and therefore in the optimal level of consumption.

Once the EMH is accepted, there is no need to worry about imbalances in savings and consumption. International capital movements can be seen as the aggregate of a large number of transactions between ‘consenting adults’, buying and selling financial assets in markets which, according to the EMH, have already taken into account all available information about future risks. If a national government has better information, the appropriate response is not to act on it, but to release the information to the markets. In the United Kingdom, this view became known as the Lawson doctrine, after Chancellor of the Exchequer Nigel Lawson, who argued in 1988 that current account deficits that result from a shift in private-sector behaviour should not be a public policy issue.

On the traditional, income-based view, by contrast, asset-based arguments are misleading and dangerous. By the time sentiment shifts in asset markets, the opportunity for an orderly adjustment will already have been lost. Advocates of the traditional view pointed to episodes of contagious panic in financial markets, most recently the Asian financial crisis of 1997.

The traditional response to macroeconomic imbalances such as trade deficits was the adoption of contractionary monetary and fiscal policies aimed at reducing demand for imports and at forcing domestic producers to seek export markets as a response to lower demand at home. The resulting ‘stop-go’ policies caused substantial suffering and economic dislocation.

Once it is realised that sustained macroeconomic imbalances ultimately reflect financial market failures, this response can be seen to be inappropriate, as can the benign neglect associated with the consenting adults view. The appropriate response is to intervene in financial markets to restrict the unsound lending practices that drive the growth of such imbalances.

[1] The term is an allusion to the ‘Thundering Herd’ a nickname for the iconic Wall Street investment bank, Merrill Lynch. In October 2008, Merrill Lynch was rescued from imminent collapse through a takeover by Bank of America, which was in turned bailed out to the tune of billions of dollars by the US government.


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