For some I know this will seem a little too low on the list, but it is low because it really is low. When you are trapped inside GET (general equilibrium theory) reality is your enemy. Inside GET everything is tranquil–like a heroin addict after the needle is in and the payload delivered. In this exotic den of opium everything is tractable (well no really, Nash cooked this dream off like a poet in the night). Take a brave step away and not all that starts well ends well–and here we are not just talking about aggregation problems.
The efficient market hypothesis (EMH) not only claimed that financial markets were narrowly efficient as in they embodied all the relevant information and said information was conveyed in usably due time, but, also, that following Hayek such information was superior to any information that could be gathered and thus regulated by a central authority.
The outside play here was that ay attempt to regulate financial markets was doomed to failure because market participants would necessarily have at their disposal timely and thus superior information than public regulators. This argument got pushed so far that it was even argued that self regulation by private individuals would be superior as private actors would have better information. This logic of course suffered from a begging the question problem as in: if information is rapidly disseminated by market actors why can’t the state access that information and evolve policy and regulations in lock-step? That is to say, if information is efficiently conveyed why can’t regulators access and then use this information to regulate.
Two defences are available to the apostles of EMH. The first would argue that because the state is not a direct player in markets it in fact does not have access to this information. This is likely true, but the problem is that such a defence invites government participation in financial markets precisely so it can monitor and regulate the industry. YET, this conclusion is exactly the one EMH was designed to trounce. EMH was above all about the capacity of markets to auto-regulate. Why after all is the state needed when private markets are already efficient.
The second, and preferred, line of defence is then the argument that markets were efficient but the quality of the information was bad and that in time markets self corrected via what layman have come to call the Great Financial Crisis (GFC). Here the GFC is painted not as a crisis but an updating from poor information to good and is thus a confirmation of the EMF.
This second line of defence of course suffers from the obvious wrinkle that it boils down to the proposition that markets get things hopelessly wrong and that they can do so for such a prolonged period of time that the whole economy (not just finance) gets sucked into the vortex of ignorance. Presented as such the second line of defence is rather effervescent. For if the updating process takes such a long time and is capable of spreading bad information across a whole host of different markets from housing through to food and energy then the case for government regulation would seem strong.
But alas no! No because we only need to default back to defence one which is that the state does not have any better information than markets. But this only begs the question about the role of the state not just in terms of the regulator but in terms of a participant. In principle there is nothing that stops the state from becoming a significant player in financial markets: taking in information and then asking prudential third party questions.
In a nutshell those who would defend EMH via the second stratagem did so to avoid increased state involvement but then they have to defer to stratagem one in order to salvo the second. But stratagem one begs the question.
None of this is gainsaid by the obvious blooper that calling something efficient which demands that entire economies suffer the pain of “updating” is incredibly glib. Auto-regulation ought to imply smooth processes of adjustment. IF what EMH boils down to is that good information is turbulent which is eventually self-correcting after long period of pain then we really are back to the debates which raged before and after the Second World War.
My bet is this: Diamond and Fama will never win the Swedish bank prize but many economists will retain the ontological model in the back of their heads and demand no less from their graduate students.
A pity really.