Effecient Market Hypothesis: 40 Years of Confusion

I just finished reading a commentary by Bernard Guerrien and Ozgur Gun entitled Efficient Market Hypothesis: What are we talking about? . Inter alia the authors do an efficient job (as in 12 pages) not at demolishing the efficient markets hypothesis but rather the central confusion created by Fama’s inclusion of the term of efficiency into what had prior to the 70s been a discussion not about whether or not financial markets could be fairly described as efficient but rather about whether they could be fairly described as a “fair game.”

The distinction is incredibly important because something can be fair but not efficient and vice-a-versa. If we define “efficiency” to mean the quickest possible method to arrive at a decision between two strategies to achieve the same goal then the strategy chosen and the attainment of the goal has nothing to do with the efficiency or fairness of the process used to arrive at the decision. A coin toss would be both a fair and efficient process. A mother saying to her child “we will do X” is equally efficient but not fair.

Economics of course has a peculiar and convoluted definition of efficiency which is directly related to the the confusion introduced by Fama by maintaining that financial markets were not only a fair game but an efficient process. As the authors show, Fama conflated the fairness of the market (price formation displaying a random walk, i.e., unpredictable), with the proposition that a spot market price reflects the “true” valuation of say a publicly traded equity on an exchange on any given day, minute or second.

It is easy to imagine that an equity’s price reflects its “real” value and imagine that that price was arrived at through a contrived and unfair process (insider information). Fama conflated all these issues and that is why when queried in 2010 he responded that EMH was right because everyone got burned; that is, it is a fair game because nobody can beat the market. But as Bernard Guerrien and Ozgur Gun remark:

Now, it is not harmless to replace “beat the market” by “market efficiency”. For economists “efficiency” has a precise meaning: Pareto optimality. That is, a propriety of resources’ allocation which has little to do with stock markets and speculation. On the contrary, there is a close relation between Pareto optimality and general competitive equilibrium (through the two Welfare Theorems); it seems then natural to put forward this particular “model of equilibrium” – as it is suggested by Fama himself at the beginning of his 1970’s paper. With, as a result, even more confusion.

I will leave readers to go and read the paper to fill in the gaps. What however I found really interesting is the account the authors gave as to why such a central confusion could become the dominant account of financial markets. The conclusion they come to is:

Only ideology – strong a priori beliefs – and circumstances can explain Fama’s decision to term the “old” Bachelier-Samuelson no-free-lunch theory “efficient market hypothesis”. In 1970, Fama was professor at the University of Chicago, where the “new classical macroeconomy” was elaborated on the postulate that an economy is always – thanks to “rational expectations” – in competitive equilibrium. Efficient resource allocations (that is, Pareto optimality) results from this postulate – at least if “market failures” are excluded. Contrary to the old “monetarist” (Friedman) tradition, external shocks – even those provoked by government’ discretionary actions – are not supposed to generate inefficiencies. Agents can be (temporary) fooled, but they always realize their optimal plan. Markets became a sort of deus ex machina which instantaneously (re)allocates resources in an efficient way12. In a nutshell, they are “efficient”. That is a postulate, an a priori belief, not a (testable) result.

This is a very interesting and concise commentary and is worth readers’ time. So go read the paper.


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