The Efficient-Market Hypothesis Needs Work

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Last week’s post outlined the GEM Project’s theory of nonstationary demand disturbances (NDD). It explains the sort of extreme instability that characterized the 2008-09 Great Recession (as well as the 1930s Great Depression). NDD macrodynamics in highly specialized market economies both needs to be understood by stabilization authorities and is not understood in the mainstream academy.

What follows tackles the second problem by looking hard at Eugene Fama’s role in macro theorists’ inability to meaningfully model the perilous NDD class of macrodynamics. Fama is singled out for attention because of his role in last week’s post. Recall that he provided the baseline neoclassical analysis that motivates mark-to-market asset pricing.

Efficient Market Hypothesis. The context for Fama’s contribution is his famous EMH, which is wholly market-centric and boldly offered as the go-to model of actual asset pricing. The EMH contends that “stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by chance or by purchasing riskier investments.”

In 1970, Fama published a review of both the theory and the evidence for his hypothesis. The paper extended and refined the basic theory, including the definitions for three forms of financial efficiency. “The weak form of the EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong form of the EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong form of the EMH additionally claims that prices instantly reflect even hidden ‘insider’ information.”

The refinements fail to address the EMH’s most fundamental challenge, illustrated by the 50% collapse in S&P 500 Stock-Market Index in the 2008-09 macro crisis. Can that behavior be consistent with the EMH? Fama has argued that his model  “held up well during the crisis and that the markets were a casualty of the recession, not the cause of it.” He is whistling in the graveyard. There is no way that such a catastrophic drop in equity prices were driven by reasonable assessments of the actual productive potential of the economy. We would have noticed if half of the capital stock disappeared or become outmoded virtually overnight. We would have noticed if he labor force, or employee skills, abruptly and hugely contracted. We know that the economy’s infrastructure did not go missing. Don’t we really know that the stock-market collapse was caused, instead, by a collapse in confidence that swamped economic fundamentals. Surely even Fama, deep down, knows that. There is simply no other way to make sense out of what actually happened.

Messages. In his consideration of the 2008-09 extreme nominal demand instability, Richard Brookstaber has challenged mainstream theorists in a basic way they have yet to accept: “Economic theory asserts a level of consistency and rationality that not only leaves the cascades and propagation over the course of a crisis unexplained but also asserts that they are unexplainable. Everything’s rational, until it isn’t; economics works, until it doesn’t.”

The GEM Project has accepted the challenge of explaining actual 2008-09 macrodynamics. It asserts that macro instability, especially extreme instability with its “cascades and propagation over the course of a crisis”, results from massive market failure. Millions of forced lost jobs and the associated reductions in output and income resulting from contracting nominal demand cannot be consistent efficient markets. It is good news that generalized exchange is capable of explaining the market failure. It is also good news that the Project  does not finger rational behavior for blame. Indeed, the GEM model crucially preserves the fundamental tenets of economic theory, optimization and equilibrium. A core message of the Project is that not possible to construct stabilization-relevant macroeconomic theory absent those two building blocks.

My concluding message is the criticality of confidence in NDD episodes. In particular, the GEM Project’s modeling of extreme instability, as summarized last week, demonstrates that investor/lender uncertainty about the credibility of stabilization authorities trend real-side objective generates rational departures from efficient-market asset pricing, providing critical conditions for the nonstationary collapse of nominal demand and consequent huge welfare. Fama’s famous EMH is a special case, rather than a general statement, of rational-behavior economic modeling.

Blog Type: Chicago School Chicago, Illinois

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