Market theories did not cause crisis

This is my latest comment from Fund Strategy. It is a bit more technical than usual.

Critics can easily pick holes in the efficient markets hypothesis (EMH) as an explanation of financial market behaviour (see cover story on p18). But blaming the EMH for the recent economic crisis, as some are doing, is absurd.

The essence of EMH is that prices tend to embody all the available information in efficient markets. For example, the price of an individual stock will reflect what is publicly known about that company.

For supporters of EMH the markets are essentially information processing machines. Investors tend to behave rationally as they react to the flow of information.

This theory had already lost ground over the years but was dealt a heavy blow by the financial crisis of 2007-09. The notion that markets behaved rationally seemed increasingly unrealistic.

Models of behavioural finance have gained ground as an alternative explanation. Rooted in psychology, they emphasise the importance of emotion over reason. They take into account the human propensity to behave irrationally, to panic at times of crisis.

On the economic side, those who blame EMH for the recent crisis see it as at the core of free market ideology alongside rational expectations theory. For example, Anatole Kaletsky, an economics writer, argues in his book Capitalism 4.0 that EMH led to a massive increase in leverage and more reliance on flawed risk management systems. “In this sense, the 2007-09 crisis could be fairly described as a failure of mathematical economics and nothing more,” he says.

This claim is flawed on several counts. First, it overestimates the influence of such theories. Practitioners in the market tend to be more pragmatic than Kaletsky suggests. Typically, they react to events rather than taking much account of financial theories.

Second, it focuses too narrowly on the importance of information. In that sense EMH and behavioural finance have a lot in common. They abstract information from the financial markets more generally.

Most importantly, such criticisms separate finance from the real economy. They fail to see that the bloating of the financial markets was itself a response to the weakness of the productive economy. Financial assets surged in value as capital was diverted from the real economy to the markets. This credit bubble was reinforced by desperate government measures to shore up a sagging economy, including high public spending, low interest rates and deregulation.

Those who blame EMH for the crisis have spent too much time playing the markets and reading financial textbooks. They fail to take a broad view of the economy as a whole.