EMH Funeral Oration, by Satyajit Das
Like Mark Anthony with Julius Caesar, many have now come to bury the Efficient Market Hypothesis (”EMH”) rather than praise it. Amusingly, some of the critics who have recently found their voice are those who for years made their living from financial markets that were predicated in no small measure from the intellectual dogmas that EMH was central to.
In his previous book Dot.Con, John Cassidy, a writer for the New Yorker, provided a penetrating history of the Internet bubble and its bust. In How Markets Fail, Mr. Cassidy attempts a critique of modern economics. In this regard, he covers similar ground to Justin Fox’s The Myth of the Rational Market and Pablo Triana’s Lecturing Birds on Flying.
At its best, How Markets Fail provides a vivid history of recent economic thought and its influence on events that laid the foundations of the global financial crisis. Drawing on anecdotes and interviews, Mr. Cassidy provides an accurate outline of the developmental trajectory of modern economies.
His description of a noted confrontation between Raghuram G. Rajan and orthodox economists led by Larry Summers and members of the Fed, at a Jackson Hole meeting is revealing. Rajan, then the chief economist of the International Monetary Fund, warned about the risks embedded in the financial system. His detractors blithely denigrated the concerns on ideological grounds.
Mr.Cassidy also attempts to extend the text to encompass a critical review of what he calls “Utopian Economics”. The central focus of the criticism is that society is best served by individual self-interest and free markets. Mr. Cassidy’s argument is that individual self interest does not work, markets frequently fail, price mechanisms are flawed and markets are plagued by problems of information asymmetry – different levels of knowledge between participants.
In his criticisms, How Markets Fail is perhaps a little too eager to embrace behavioural economics and the work of Hyman Minsky. Useful as both alternatives are, they are also incomplete explanations of the complex economic and financial relationships.
In the final section of the book argues that it was these failures that led to the disastrous sequence of events that caused the global financial crisis.
Well written and researched, How Markets Fail is superior to the growing list of titles that cover similar ground. Mr. Cassidy largely succeeds in his objectives although the book does not extend the debate. The book undoubtedly will introduce a new generation of readers to the debate and encourage further debate.
There are some contentious and erroneous pieces of analysis of individual technical elements of the theory. In this regard, Donald Mackenzie’s brilliant An Engine Not A Camera provides a more technical and deeper analysis of aspects of the theory.
Recent criticism of the EMH, Chicago economics and “free market idolatry” tends to gloss over some interesting anomalies. Markets are rarely entirely free and regulatory failures were a contributing factor to many of the problems that have emerged. That is not to make the case for unfettered ‘red tooth and claw’ capitalism but to point out that many proposed regulatory interventions will not necessarily have the intended effects.
All economics is deeply embedded in a political, cultural and sociological framework. In many ways, it is symptomatic of these underlying issues.
For example, the analysis of sub-prime mortgages misses several factors. Firstly, a lack of growth in real income, especially for middle and lower paid employees, made it difficult for them to achieve the material success that was daily sold to them by the media and advertising. Secondly, the rise of stated income and low or no documentation mortgage reflected the change in work practice where large parts of the work force were no longer employed full-time. Casual or part-time employment and contracting arrangements made the required proof of income difficult.
Interestingly, many problems arise from the lack of humility about the theories. They are, at best, incomplete and highly conditional models that compare unfavourably to middle-age medical and religious superstitions.
Robert Merton articulated this concept precisely. “At times we can lose sight of the ultimate purpose of the models when their mathematics become too interesting. The mathematics of models can be applied precisely, but the models are not at all precise in their application to the complex real world. Their accuracy as useful approximations to that world varies significantly across time and place. The models should be applied in practice only tentatively, with careful assessment of their limitations in each approximation.” Ironically, the speech was less than a year before the collapse of LTCM. Writing in 1995, Merton foreshadowed the events that were to unfold 3 years later at LTCM: “any virtue can become a vice if taken to extreme”.
As recent events in Copenhagen suggest, the only thing that history tells us is that mankind generally are poor learners. Mr. Cassidy quotes a recent column by Harvard’s Greg Mankiw: “despite the enormity of recent events, the principles of economics are largely unchanged.” Professor Mankiw suggested that student still needed to learn about “the efficiency properties of market outcomes.”
How Markets Fail is perhaps merely a sub-set of a wider phenomenon – How Mankind Fails.