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Why 'efficient markets' are merely wishful thinking

While most of our attention these days is focused on the tight and tense U.S. presidential election and what the results may portend for Canada's increasingly cloudy economic prospects, Europe is proving an excellent laboratory for politicians and economists still preaching the benefits of austerity.

Greek Finance Minister Yannis Stournaras revealed last week that public debt will be closer to 190 per cent of GDP next year than the 179 per cent projected just weeks ago. The economy will shrink by another 4.5 per cent; and the deficit isn't budging from its 5.2 per cent level. Not even an extra two years of grace from its European and IMF minders will enable Athens to come anywhere near its imposed targets. So a splintering government will attempt to push through further public-sector austerity cuts this week. More strikes will ensue; and the slow dance toward default will continue.

Meanwhile, over in Portugal, the government hiked taxes dramatically last week, after finally realizing it could not meet deficit targets set by its overseers through deep cuts alone. The results in Spain have been no better. And the supposed benefits of austerity, including increased confidence and investment, have proved elusive. No wonder a British study concluded that the euro zone's "fundamentally flawed" austerity drive is only making a dreadful situation worse.

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Plenty of smart economists, including a very vocal Paul Krugman, have long preached against this form of economic suicide by a thousand cuts. But austerity advocates argue, as The Economist did recently, that the problem lies with the way the Europeans have gone about plugging the holes in their sinking fiscal ship. "The experience of the past couple of years argues against sudden sharp cuts, and especially against tightening more when the economy turns out weaker than expected," the magazine intoned. "[T]he main lesson is that austerity hurts more if it is not accompanied by bold monetary loosening."

What it shows is how hard it can be to kill off a bad idea in the world of economics.

Just ask Canadian mathematician and author David Orrell, whose 2010 book Economyths , a pointed assault on mainstream economic thinking, met a predictably frosty response in traditional economics circles. His latest book, Truth or Beauty , ranges over much broader scientific ground, but reserves room for a further critique of neoclassical economics and such cherished theories as the efficient market hypothesis (EMH). That's the one that holds prices of stocks and other assets reflect all available information and that the markets as a whole are rational, stable and smarter than any individuals, who can't possibly hope to outperform them.

EMH stems from our impulse, dating from the ancient Greeks, to see the world in simple, elegant mathematical terms. To this end, economists made various assumptions "in order to basically make the economy mathematically tractable," Mr. Orrell said in an interview at his midtown Toronto apartment. One of those assumptions was that people would act independently and rationally in their own self-interest. Which explains why a true believer like former Fed chief Alan Greenspan was so shocked when Wall Street bankers failed to do so in the months leading up to the Great Meltdown of 2008.

I wrote three years ago that this shaky theory that had long dominated academic thinking about the markets had finally been buried under an avalanche of uncontrolled greed, bizarre asset valuations, spectacularly burst bubbles, the historic global financial collapse and a wave of other irrational behaviours that the hypothesis couldn't possibly explain. But I was wrong.

"The idea that we're still talking about this efficient markets stuff is kind of amazing," Mr. Orrell said. EMH fans have done some tweaking to the theory and seek to explain the unexplainable by blaming Washington, for example, for blatantly interfering in the workings of the mortgage market.

But Mr. Orrell doesn't buy the case for the defence. "It's very hard to portray the recent crashes as efficient in any way." EMH, he writes in Truth or Beauty, "enjoys no empirical support. Its popularity amongst economic modellers can be explained by the fact that it did exactly what the butterfly effect did for weather modellers: It gave an excuse for prediction error and helped to preserve the idea that models are not flawed."

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So why does EMH still hold so much sway in academic and investment circles, where it remains a supporting pillar for such concepts as passive investing and less regulation?

Think about who benefits, Mr. Orrell suggests. "The fundamental message of mainstream economics is that the price is right." That provides a defence for stratospheric CEO salaries and widening income inequalities. And if you can argue that the only time natural market efficiency is seriously threatened is when heavy-handed governments meddle in the process, so much the better.

"If you have a theory which says that markets are efficient and everything is rational and it's all okay, that's the perfect theory for the 1 per cent."

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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