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The market's taking a beating lately, and we're not talking here about investment returns. Rather, the theory that market prices offer valuable information is on the defensive…again.

The latest assault came over the weekend in Paul Krugman's New York Times Magazine article "How Did Economists Get It So Wrong?" Among the various indictments in the story is the charge that the efficient market hypothesis (EMH) is a principal cause of the economic ills that afflict the U.S.

Attacking EMH has become a popular sport recently, which is to say more popular than usual. Some of these attacks are exaggerated, others are misleading and some are just plain wrong, especially when it comes to interpreting (and often dismissing) EMH as it relates to investing. We've written about such issues regularly over the years and tackle the subject in more detail in our upcoming Dynamic Asset Allocation: Modern Portfolio Theory Updated For The Smart Investor, which will be published in February by Bloomberg Press. Meantime, let's focus on one point in Krugman's story regarding the management of the economy.

Krugman writes that:

the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.

Among the alleged smoking guns presented are the decisions by former Fed Chairman Alan Greenspan, who ran the central bank until 2006 and embraced a market-oriented approach to monetary policy. But equating the Fed's monetary policy under Greenspan, and currently under Ben Bernanke, with EMH is problematic.

The idea that the Fed's monetary policy and EMH are one and the same is a stretch. Yes, the price of credit is partly set by the market, i.e., supply and demand, although most of the market's influence resides at the medium and long-term points on the yield curve. Meanwhile, the Fed's influence is dominant at the short end of the curve, and the tool of choice is the Fed funds rate. But just because the Fed chooses to set Fed funds at a particular rate doesn't necessarily mean that rate also reflects supply and demand.

The Fed, in other words, manipulates the price of money at times. That may or may not be productive at times, depending on other factors. Even so, one can argue that a central bank is a necessary evil for reasons that start with the idea that the economy needs a lender of last resort. But the question before the house is: Was the Fed remiss in managing the economy in the years leading up to 2008? We can never answer definitively because we don't know how the economy would have fared if the Fed had done something different. Nonetheless, we can look back and consider what happened and review the context for the decisions by the central bank.

On that note we'll present one bit of evidence. In the chart below (click to enlarge), we graph the real (inflation-adjusted) Fed funds rate on monthly basis for the past 20 years. Note that the real Fed funds rate has been negative three times since 1989. At such times the question is whether a negative rate is warranted?

Today, one could argue "yes," given the weak state of the economy at the moment. But what about 2001-2005? Allowing Fed funds to remain at negative real rates for nearly four years looks like a crucial error in monetary policy. Such extraordinarily low real rates almost certainly contributed to the excesses that came back to bite the economy in 2008, including an excessive degree of speculation in the housing market.

This is a critical issue for several reasons. One is that economists of the monetarist persuasion argue that monetary policy casts a long shadow over the health of the economy. Accordingly, if the Fed makes poor decisions in managing monetary policy, the economy will suffer sooner or later. In fact, there's a strong case for arguing that the Great Depression was largely a byproduct of poor monetary decisions. The central bank was also responsible for much of the economic troubles in the 1970s. And it looks like the Fed made a poor decision in keeping interest rates too low for too long during 2001-2004. Initially, in the wake of the market correction of 2000-2002, low interest rates were warranted. The problem was one of keeping the price of money too low through 2005.

If flawed monetary policy is a critical reason for recent macro events, it's not clear that this is a direct indictment of the efficient market hypothesis or the idea that market prices generally contain valuable information for investing as well as managing economies.

So, what's the solution? Krugman suggests that we should discard EMH. But there's another answer and arguably a superior one: improve the Fed's monetary policy.

Alas, there's no silver bullet here, although there are some changes that could help. That starts with dispensing with the standard that Greenspan established, which favored the idea of letting one man have an undue influence over interest rates. In short, the maestro approach to monetary policy has some problems.

There are a number of alternatives, and most of the good ones involve letting the market provide more input into the setting of Fed funds. Yes, that's right: we need more of the market's influence in the design and management of monetary policy, not less. Less is what got us into this mess, despite what some EMH critics argue. It's tempting to equate Greenspan's decisions with what an EMH-inspired approach would do, but that's misleading. It's unconvincing to argue that because Greenspan dismissed the idea of financial bubbles that also means that his decisions were defacto EMH-inspired choices. Greenspan was making activist choices that weren't necessarily based on market signals. As it turned out, some of his choices were wrong. The lesson is that individuals make mistakes, and so we should be wary about letting one Fed chairman amass too much influence over the setting of interest rates, regardless of what he thinks or says.

A better approach for setting Fed funds is incorporating more price information from commodities, housing, the stock market, to name a few key variables. There's also a case for setting a stated inflation target that the Fed is routinely targeting and that everyone can judge. There's some of this going on now, but there's still too much mystery surrounding the Fed's operations and how it reaches decisions about monetary policy. In turn, that fosters the possibility of making decisions that stray too far from what the market implies interest rates should be.

Monetary policy is too important to be left solely to a handful of people. Individuals aren't gods, even if they work for a central bank. Meantime, let's also recognize that the further marginalization of market forces isn't an answer either. Prices running skyward during 2002-2007 in a wide range of assets, from homes to commodities (including gold) to stocks and bonds, were telling us something. Unfortunately, it's not obvious that the Fed was listening.

Source: Markets, Macroeconomics and the Fed