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Article from The Economist suggests the Efficient Market Theory is Dead


The demand for financial assets is not like the demand for iPods

The Economist, Aug 12th 2010

MARKETS work. A government would never have made a success of an iPod, iPhone or iPad whereas Steve Jobs at Apple was able to anticipate demand for such hand-held devices. Other companies quickly noted Apple’s success and produced rival devices, thereby driving down prices and widening their appeal to consumers.

Friedrich Hayek argued that markets were the most efficient mechanism for allocating resources because they represented the individual decisions of millions of consumers and thousands of producers—the wisdom of crowds, if you like. Bureaucrats and politicians would never have enough information to allocate resources as efficiently.

This newspaper believes passionately in the principle of free markets. But in recent years it has also argued that central banks should do more to counteract bubbles, even though asset prices are also set through the market mechanism.

This apparent contradiction can be resolved. Financial markets do not operate in the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally falls. When the price of a financial asset rises, demand generally increases.

Why the difference? The reason is surely that goods and services are bought with a specific use in mind. Our desire for them may be driven by fashion or a desire to enhance our status. But those potential qualities are inherent in the goods themselves—the sports car, the designer sunglasses, the fitted kitchen. Such goods may be means to an end but the nature of the means is still important.

Financial assets appeal for one reason only: their ability to enhance, or conserve, the buyer’s wealth. There is nothing that so induces a change in attitude as seeing a friend get rich. People learn through anecdote and example—the friend who sold his house for a million, the colleague who made a fortune buying dotcom stocks.

When goods prices are rising, manufacturers make more of them. The same is true of financial assets and it does not take long or cost much to create new shares. But if the underlying value of the businesses has not changed, then the creation of new shares simply dilutes the wealth of existing investors. The dotcom boom transferred the wealth of pension funds to 20-somethings in Silicon Valley.

If rising prices create euphoria, falling prices induce paralysis. Trading volume in the market tends to dry up as investors wish neither to realise losses nor to hunt for bargains. In other words the attitude of investors towards the stockmarket is the complete opposite of their attitude towards a department store. They will not rush to take advantage of a sale.

Surely there are rational investors who can profit from market booms and panics? There are some but not enough. Such rational beings are simply overwhelmed by the force of the herd. It does not help that many countries impose restrictions on short-selling (the ability to bet on falling prices). There is also, as Paul Woolley of the London School of Economics has pointed out, an “agency” problem. Many investors have their money managed by professionals, whom they select on the basis of past returns. Given that managers usually have a bias toward a particular style of investing, this causes even more money to flow to the most popular stocks.

After so many financial crises in the past 40 years most reasonable people would now accept that bubbles in asset markets can exist. The feedback mechanism described by Hyman Minsky, an American economist, seems pretty clear. A period of rising markets and steady economic growth creates the incentive for investors to speculate with borrowed money. This speculation drives prices even higher, until some shock (or the desire to take profits) causes the boom to implode.

Why not just let the markets rip? Some would say that bubbles tend to coincide with periods of great economic change, such as the development of the railways or the internet. Individual speculators may lose from the resulting busts but society gains from their overoptimistic investments. However, this argument is harder to sustain after the recent bubble in which society “gained” some empty condos in Miami and holiday homes in Spain.

The evidence is clear that the clean-up costs after debt-financed bubbles are too high. Central banks and governments do have to intervene when credit growth and asset prices (particularly in property) start dancing their toxic two-step. Asset markets do not work as well as those for consumer goods.


Disclosure: 65% sh, 35% cash