Date created:14 September 2002 Last modified: 14 September 2002 Maintained by: John Quiggin John Quiggin
4 July 2002
With yet another round of accounting scandals in the US and Australia, the hunt is on for culprits. At the human level, the results are predictable. A few CEOs will spend a year or two in jail before they emerge to spend their multi-million dollar golden handshakes. A few politicians will lose office. And thousands of ordinary workers will lose their jobs and life savings.
But an idea is more powerful than any CEO, and more perceptive critics are starting to look hard at the ideas that led to this mess. Already, fingers are being pointed at one of the biggest ideas of the last few decades, the efficient markets hypothesis.
Although the name gives the general idea, the efficient markets hypothesis is hard to state in simple terms. To complicate matters further, the hypothesis comes in a variety of intensities, from weak to very strong. The weakest version simply says that it is impossible to predict shares prices based on their past behavior. This is bad news for day-traders and chartists, but does not matter much to the rest of us.
In the strongest version of the efficient markets hypothesis, market prices for assets such as shares represent the best possible estimate of their value, taking account of all available information, public or private. Moreover, markets yield the most efficient possible allocation of risk. Markets are not perfect, but, they are claimed to be better than any alternative institution, including governments.
During the 1980s and the 1990s, the efficient markets hypothesis came to dominate not only analysis of sharemarkets, but much of everyday life. Governments abandoned responsibility for planning public infrastructure, leaving it to the superior wisdom of 'the markets'. They tore down the web of restrictive financial regulation that had been in place since the Great Depression. Corporate managers stopped worrying about production and profits, and focused instead on their share prices. Ordinary people turned from the sports pages to the stockmarket reports.
Since it was first rigorously formulated in the 1960s, the efficient markets hypothesis has given employment to a small army of finance theorists and econometricians, designing ever more sophisticated statistical tests of its various versions.
The weak version comes out of these tests pretty well. If there are predictable patterns in share price movements, they are subtle features of long-term behavior, nothing like the trends and profit-taking we hear about every night on TV.
The strong versions, on the other hand, have been consistently refuted. Share prices are too volatile, and too prone to overshooting, to be consistent with the idea that markets rationally process information about future earnings. The equity risk premium is too great to be consistent with efficient risk-spreading. History is replete with asset price 'bubbles' And so on.
But statistical and historical evidence has rarely changed anyone's mind about anything. Only lived experience will do the job. The US bubble of the last five years should be enough to refute the efficient markets hypothesis for good, or at least until it passes out of living memory.
The NASDAQ stock market index rose by 260 per cent between 1997 and early 2000, and lost the lot in two years. The Standard and Poors 500 index rose and fell 70 per cent. Whether today's prices, or those of two years ago, are closer to true long-term value is immaterial. Either way, supposedly efficient markets have been out by trillions of dollars in their estimates of share values.
As ever more financial scandals come to light, macro evidence from movements in prices is being backed up by micro evidence about the way (deregulated) capital markets actually work. Once the efficient market view that only share prices matter is accepted, everything else goes out the window.
Executives make absurd investments to follow market trends, then doctor the accounts to make the results look good. Internal and external auditors collude in the process and are richly rewarded. Stockbrokers and analysts 'pump and dump' worthless shares, while journalists cheer them on in return for juicy tidbits. The idea that this process could lead to efficient outcomes is laughable.
Judging by the experience of other bubbles, share markets will take years to recover from the 1990s. The social and political implications will emerge even more slowly. Political programs like privatisation, cultural attitudes based on the idolisation of ruthless CEOs, and much of the ideological framework of the last two decades have been founded on the efficient markets hypothesis. They will not vanish overnight. But they are doomed, nonetheless.
Professor John Quiggin is a Senior Research Fellow of the Australian Research Council, based at the Australian National University and Queensland University of Technology.Read more articles from John Quiggin's home page
