Wednesday, January 26, 2011

Efficient Markets and the financial crisis

Craig Newmark discusses Robert Shiller's view that the Efficient Market Hypothesis predicts that the financial crisis couldn't happen.

Craig thinks Shiller is wrong, and I agree with Craig.  I'm a little surprised that Prof Shiller would actually make such a statement.    

It's worth remembering that the EMH is actually quite narrow in its predictions.   All the EMH states is that prices should reflect all available public information.  This coupled with frictions in the market, such as the inability to short certain stocks means that a market collapse can occur when there is a great deal of uncertainty about the future.  

The EMH does not imply that markets should function in a nice orderly fashion - only that when markets do get out of whack, investors cannot earn abnormal profits by trading on public information.

Although the EMH is quite narrow, it is also very powerful.  A simple way of thinking about how the EMH applies to the financial crisis is to ask the question: - At each point in time, was there clear information available that would allow an investor to risklessly earn an abnormal profit from trading on a mispriced security?  I think the answer to this question is no.