What Happened to Efficient Markets

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What Happened to Efficient Markets?

• Peter J. Boettke
• University Professor of Economics
• BBT Professor for the Study of Capitalism
• George Mason University

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Basic Point

• There are 3 competing hypotheses
• H1 -- Markets are first-best efficient and there
  are no unexploited activities
• H2 -- Markets are first-best inefficient, and
  government is the necessary corrective mechanism
• H3 -- Markets are first-best inefficient but
  effective at mobilizing individual initiative and
  utilizing dispersed knowledge to realize gains
  from trade and gains from innovation and in so
  doing making systemic adjustments that promote
  wealth creation and produce generalized
  prosperity
• My take -- the 3rd hypothesis is too subtle, so
  the public debate tends to focus on the first
  two, and often commits the error of leaving the
  proposition of government as a corrective to
  market inefficiency unexamined.

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Definition of Efficient Market

• Eugene Fama, Foundations of Finance, 1976, p.
  132.
• An efficient capital market is a market that is
  efficient in processing information. In an
  efficient market, prices fully reflect
  available information.
• Eugene Fame and Merton Miller, The Theory of
  Finance, 1972, p. 335.
• Such a market have a very desirable feature. In
  particular, at any point in time market prices of
  securities provide accurate signals for resource
  allocation that is, firms can make
  production-investment decisions, and consumers
  can choose among the securities that represent
  ownership of firms activities under the
  presumption that security prices at any time
  fully reflect all available information. A
  market in which prices fully reflect available
  information is called efficient.

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Challenge to the Efficient Market

• Joe Stiglitz, Whither Sociailsm? 1994, pp. 43-44.
• One of the claims frequently made of the price
  system is its informational efficiency. To be
  sure, there is great informational efficiency.
  Under the idealized conditions of the
  Arrow-Debreu model, prices do convey information
  efficiently from producers to consumers, and vice
  versa. Yet this is an extremely limited
  information problem. When a heavier
  informational burden is placed on markets ---
  when it must sort among workers of different
  ability or securities of different qualities,
  when it must provide incentives to workers in the
  presence of imperfect monitoring, when it must
  obtain and process new information about an ever
  changing environment --- markets do not perform
  so well, even in terms of our limited welfare
  criterion of constrained Pareto efficiency.

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The Hayek Hypothesis

• Hayek, Individualism and Economic Order, 1948, p.
  87.
• These adjustments are probably never perfect
  in the sense which the economist conceives them
  in his equilibrium analysis. But I fear that our
  theoretical habits of approaching the problem
  with the assumption of more or less perfect
  knowledge on the part of almost everyone has made
  us somewhat blind to the true function of the
  price mechanism and led us to apply rather
  misleading standards in judging its efficiency.
• Hayek, The Constitution of Liberty, 1960, p. 228.
• A free system can adapt itself to almost any set
  of data, almost any general prohibition or
  regulation, so long as the adjusting mechanism
  itself is kept functioning. And it is mainly
  changes in prices that bring about the necessary
  adjustments. This means that, for it to function
  properly, it is not sufficient that the rules of
  law under which it operates be general rules, but
  their content must be such that the market will
  work tolerably well.

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Smith and the Robustness of the Market Economy

• Adam Smith, The Wealth of Nations, Bk IV, chap v,
  pp. 49-50.
• The natural effort of every individual to better
  his own condition, when suffered to exert itself
  with freedom and security, is so powerful a
  principle, that it is alone, and without any
  assistance, not only capable of carrying on the
  society to wealth and prosperity, but of
  surmounting a hundred impertinent obstructions
  with which the folly of human laws too often
  incumbers its operations.

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The Surreal Situation We Are In

• Incentives and Information
• Moral Hazard and Bank Practice
• Confused signals and investment decisions
• Endogenous Demand for Government Action
• Big Government creates problems that requires Big
  Government to solve

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Monetary Policy

• Fight inflation in rhetoric but fear deflation in
  practice results in inflation
• The Constitution of Liberty, p. 332.
• the stimulating effects of inflation must cease
  to operate unless its rate is progressively
  accelerated and that as it proceeds, certain
  unfavorable consequences of the fact that
  complete adaptation is impossible become more and
  more serious. The most important of these is
  that the methods of accounting on which all
  business decisions rest make sense only so long
  as the value of money is tolerably stable. With
  prices rising at an accelerating rate, the
  techniques of capital and cost accounting that
  provide the basis for all business planning would
  soon lose all meaning.

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Fiscal Policy

• Public Debt, Public Choice, and the Governmental
  Habit
• Buchanan and Wagner, Democracy in Deficit, 1977,
  p. 56.
• Sober assessment suggests that, politically,
  Keynesianism may represent a substantial disease,
  one that can, over the long run, prove fatal for
  a functioning democracy.
• Deficits, inflation, growth of government

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The End Game of the Current Crisis
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Are Markets Efficient?

• In the sense that no errors are ever made?
• STATIC EFFICIENCY
• NO, errors are made all the time
• Errors of over optimism
• Errors of pessimism
• In the sense that errors are detected and
  corrected?
• ADAPTIVE EFFICIENCY
• YES, todays inefficiencies are tomorrows profit
  opportunities
• Profit and Loss system
• Entrepreneurial discovery and market selection

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So What Policy Path Are We On? Turning a
Correction into a Crisis

• Ownership and Regulation
• Bank Nationalization in the name of
  recapitalization will create vested interests
  that will be difficult to reverse
• Monetary Policy
• Expansion to address credit crunch will be long
  term inflationary
• Fiscal Policy
• Stimulus package that doesnt adequately address
  the microeconomic issues of market correction to
  misallocation of resources will be
  counter-productive

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Bottom Line

• Markets are self-correcting, let them do this
  work of correcting for malinvestments in the past
  by reallocating scarce resources and re-directing
  economic activities
• Governments role should never be envisioned as
  an active corrective to market imperfections, but
  be limited to establishing the framework of rules
  and their enforcement that effectively govern
  economic interaction