[A-List] Ruling Paradigm coughs up a lung

[Rob Schaap <rschaap@xxxxxxxxxxxxxx>]

Market theory unravels
Australian Financial Review  4 July 2002
John Quiggin

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.